Present value

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The value of something now. Of particular interest when that “something” is a payment obligation that falls due in the future: for example, the repayment of a loan: The present value of my promise to pay you £10 in a year’s time is something less than £10.

Why?

  • For one thing, because you have to wait a year for that money. If you wanted it now, you'd have to borrow it, and you would have to pay interest on it. Call this the “funding cost”. Deduct that funding cost from the value of the £10.
  • For another, until I actually pony up the cash, you are my creditor, and if I go bust, you may not ever get that £100. Call this the “credit risk”.
  • For a third, inflation. what £10 buys today is likely to be more than what £10 buys in a year.

Think of it another way: imagine you loaned me £10, for a year, without interest. You would never do that, right? This is why a zero-coupon bond issues at a discount. it doesn’t pay interest, so instead you buy at a discounted price which implies the interest rate you would be prepared to pay.

Careful book-keepers therefore discount the value of future cashflows back, by reference to an implied interest rate, to find their present value.

See also