Present value calculations involve the discounting of future cash amounts to a present value. To discount means to remove the interest or to remove the time value of money.
The rate used to discount the future cash amounts is referred to as the discount rate, the effective interest rate, the yield, the yield-to-maturity, the market interest rate, the required rate, the target rate, the time value of money, the time-adjusted rate of return, the internal rate of return, and perhaps others.
To assist in calculating the present value of the future amounts, one can use mathematical formulas, the present value factors contained in present value tables, a financial calculator or computer software.
The two most common present value tables are (1) the present value of 1 table, and (2) the present value of an ordinary annuity table. The present value of 1 table shows the present value of receiving a single payment of $1 sometime in the future. For example, if the time value of money is 10% per year, receiving $1 at the end of one year has a present value of 0.90909 which is calculated as follows: [1/(1 + 10%)1] or [1/(1.10)1]. The present value of receiving a single $1 at the end of two years is 0.82645 calculated as follows: [1/(1 + .10)2] or [1/1.21].
A series of equal cash amounts occurring at the end of equal time intervals is known as an ordinary annuity or an annuity in arrears. When the amount occurs at the beginning of each equal time interval, it is an annuity due or an annuity in advance.
A bond is both an ordinary annuity and a single amount. The bond's interest payments at the end of each six-month period form an ordinary annuity. The bond's maturity amount or face amount is a single amount that occurs when the bond matures. To determine the present value of a bond, both (1) the series of interest payments and (2) the maturity amount must be discounted by the market interest rate. The market interest rate is also referred to as the yield or yield-to-maturity.
Accountants may need to calculate the present value of some future amounts in order to comply with the cost principle.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.