How is Present Value (PV) calculated from Future Value (FV)?

The calculation of Present Value (PV) from Future Value (FV) is grounded in the underlying principles of the time value of money. The correct formula states that PV is equal to FV divided by (1 + r) raised to the power of n, where r is the interest rate and n is the number of time periods.

This relationship captures the concept that the value of money today (PV) is less than its value in the future (FV) due to factors such as interest and inflation. By dividing the future value by the compounded interest factor (1 + r)^n, we effectively discount the future amount back to its present value, accounting for the expected growth over time.

This method enables individuals and businesses to assess how much a future cash flow is worth in today’s terms, thus making informed financial decisions based on the time value of money.

Other formulas, like adding or multiplying the variables incorrectly, do not correctly represent this relationship, as they misinterpret how interest accumulates over time or how discounting works. Understanding the rationale behind the PV formula helps in comprehending broader financial concepts and their applications.