Concept of Future Value of Money
Future value of money refers to the amount of cash that will be received at a certain time in the future if a certain amount of money is invested somewhere at a certain rate.
Example:
i) Johnson deposits $1,000 in a bank today at 10% interest. How much money will he get back at the end of 3 years?
ii) John Locke will buy a house five years from today for $500,000. If the interest rate is 8%, how much money should be deposited in the bank?
These are examples of the future value of money.
Process of Calculation of Future Value of Money
Future Value, FV = PV (1 + i)n
Here,
PV = Present value
FV = Future value
i = Interest rate
n = Duration
Example: Today Jane Austen deposited $100,000 in a bank at the rate of 10% interest. We will calculate how much money she will get back at the end of 1st year, 2nd year, and 3rd year.
FV = PV (1 + i)n
Present Value (PV) = $100,000
Interest rate (i) = 10% = 0.1
Duration (n) = 1,2,3 years
Future value (FV) =?
Future value after one year = 100,000 (1+.01)1
= 100,000 × 1.10 = $110,000
Future value after second year = 100,000 (1+.01)2
= 100,000 × 1.21 = $121,000
Future value after third year = 100,000 (1+.01)3
= 100,000 × 1.331 = $133,100
The process used in the above example to determine the future value is called the compound interest method. Note that, the future value of $110,000 after the first year is $100,000 in principal and $10,000 in interest at 10%. Similarly, with an additional $10,000 in interest in the second year, the future value in the second year should be $120,000, but the future value in the second year is $121,000. This is because the principal at the beginning of the second year is $110,000 and the interest at 10% in the second year is $11,000. The interest and principal of the first year are compounded by the principal of the second year, and the interest of the second year is charged on it; this process is called compound interest method. In the compound interest method, the future value is determined by charging interest on the compound-based interest every year.
Why Future Value of Money?
1. The concept of future value of money is used to estimate how much money will be earned in the future by investing a certain amount of money today.
2. Future value of the present money after a certain period of time can be determined. Let’s illustrate the point with the help of an example.
Example: Jennifer wants to know how much money she will have in her account after 5 years if she deposits $1,000 in Bank at 10% interest?
Present value (PV) = $1,000
Interest rate (i) = 10%
Duration (n) = 5 years
Future value (FV) = ?
FV = PV(1+i)n
= 1,000 (1 + 0.10)5
= 1,610.51 = $1,611
The value of $1,000 after five years is worth $1,611.
So present value is = $1,000
Future value(after 5 years) is = $1,611 (if interest rate is 10%)