The present value of a lump sum is the current worth of a lump sum payment that is anticipated to be received at some point in the future. While it is possible to project what this present value may be, it is important to keep in mind that a number of factors can have some impact on what that that value happens to be. Events such as changes in the interest rate applied to the lump sum up to the point of receipt as well as shifts in how that rate is applied are two examples. The number of compounding periods involved between the present date and the date that the lump sum is actually tendered will also make a significant difference in how much of a return is realized.
One of the key factors that will affect the present value of a lump sum is the rate of interest that will apply to the investment. The presence of a fixed rate helps to reduce a great deal of the investment risk associated with this type of earning activity. For example, if the rate is fixed at 5%, then that rate of interest will be compounded each period, based on the terms of the agreement surrounding the asset. Should the interest rate be floating or variable, the amount of interest compounded will likely be different at various times during the asset’s life, making it necessary to base projections on what is anticipated to happen with the average interest rate. Identifying and accurately projecting that movement with the interest rate is very important when it comes to calculating the present value of a lump sum.
The present value of a lump sum can also be impacted by how the interest is compounded. While the process will call for the interest to be compounded in specific periods as outlines in the terms of the contract, it is important to know what exactly is meant by a period. If the period is annual, that may mean that the compounding is done based on a full calendar year of 365 days, or an average period of 360 days that assumes an average of 30 days in each calendar month. While this would make relatively little impact on a small lump sum, the compounding periods involved do matter when dealing with much larger sums.
Along with the type and rate of interest and the specifics of each compounding period, the number of compounding periods will also be very important to projecting the present value of a lump sum. If the anticipated date of delivery is ten years from the present date, chances are the arrangement is configured with ten compounding periods. By allowing for any variables in the interest rate as well as how the interest is compounded in each period, it is possible to come up with a reasonable figure for the lump sum, assuming that the arrangement remains in place for the duration of the contract.
