PRESENT VALUE CONCEPT Samuel L.

Baker

Discounting Future Income and Present Value

Samuel L. Baker

Which is worth more to you, according to economic theory: $200 given to you today, or $200 given to you one year
from now?

Suppose that there is no risk. You absolutely, positively, will get the money at the time you choose. Also suppose that
there is no inflation. $200 in one year will have the same buying power as $200 does today. Which is worth more?

Time Preference
Time preference is, preferring income today to getting the same income in the future. Economists assume that pretty
much everybody has time preference, and here's why: Life is short. Suppose you're broke and you need a car today to
be able to drive to the job you want. Working and saving to buy a car someday may not be your best option. If the job
you want pays better, you'll be better off borrowing money to buy a car now, even though you'll have to pay interest to
the lender.

Because there are always people in this circumstance, for whom borrowing is a good idea, there is a market for
loanable funds, and that's why there are bank accounts that pay interest. The existence of these bank accounts in turn
means that even if you don't have a pressing need for money now, you're still better off getting it now than getting it
later.

(One exception to the time preference rule is that some people like to have their future money held for them so they
don't spend it foolishly now. Contributions to Provident Fund or Insurance schemes are some examples.)

Bank Account Math

Suppose we put $200 in a bank account and leave it there for a while. The bank account pays 5% interest at the end of
each year. After one year, we'll have $210. That's the $200 we started with, plus 5% of $200, which is $10, for a total
of $210.

We can express that this way:

At 5% interest, $200 in the bank today will grow to $210 in one year.

$200 × (1.05) = $210

Present Value × (1 + Interest Rate) = Future Value in One Year

Multiplying $200 by 1.05 is mathematically equivalent to adding 5% to it.

If we leave all the money in the bank, how much will we have after two years?
Here's what we have if we leave all the money in the bank for two years:

$200 × (1.05) ²= $220.50

Present Value × (1+Interest Rate) ² = Future Value in Two Years

To calculate how much we'll have in two years, we multiply by 1.05 twice, once for the first year and once for the
second year.

If we leave all the money in the bank for three years, we have:

$200 ×(1.05) ³= $231.52

Present Value × (1 + Interest Rate) ³ = Future Value in Three Years

To calculate how much we'll have in three years, we multiply by 1.05 three times, once for the first year, once for the
second year, and once for the third year.

By now, you can probably imagine the general formula for any number of years:

$200 × 1.05 n

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PRESENT VALUE CONCEPT Samuel L. Baker

Present Value × (1+Interest Rate) n = Future Value in n Years

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PRESENT VALUE CONCEPT Samuel L. Baker

To calculate how much we'll have in n years, we multiply by 1.05 n times, once for each year.

If interest is paid and compounded more frequently than once a year, the formula gets more complicated, but the basic
idea is the same. Applying the formula,

Future Value = Present Value × (1 + Interest Rate) n

Where ‘n’ is the number of years in the future, we can construct this table (based on a present value of $200 and an
interest rate of 5%):

Present Years in the future (n)

0 1 2 3 4 5 6

$200 $210 $220.50 $231.52 $243.10 $255.26 $268.02

How $200 grows at 5% interest per year, compounded annually. ($200×1.05ª)

Now, let's use the same reasoning, except in reverse, to answer this question:

How much do you need today in order to have $200 in one year, assuming that your only possible investment is a 5%
bank account?
Present Years in the future

0 1 2 3 4 5 6

???? $200

Present Value
$200 divided by 1.05 equals $190.48 (rounded to the nearest paisa). $190.48 is the present value of $200 one year
from now, if putting money in a 5% bank account is our best investment. Under that circumstance, we are equally well
off getting $190.48 now or $200 in one year. I say that we're equally well off, because either way gives us the same
amount of money next year.

The present value of a future income amount is the amount that, if we had it today, we could invest and have it grow
to equal the future income amount.

What is the present value of $200 two years from now?

Present Years in the future

0 1 2 3 4 5 6

???? $190.48 $200

We need the amount of money that will grow to $200 in two years at 5% interest. This is the amount X such that

X × 1.05 ² = $200.

Divide both sides of that by (1.05) ² to solve for X:

X = $200 / 1.05 ² = $181.41

To calculate the present value of $200 two years in the future, we divide by 1.05 twice.

