Answer to Question #203752 in Financial Math for Yoyo

Question

a. Where do we use Present Value. Give three examples and explain how PV is used in these fields

Answer 1

Solution:

Present value (PV) or net present value (NPV) is used to calculate the current total value of a future stream of payments.

Three fields where PV is used:

Financial modeling, stock valuation, and bond pricing.

Examples:

(a) If an investor needs to compare two types of investments, she can assess which one offers the best returns by comparing their present values. 

(b) An investor could receive $100 today or a year from now. Most investors would not be willing to postpone receiving $100 today. However, what if an investor could choose to receive $100 today or $105 in one year? The 5% rate of return (RoR) for waiting one year might be worthwhile for an investor unless another investment could yield a rate greater than 5% over the same period.

(c) The present value of $67,000 tells us that an investor requiring an 8% per year return compounded semiannually would be willing to invest $67,000 in return for a single receipt of $100,000 at the end of 10 semiannual periods of time. The difference between the present value of $67,000 and the single future principal payment of $100,000 is $32,400. This $32,400 return on an investment of $67,000 gives the investor an 8% annual return compounded semiannually.