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The present value of a future payment is a calculation that is designed to identify the amount that would be received now as opposed to delaying the receipt of that payment to some specific future date. This type of calculation can be very important in various types of investing and business deals, since doing so can aid the recipient in deciding if there are compelling reasons to put off the receipt of that payment or if receiving the payment now would be better in the long run. While there are several ways to calculate the present value of a future payment, the task normally involves determining what type of interest, if any, is associated with the payment and if receiving now rather than later would sufficiently improve the financial circumstances of the recipient enough to offset any potential gains achieved by the delay.
Determining the present value of a future payment involves identifying how much would be received if the payment were tendered today rather than delaying the payment to some future date. For example, an investor who is holding a bond issue that is due to mature in two years can use this approach to identify the monetary rewards that would be received by selling the bond today versus holding the asset until that maturity date. Depending on how much he or she could sell the bond for in the marketplace and the amount of interest that the bond would accumulate by the future payment date, it is possible to determine which approach would be most lucrative. Typically speaking, if the bond can only be sold at current market value and not for a figure that allows for the anticipated interest that will accrue over the next two years, the investor would likely do well to retain ownership of the bond until maturity is reached.
Another example of how calculating the present value of a future payment may be helpful is to consider the case of an individual who wins a lottery. Typically, the options for payment will include either receiving a lump sum up front or breaking the amount down into annual payments over a number of years. One school of thought holds that even allowing for the payment of taxes, the winner should go for the lump sum payment and invest the money, creating a steady flow of interest and dividend income that will ultimately create additional benefits. A different approach holds that by receiving annual payments, the tax burden is lessened and it is still possible to invest the funds and create interest income that helps to build a nest egg for later years. Only by understanding all relevant factors and accurately projecting the outcome of each scenario is it possible to decide which approach would be the most beneficial.
Since the present value of a future payment focuses on what that payment would be if it occurred today rather than at some point in the future, the calculation can go a long way toward identifying not only what might be gained by receiving the payment immediately as well as the losses that could occur from that same action. By identifying the payment amounts now and in the future, considering all factors that include what could be done with the payment if it were received sooner rather than later, it is possible to settle on a course of action that is likely to produce the most desirable results. It is not unusual for investors to calculate the present value of a future payment on an annual basis, just to make sure there are still compelling financial reasons to keep the original payment date in place. Should the calculation indicate that due to changing circumstances an earlier payment is justified, arrangements to move forward with the revised strategy could be implemented.
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