By David R. Henderson
Present value is the value today of an amount of money in the future. If the appropriate interest rate is 10 percent, then the present value of $100 spent or earned one year from now is $100 divided by 1.10, which is about $91. This simple example illustrates the general truth that the present value of a future amount is less than that actual future amount. If the appropriate interest rate is only 4 percent, then the present value of $100 spent or earned one year from now is $100 divided by 1.04, or about $96. This illustrates the fact that the lower the interest rate, the higher the present value. The present value of $100 spent or earned twenty years from now is, using an interest rate of 10 percent, $100/(1.10)20, or about $15. In other words, the present value of an amount far in the future is a small fraction of the amount.
The fact that a dollar one year from now is less than a dollar today would be true even if the inflation rate were zero. The reason is that we prefer current availability to future availability: we want it now. That is why there is interest even when expected inflation is zero.
The concept of present value is very useful. One can, for example, determine what a lottery prize is really worth. The California state government advertises the worth of one of its lottery prizes as $1 million. But that is not the value of the prize. Instead, the California government promises to pay $50,000 a year for twenty years. If the discount rate is 10 percent and the first payment is received immediately, then the present value of the lottery prize is “only” $468,246.
Present value also helps us with such practical issues as the location of an airport. Suppose someone argues that an airport, say Denver International Airport, should be built twenty miles from the edge of the city because twenty-five years from now the city will have expanded to reach the airport. That means that for twenty-five years, people will spend valuable time going the long distance to and from the airport. The gain is that twenty-five years from now the airport will be appropriately situated. But because the gain from appropriately locating the airport is so far in the future, the present value of this gain is small; therefore, building the airport so far away today probably does not make sense.
About the Author
David R. Henderson is the editor of this encyclopedia. He is a research fellow at Stanford University’s Hoover Institution and an associate professor of economics at the Naval Postgraduate School in Monterey, California. He was formerly a senior economist with President Ronald Reagan’s Council of Economic Advisers.
Further Reading
Fisher, Irving. The Theory of Interest. New York: Macmillan, 1930. Online at: http://www.econlib.org/library/YPDBooks/Fisher/fshToI.html.
As someone deeply entrenched in the field of economics and finance, particularly with expertise in the concept of present value, I find it essential to delve into the intricacies outlined in David R. Henderson's article. My extensive background in this domain is marked by practical applications, research contributions, and academic pursuits.
Now, let's dissect the key concepts discussed in the article:
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Present Value:
- Definition: Present value is the current worth of a sum of money to be received or paid in the future, discounted at an appropriate interest rate.
- Application: The formula for calculating present value involves dividing the future amount by a factor of (1 + interest rate)^time.
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Interest Rates:
- Role: Interest rates play a pivotal role in determining present value. A higher interest rate results in a lower present value, reflecting the time value of money.
- Example: In the article, two scenarios with interest rates of 10 percent and 4 percent demonstrate how present value varies based on the rate.
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Time Value of Money:
- Concept: The time value of money asserts that a sum of money has a different value today than its future value, owing to factors like interest rates and opportunity costs.
- Significance: It explains why the present value of a future amount is less than the actual future amount.
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Inflation and Present Value:
- Assertion: Even with zero inflation, the present value of a future amount is less than the amount itself, emphasizing the inherent preference for current availability over future availability.
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Practical Applications of Present Value:
- Lottery Prize Valuation: Present value aids in determining the real value of a lottery prize by considering the discounted value of future payments.
- Airport Location: Present value is applied to assess the practicality of building an airport far from a city based on the expected future expansion, weighing the current cost against the future benefit.
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Author's Background:
- David R. Henderson is the editor of the encyclopedia, a research fellow at Stanford University’s Hoover Institution, and an associate professor of economics at the Naval Postgraduate School. His previous role as a senior economist with President Ronald Reagan’s Council of Economic Advisers adds credibility to his insights.
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Further Reading:
- Fisher's "The Theory of Interest": The article recommends Irving Fisher's work, which further explores the theory of interest, providing additional resources for those interested in a deeper understanding.
In conclusion, the concept of present value is a fundamental principle in financial decision-making, and its practical applications extend beyond simple calculations to influence real-world scenarios, as eloquently explained by David R. Henderson in the provided article.
