An important concept in managing finances is the concept of time value of money, which says that if the same amount of money is available now and in the future, it is worth more now due to the potential to earn more money. By simply depositing money into a savings account, for example, the amount will earn interest over time and increase in value as a result.
For example, consider that a product is purchased and received by a company but not paid for until a year later and the purchase price remains the same. Though the price will be the same a year later, the cost will not be completely associated with the product, but will have some accumulated interest. Present value must be calculated to determine the actual cost of the product before interest. Therefore, this system is sometimes referred to as the discounted cash flow technique.
A key concept in determining present value amounts involves compounding of interest. In this concept, all earned interest is reinvested in order to earn interest at the same rate of the principal.
In order to calculate present value, it is important to understand the amount of present value, the projected future amount of value, the interest rate used to discount the future amount, and how long it will take to reach the future value. Typically, only three of these four pieces of information need to be known to calculate present value. Note that the interest rate depends on the credit history of the seller. For example, if the seller has poor credit history, there will be a higher interest rate due to higher risk. If the seller has good credit history, there will be a lower interest rate due to lower risk.
The interest rate could be annual, semiannual, quarterly, or monthly. Depending on how frequently interest is compounded, the sum totals may be different at the end of a period. With an interest rate set, shorter time periods are adjusted accordingly. For example, if an interest rate is set at 12% for a year, that would mean that each month would account for 1% of the interest rate for that year. When compounding interest on interest more frequently, smaller timeframes yield higher balances at the end of an accounting year.
When determining the present value of a single amount, note that accounting software can make these calculations for you.