Monday, March 4, 2013

Future Value Calculations



 The difference between and present values and future values is a tough concept to grasp. I’ve found that the best way to explain the difference is calculate a future value- then use that result and work backward using present value tables. That method allows the reader see how the two concepts are connected.

The impact of compounding
Compounding assumes that you leave your earnings in the investment vehicle, maybe a CD at a bank. When you compound your invested dollars, you are earning interest (some rate of return) on two amounts. First, you’re earning additional interest on your original investment (principal amount), say $1,000. With compounding, you also earn interest on prior interest payments. Finance people refer to the concept as “earning interest on interest”.

Future value example
You have $1,000 that is invested at a rate of 10% interest per year- compounding annually. Once a year, your total investment (principal amount plus prior interest payments) will be credited with 10% interest. This example will take you through three years of compounding (3 years of investments).

The importance of present and future value tables
Calculators are great, but you need present and future value tables to understand these concepts. I think you need to see- on a chart- where the present and future values come from. By looking at a chart, you can see trends. The higher the future value rate (interest rate), the more each dollar is worth when you calculate future value. So, find a set of tables of the web and use them.

Future value- Years 1 to 3
You invest $1,000. At the end of year one, you’ve earned 10% interest. The present value factor for 10%, 1 year is 1.1. (Or 1 * 1.1)

Total investment after year 1: $1,000 investment * 1.1 = $1,100

You invest the entire $1,100. At the end of year two, you’ve earned another 10% interest. The present value factor for 10%, 2 years is 1.21.

Total investment after year 2: $1,000 investment * 1.1 * 1.1= $1,210

You’ll note that 1.21 = $1 *1.1* 1.1

You invest the entire $1,210. At the end of year three, you’ve earned another 10% interest. The present value factor for 10%, 3 years is 1.331.

Total investment after year 3: $1,000 investment * 1.1 * 1.1 * 1.1= $1,331

You’ll note that 1.331 = $1 *1.1* 1.1*1.1

The next blog will use the same data to calculate present value. In the meantime, here’s a video that will help:


Your comments are welcome! Visit my website for online classes on the toughest accounting topics.

Thanks!
Ken Boyd
St. Louis Test Preparation
(cell) (314) 913-6529
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