What Does Present Value Mean?
The present value of money is simply the value of a future cash flow today — the value at the present. Say you have $100 in a bank at 5% interest. In one year, you would have $105. That’s called the future value of money — it is a sum of money today ($100) valued in the future ($105). Present value just works backwards. If you are owed $105 in one year, how much should you accept today? Simple, just undo the above calculation — $105/1.05 = $100. We would say the present value of $105 due in one year is $100 today if risk-free interest rates are 5%. In other words, an investor should be indifferent between $100 due today or $105 due in one year. If the $105 is due in two years you must divide by 1.05 twice which mathematically is the same as 1.05 squared. So an investor who is due $105 in two years should be willing to accept $105/1.052 = $95.24 today if risk-free interest rates are 5%. Zero-coupon bonds do not pay any interest during their life. Instead, you buy them at a discount (
