Future Values 39

to find, are indicated by question marks. Here the interest rate is 5%; a single cash outflow, $100, is invested at Time 0; and the Time 3 value is an unknown inflow. In this example, cash flows occur only at Times 0 and 3, with no flows at Times 1 or 2. Note that in our example the interest rate is constant for all three years. That condition is generally true, but if it were not then we would show different interest rates for the different periods. Time lines are essential when you are first learning time value concepts, but even experts use them to analyze complex finance problems, and we use them throughout the book. We begin each problem by setting up a time line to show whats happening, after which we provide an equation that must be solved to find the answer, and then we explain how to use a regular calculator, a financial calculator, and a spreadsheet to find the answer.

2.2 Future Values

A dollar in hand today is worth more than a dollar to be received in the future because, if you had it now, you could invest it, earn interest, and end up with more than a dollar in the future. The process of going to future values (FVs) from present values (PVs) is called compounding. To illustrate, refer back to our 3-year time line and assume that you plan to deposit $100 in a bank that pays a guaranteed 5% interest each year. How much would you have at the end of Year 3? We first define some terms, after which we set up a time line and show how the future value is calculated. PV_ Present value, or beginning amount. In our example, PV _ $100. FVN _ Future value, or ending amount, of your account after N periods. Whereas PV is the value now, or the present value, FVN is the value N periods into the future, after the interest earned has been added to the account. CFt_ Cash flow. Cash flows can be positive or negative. The cash flow for a particular period is often given a subscript, CFt, where t is the period. Thus, CF0 _ PV _ the cash flow at Time 0, whereas CF3 would be the cash flow at the end of Period 3. I _ Interest rate earned per year. Sometimes a lowercase i is used. Interest earned is based on the balance at the beginning of each year, and we assume that it is paid at the end of the year. Here I _ 5%, or, expressed as a decimal, 0.05. Throughout this chapter, we designate the interest rate as I because that symbol (or I/YR, for interest rate per year) is used on most financial calculators. Note, though, that in later chapters we use the symbol r to denote rates because r (for rate of return) is used more often in the finance literature. Note too that in this chapter we generally assume that interest payments are guaranteed by the U.S. government; hence they are certain. In later chapters we will consider risky investments, where the interest rate actually earned might differ from its expected level. INT _ Dollars of interest earned during the year _ beginning amount times I. In our example, INT _ $100(0.05) _ $5. N _ Number of periods involved in the analysis. In our example, N _ 3. Sometimes the number of periods is designated with a lowercase n, so both N and n indicate number of periods.
Do time lines deal only with years or could other periods be used? Set up a time line to illustrate the following situation: You currently have $2,000 in a 3-year certificate of deposit (CD) that pays a guaranteed 4% annually.

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