Legal Definitions - present value

Present value refers to the current worth of a sum of money that is expected to be received or paid at a specific point in the future. It acknowledges that money available today is generally more valuable than the same amount of money received in the future, primarily because money today can be invested and earn interest over time. This concept, often called the time value of money, means that a future amount must be "discounted" back to its equivalent value in today's terms, taking into account factors like prevailing interest rates or the expected rate of return.

Understanding present value helps individuals and organizations make informed financial decisions by allowing them to compare financial opportunities that occur at different points in time on an apples-to-apples basis.

• Example 1: Evaluating a Lottery Payout

  Imagine someone wins a lottery and is given two options: receive a lump sum of $500,000 today, or receive $600,000 five years from now. To make the best decision, the winner would calculate the present value of the $600,000 future payment. If, after discounting the $600,000 back to today using a reasonable interest rate (representing what they could earn by investing the money), its present value is less than $500,000, then taking the $500,000 today would be the financially smarter choice. Conversely, if its present value is greater than $500,000, waiting for the larger sum might be preferable.

• Example 2: Business Investment in Equipment

  A manufacturing company is considering purchasing a new piece of machinery that is projected to save them $100,000 per year in operational costs for the next seven years. To decide if the machinery is a worthwhile investment, the company's finance team would calculate the present value of those future annual savings. They wouldn't simply add up $100,000 x 7 years ($700,000) because money saved in year seven is less valuable than money saved in year one. By discounting each year's savings back to today, they can determine the total current worth of those future benefits and compare it against the purchase price of the machinery.

• Example 3: Structured Legal Settlement

  A person involved in an accident is offered a legal settlement that will pay them $25,000 annually for the next 15 years. However, they need a significant amount of money upfront to cover immediate medical expenses and lost income. The defendant's insurance company might offer a single, smaller lump sum payment today instead of the annual payments. To determine a fair lump sum, the present value of the entire stream of 15 annual $25,000 payments would be calculated. This lump sum would represent the equivalent amount of money today that, if invested, could generate the same future annual payments, accounting for the time value of money.