If we have a 5% bank account available, the present value of $200 two years from now is $181.41. We are equally well
off getting $181.41 now or $200 in two years. By equally well off, I mean that either way gives us the same amount of
money in year 2. Notice that the present value of $200 in two years ($181.41) is less than the present value of $200 in
one year ($190.48).

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PRESENT VALUE CONCEPT Samuel L. Baker

To calculate the present value of $200 three years in the future, how many times do you divide by 1.05?
Present Years in the future

0 1 2 3 4 5 6

$172.77 $181.41 $190.48 $200

The general formula for the present value of a future income amount n years in the future is:

Present Value = (Future Value) / (1 + Interest Rate) n

Notice that this is equivalent to the formula given earlier for the Future Value:

Future Value = (Present Value) × (1 + Interest Rate) n

The Discount Rate = The Interest Rate Used in Reverse

When an interest rate is used in reverse like this, to calculate how much you need now to have a certain amount later,
economists conventionally use the term discount rate rather than interest rate. The two terms mean the same thing. A
reason for using the term "discount rate" when you calculate a present value is that you are taking a larger number, the
future value, and calculating from it a smaller number, the present value.

Formula may be restated as Present Value = (Future Value) × (Discount Rate) n

An alternative definition is Discount rate = 1 / (1 + interest rate)

If the interest rate is 5%, the discount rate, by this definition, is about 0.9524, what 1/1.05 equals.

As you see, this alternative definition is awkward to use. The concept is really the same as in previous definition. Either
way, the discount rate is measuring the opportunity cost of capital.

To digress for a moment, this table also shows how prices are figured for ‘Deep Discount’ bonds. (A bond is an I.O.U.,
a promise to pay a certain amount at a certain time in the future. A ‘Deep Discount’ bond pays only at the end of the
time, with no payments along the way. They pay no monthly or annual interest. You get all your money the day you
cash them in.)

Imagine that there is for sale a $200 ‘Deep Discount’ bond that matures in five years. That means the bond pays $200
in 5 yeas. If the discount rate is 5%, how much will the bond sell for today? (Ignore sales expenses like the broker's
commission.)

The table below shows values for n, the number of years in the future, from 6 down to 0.
The second row shows corresponding values of $200/1.05ª.

Years in the future (n)

In this table's upper row, the ‘n’ numbers are in descending order.

6 5 4 3 2 1 0

$149.24 $156.71 $164.54 $172.77 $181.41 $190.48 $200

The numbers in the row just above show the present value of $200 in ‘n’ years, at a 5% discount rate. The number in
the n column is $200 / (1 + .05) n

Suppose you buy the bond. Two years go by, and you decide to sell the bond. If the discount rate is still 5%, how much
should you get for selling your bond, which now has three years left to maturity? (Ignore sales expenses, such as the
broker's commission.)

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How Present Value Changes When the Discount Rate Changes

So far, we've done everything with a discount rate of 5%. Now let's see how the changes in the discount rate affect the
present value. Our formula is

Present Value = (Future Value) × (Discount Rate) n

Where n is the number of years in the future that the future value will be received.

Dust off your high school algebra and tell me what happens to the Present Value in this formula if the Discount Rate
goes up or down. (Assume that the Future Value and a stay the same, and that a is bigger than or equal to 0.) Try the
exercise for different values of discount rate.

The exercise shows how present values change as the discount rate changes. Imagine that you are the Governor of the
Reserve Bank. Your Board has the power to change the discount rate in the country. Doing so makes bond prices go up
and down just like the present values in the exercise above. Stock prices go up and down the same way, because stocks,
like bonds, represent promises to pay amounts of money in the future.

Summary
The key concepts of this tutorial are:
• Income received in the future is worth less now than income received now because income you get now can
earn interest and grow.
• The future value of an amount you get now is

Future Value = Present Value × (1 + Interest Rate) n

where n is the number of years it grows.
• Therefore, the present value of a future income amount a years in the future is:

Present Value = (Future Value) / (1 + Interest Rate) n

• The discount rate is another name for the interest rate, so

Present Value = (Future Value) × (Discount Rate) n

• When the discount rate goes up, present values go down. When the discount rate goes down, present values go
up.

Adapted from tutorial by Samuel L. Baker

University of South Carolina, Norman J. Arnold School of Public Health, Dept. of Health Administration, Economics
Interactive Tutorials, July 24, 2001 Copyright © 1997-2001

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