We have discussed the computation of the future value in the previous sections; here let us work the process in opposite. Let us assume you have won a lottery ticket worth Rs. 1000 and such Rs. 1000 is payable after three years. You should be interested in understanding the present value of Rs. 1000. Whether the interest rate is 10 percent, the present value can be computed by discounting Rs. 1000 to the present point of time as given below:
Value three years hence = Rs. 1000 (1/1.10)
Value one years hence = Rs. 1000 (1/1.10) (1/1.10)
Value now (Present Value) = Rs. 1000(1/1.10) (1/1.10) (1/1.10)
Formula
For compounding translates a value at individual point in time into a value at several future points in time. The opposite method translates future value in present value. Discounting translates a value get back in time. By the basic valuation equation
FV = PV (1 + k)^{n}
Dividing both the sides by (1+k)^{n} we find that
PV = FV [1/(1 + k)]^{n} ............................Eq(10)
The factor [1/(1 + k)]^{n} is termed as the discounting factor or the present value interest factor [PVIF_{k,n}]