Calculating Present Value of Money
Suppose your business has a job from a new customer that requires a time frame of three years to complete. In contract negotiations, you both settled on a price of $100,000, and now you’re bouncing around different possibilities for payment terms. Your company prefers to receive payment up front, but the client wants to pay after your company completes the work.
The client is so adamant about paying when you finish the job that he threatens to walk if you don’t agree to his terms. Your company agrees, but points out that, due to inflation, $100,000 received in three years isn’t really $100,000. The client doesn’t understand, so you show him thepresent value calculationto explain.
To determine what money today could be worth in three years, you have to subtract the inflation accumulated during that time. The equation goes like this: PV = FV (1+i)^-n, where PV equals present value, FV equals future value, i equals annual inflation, and n equals number of years.
Assuming an inflation rate of 3% (or 0.03), the equation looks like this: PV = $100,000 * 1.03^-3. The present value of $100,000 in three years is $91,514. If the customer waits to pay you the agreed-upon $100,000, he essentially shorts your company $8,486.
