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
(you
tube channel) kenboydstl
(blog) http://accountingaccidentally.blogspot.com/
(twitter)
@StLouisTestPrep
Author/ Cost Accounting for Dummies
Amazon Author Page: amazon.com/author/kenboyd
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