Present and Future Value: Calculating the Time Value of Money

The Time Value of Money

Donna was puzzled about something, so she went to talk to Becky about it. She told her friend that the problem is whether she would want a dollar today or a dollar one year from now. She doesn’t see what the difference is, since it’s still one dollar, no matter when you get it.

Becky had to think about this for a while. When she sees Donna again, she tells her to take that dollar now and put it in a savings account. The bank will pay interest, so one year from now she’ll have more than one dollar.

To sum up the time value of money, money that you have right now will be worth more over time. So one dollar now will be worth more than a dollar in a year from now.

Future Value

Donna went home and did some research and she discovered a formula for future value, or how much money put in the bank today will turn into at some point in the future with the interest. She needs to know three things:

1. How much she has now
2. What the interest rate is
3. How many years she wants to put the money away for

Then she can use a formula to figure out how much she’ll have at the end. The formula is:

FV = PV (1 + r)n

In this formula,

• PV is how much she has now, or the present value
• r equals the interest rate she will earn on the money
• n equals the number of periods she will put the money away, and
• FV equals how much she will have at the end, or future value.

Let’s imagine that Donna puts $100 in the bank for five years at five percent interest, and plug that into the equation.

FV = 100 (1 + 0.05)5

FV = 100 * 1.2762

FV = $127.62

Pretty nice, huh?

Present Value

Donna’s parents think she’s a pretty smart girl, especially after she shows her Dad these cool formulas. Dad knows he will need money in a few years to pay for Donna’s college. He’s wondering how much he can invest today in some CDs that would be worth $20,000 or so in 10 years when he’ll need it. Donna shows him a formula for present value, or how much you need to save today to have a specific amount at some point in the future. Here’s the formula:

PV = FV / (1 + r)n

In this formula,

• PV equals how much he needs to have today, or present value
• r equals the interest rate he’ll earn
• n equals the number of periods before he needs the money, and
• FV equals how much he will need in the future, or future value.

So, if Dad needs the $20,000 in 10 years and can invest what he has for five percent, let’s find out how much he needs to invest today.

PV = $20,000 / (1.05)10

PV = $20,000 / 1.6289

PV = $12,278

Her dad is very happy to hear that.

Future Value of an Annuity

An annuity is a stream of equal payments. If Donna’s parents give her an allowance of $20 every month on the first, that’s an annuity. It isn’t just one allowance payment, but a stream of them, since they happen every month, and it’s always just the same amount.

Donna went and told Becky all about the formulas and Becky told her parents about how they work. Becky’s dad wants to save for Becky’s college in a different way. He wants to put $1,500 in the bank at the end of every year for 10 years. He wonders how much he’ll have at the end.

Becky looks up a formula for that. It’s called the future value of an annuity, which is how much a stream of A dollars invested each year at r interest rate will be worth in n years. Here’s what it looks like:

FV A = A * {(1 + r)n -1} / r

In this formula