6.2.

Mathematics of Finance (2): Present Value

Tony U
University of Macau

Outline

1 Present Value

Present Value

Present Value

Suppose that $100 is deposited in a savings account that pays 6%

compounded annually. Then at the end of 1 year the account is
worth
100(1 + 6%) = 106,
The compound amount $106 is future value, realize at a
future date
The principal $100 is present value

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Present Value

The present value (P) of a compounded amount S due n years in

the future is the amount, if it were on hand today, would grow to
equal the future amount.
P=

Sn
(1 + i )n

The process of determining the present value of a cash flow is

called discounting.

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(1)

Present Value

Example 1 (Present Value)

Determine the present value of a $500 due in 10 years at a 6

percent discount rate compounded annually.

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Present Value

Example 1 (Present Value)

Determine the present value of a $500 due in 10 years at a 6

percent discount rate compounded annually.
Sol.: Sn = 500, i = 6% and n = 10, from equation (1)
P

500
(1 + 0.06)10

= 279.20.

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Present Value

Example 2 (Application of Present Value)

Ms. Choy wishes to have $90,000 2 years from now in order to buy
the car she has her eye on. What amount of money does she need
to invest today at an interest rate of 6% p.a. compounded
quarterly in order to attain her goal?

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Present Value

Example 2 (Application of Present Value)

Ms. Choy wishes to have $90,000 2 years from now in order to buy
the car she has her eye on. What amount of money does she need
to invest today at an interest rate of 6% p.a. compounded
quarterly in order to attain her goal?
Sol.: Sn = 90000, i = 6%/4 and n = 2 4,
P

90000
(1 + 1.5%)8

= 79894.00

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Present Value

Example 3 (Present Value of an Uneven Cash Flows)

Mr. Wong needs the following amounts available at the end of

each of the coming three years. How much must Mr. Wong save
now in order to meet his needs? The appropriate interest rate is 8
percent p.a. compounded annually.
Year
1
2
3

Amount needed ($)

100
400
300

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Present Value

Sol.: There are three compound amounts, S1 = 100, S2 = 400 and

S3 = 300. Therefore her save now should be equal to the sum of
present value of these three compound amounts,
P =

400
300
100
+
+
1
2
(1 + 8%)
(1 + 8%)
(1 + 8%)3

= 673.68.

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Present Value

Example 4 (Application of Present Value)

Mr. Chan has a debt of $550 due in 4 years and $550 due in 5
years. He decides to set aside a single amount of money now to
repay these two debts. Find how much must he set aside if an
interest rate of 10% p.a. compounded quarterly is assumed.

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Present Value

Example 4 (Application of Present Value)

Mr. Chan has a debt of $550 due in 4 years and $550 due in 5
years. He decides to set aside a single amount of money now to
repay these two debts. Find how much must he set aside if an
interest rate of 10% p.a. compounded quarterly is assumed.
Sol.: First we can convert all time units from year to quarter, i.e. 4
years = 16 quarters, etc., 10% p.a. = 2.5% per quarter,
P

550
550
+
16
(1 + 2.5%)
(1 + 2.5%)20

= 706.14.

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Present Value

Example 5 (Present Value of an Uneven Cash Flows)

Mr. Lei wishes to have the following amounts available at the end
of each of the coming four years to cover his sons tuition fee.
End of Year
1
2
3
4

Amount needed ($)

20,000
22,000
23,000
24,000

Given that the interest rate is 4% p.a. compounded quarterly, how

much must Mr. Lei invest now in order to meet the above
expenses?

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Present Value

Sol.: Similar as Ex 3 and 4, first convert units and find the present
value as the sum of present of each compounded amounts, i.e., 1
year = 4 quarters, 4% p.a. = 1% per quarter,
P

22000
23000
24000
20000
+
+
+
4
8
12
(1 + 1%)
(1 + 1%)
(1 + 1%)
(1 + 1%)16

= 80415.28.

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