Present Value of A Single Sum

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Present Value of a Single Sum

Facts: We know a future value of €73,466 is to be paid or received in five years, and want to know the
present value.

Problem: Show this situation in time diagram form and determine the present value of
€73,466 to be received or paid in five years discounted at 8% compounded annually.

Solution:

Using the formula, we solve this problem as follows.


Present value = FV(PVFn,i)
= €73,466(PVF5,8%)

1
= €73,466( 5
)
(1 + .08)

= €73,466(.68058)
= €50,000 (rounded by €.51)
To determine the present value factor of 0.68058, use a financial calculator or read the present
value of a single sum in Table 6.2 (8% column, five-period row).

ILLUSTRATION 6.11 Present Value Problem (n = 5, i = 8%)


The time diagram and formula approach can be applied in a variety of situations. Illustration 6.12
presents another present value problem.
Present Value of a Single Sum
Facts: A rich relative decides to give you $2,000 for a trip to Europe when you graduate from college
three years from now. He proposes to finance the trip by investing a sum of money now at 8%
compound interest that will provide you with $2,000 upon your graduation. The only conditions are
that you graduate and that you tell him how much to invest now.

Problem: Show this situation in time diagram form and determine the present value.

Solution:

Present value = $2,000(PVF3,8%)

1
= $2,000( 3
)
(1 + .08)

= $2,000(.79383)
= $1,587.66
Advise your relative to invest $1,587.66 now to provide you with $2,000 upon graduation. To satisfy
your relative’s other condition, you must pass this course (and many more).

ILLUSTRATION 6.12 Present Value Problem (n = 3, i = 8%)

Solving for Other Unknowns in Single-Sum Problems


In computing either the future value or the present value in the previous single-sum illustrations, both
the number of periods and the interest rate were known. In many business situations, both the future
value and the present value are known, but the number of periods or the interest rate is unknown. The
following two examples are single-sum problems (future value and present value) with either an
unknown number of periods (n) or an unknown interest rate (i). These examples, and the
accompanying solutions, demonstrate that knowing any three of the four values (future value, FV;
present value, PV; number of periods, n; interest rate, i) allows you to derive the remaining unknown
variable.

Example—Computation of the Number of Periods


The Village of Somonauk wants to accumulate $70,000 for the construction of a veterans monument
in the town square. At the beginning of the current year, the Village deposited $47,811 in a memorial
fund that earns 10% interest compounded annually. How many years will it take to accumulate
$70,000 in the memorial fund?
In this illustration, the Village knows both the present value ($47,811) and the future value ($70,000),
along with the interest rate of 10%. Illustration 6.13 depicts this investment problem as a time
diagram.
ILLUSTRATION 6.13 Time Diagram to Solve for Unknown Number of Periods
Knowing both the present value and the future value allows the Village to solve for the unknown
number of periods. It may use either the future value or the present value formulas, as shown in
Illustration 6.14.

Future Value Approach Present Value Approach

FV = P V (F V F n,10% ) PV = F V (P V F n,10% )

$70,000 = $47,811(F V F n,10% ) $47,811 = $70,000(P V F n,10% )

$70,000 $47,811
F V F n,10% = = 1.46410 P V F n,10% = = .68301
$47,811 $70,000

ILLUSTRATION 6.14 Solving for Unknown Number of Periods


Using the future value factor of 1.46410, refer to Table 6.1 and read down the 10% column to find that
factor in the 4-period row. Thus, it will take four years for the $47,811 to accumulate to $70,000 if
invested at 10% interest compounded annually. Or, using the present value factor of 0.68301, refer to
Table 6.2 and read down the 10% column to find that factor in the 4-period row.

Example—Computation of the Interest Rate


Advanced Design, SA needs €1,070,584 for basic research five years from now. The company currently
has €800,000 to invest for that purpose. At what rate of interest must it invest the €800,000 to fund
basic research projects of €1,070,584, five years from now?
The time diagram in Illustration 6.15 depicts this investment situation.

ILLUSTRATION 6.15 Time Diagram to Solve for Unknown Interest Rate


Advanced Design may determine the unknown interest rate from either the future value approach or
the present value approach, as Illustration 6.16 shows.

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