We will begin with definitions:
- A flow of income is a sequence of amounts of money to be received at various times in the future.
- A flow of payments is a sequence of amounts of money that must be paid at various times in the future.
Present value can also be calculated for a flow of income (and a flow of payments). This can be seen in the following example. Assume that each year of the next three years, you are due to receive a scholarship amounting to $1,000 (a total of three income installments).
Assume that the capitalization interest rate for you is 8%. The present value of the flow of income is $2,577. In other words, you will be indifferent to your choice of receiving $2,577 today or receiving this flow of income.
How did we calculate the present value of the flow of income?
As shown in the following table, we first calculated the present value of each installment separately, and then added the three resulting present values together.
(End of year 1)
(End of year 2)
(End of year 3)
|Total Present Value: $2,577|