In simple words:
If you have two options of (1) Collecting $ 1 today and (2) Collecting $ 1 after 10 years, what would you pick? I hope your answer was (1). That is the right answer. Here's why:
1. If collect $1 today( Present Value) and invest it at 2%, you will have $1.21 in 10 years ( Future Value) . As your $ increases, the difference increases as well.
2. You can buy more with $1 today ( Present Value) than you can with $1 in 10 years (Future Value). That is the change in buying power caused by inflation.
So a dollar today > a dollar tomorrow. Money loses its value over time.
Interest Rate adjusted for inflation will be the discount rate which you can plug in to the following formula to check the PV of your expected future cash flows.
Stepping up a bit: Now that you have the formula, if the discount rate is 2%, which of the following options would you chose?
Option 1: Collect $ 100 today
Option 2: Collect $ 108 after 5 years
Option 3: Collect $ 21 every year for 5 years
The correct answer is (1) again!
The questions to ask will be, " Is the PV (Present Value) of $108 in 5 years greater than $100?" " Is the PV of $ 21 over the next 5 years greater than $100?"
PV of Option 2 = $108/ ( 1+0.02) ^5 = $ 97.81
So collecting $100 today is better than collecting $108 in 5 years
PV of Option 3 = $21/( 1+0.02)^1 = 20.59
+
$21/( 1+0.02)^2 = 20.18
+
$21/( 1+0.02)^3 = 19.79
+
$21/( 1+0.02)^4 = 19.40
+
$21/( 1+0.02)^5 = 19.02 = $98.98
Again collecting $ 100 today is a better option.
If you want to use a spreadsheet, the formula =PV (2%,5,21)
And finally, NPV ( Net Present value)
In real life, when we make investment decisions, there are a series of cash inflows and outflows to be considered, so we use the 'Net' PV calculation.
The spreadsheet formula will be =NPV(2%,-25,21,-11,40,-10,50)
A positive NPV implies that the investment is worth making!
And if you are craving more knowledge, here is a video courtesy Khan Academy.
If not, you can go back to blog posts
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