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Tutorial: Time Value of Money

Topic: Future Value

Future Value & Time Value of Money

Would you exchange USD 8,000 for USD 7,200?

Your answer will almost certainly be 'no'.

But what if the USD 8,000 was to be received one year from now?

In effect, you would be borrowing USD 7,200 now and paying back USD
8,000 at the end of the year. Can these amounts be considered equivalent?
Yes, if you 'discount' the USD 8,000 by reducing its value to compensate
for the fact that it is to be paid not now, but in one year's time. This
discounting reflects the time value of money.

The time value of money connects the future value of an investment to its
value to investors today, and is determined by the interest rate (or discount
rate) and the time elapsed.

The future value of money is the amount by which an investment will grow
after earning interest. Interest could be simple, discretely compounded, or
continuously compounded. With discrete compounding, for example, the
future value of money is calculated as follows:

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Future Value – Example

Suppose that you invest USD 100 in an interest-bearing bank account

paying 5% per annum. The future value of your USD 100 a year from now
would be calculated using the following formula:

Inserting the values into the formula we get:

1
USD 100 (1 + 0.05) = USD 105

Now suppose you decide to invest the initial USD 100 for four years with
interest compounded annually. This means that at the end of four years, the
initial investment will grow to:

4
USD 100 (1 + 0.05) = USD 121.55

N
The term (1 + r) is known as the future value factor, and is equal to the
future value of a USD 1 cash flow today.

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Future Value – A Historical Example

Was this a good deal?

To answer the question, all we have to do is determine what the initial USD
24 investment in 1626 is worth in the year 2013. We assume a modest rate
of return of 8% per annum, compounded annually. Between 1626 and 2013
there are 387 years. The 2013 equivalent of USD 24 in 1626 would
therefore be:

387
USD 24 (1 + 0.08) = USD 206,635,347,617,550

It turns out that the 2013 value of Manhattan Island is well below this
figure. Hence, Peter Minuit paid too much for Manhattan Island in 1626.

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Future Value

Suppose that your bank has offered you an interest rate of 5% per annum,
compounded semi-annually, on an initial investment of USD 5,000. What will
the future value of your investment be at the end of year 3? Input your
answer correct to two decimal places.

USD

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