Present value calculations involve the discounting of future cash amounts to a present value. To discount means to remove the interest, time value of money, or targeted rate of return.
The rate used to discount the future cash amounts is referred to as the discount rate, effective interest rate, yield, yield-to-maturity, market interest rate, required rate, target rate, time value of money, time-adjusted rate of return, 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 an ordinary annuity table shows the present value of receiving a series of payments of $1 at the end of each year for 5 years has a present value of 3.7908.
The greater the interest rate, the smaller the present value of the series of equal payments.
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.