The future or present value of money can be calculated given the variables of the number of periods (time), interest or discount rates, the amount invested, or the future value of money.
The future value (FV) calculation allows investors to predict, with a very high degree of accuracy, the amount of profit that can be generated by varying investments. The amount of growth earned by holding a given amount in cash will most likely be different than if that same amount were invested in stocks or other equities. The FV formula is used to compare multiple options and scenarios.
When applying the FV formula, the Present Value (PV) must first be calculated and then the rate and time period in which interest is earned, or compounded, is required to complete the calculation. As a result, the PV is multiplied times a constant of 1 plus the rate of return with an exponent of how many periods of interest is earned or compounded.
There is a formula for calculating future value.
For example, assume Mary Nelson wants to calculate the future value of an investment and puts $1,000 into a bank for five years at 5 percent interest
compounding annually, or
. This means that Mary knows that making the investment at 5 percent will leave her with $1,276.28 at the end of five years.
There is a formula for present value.
The present value calculation is useful in planning for a future expense, such as college tuition. For example, Jim and Susan Smith might want to know how much they need to invest in a certificate of deposit (CD) that pays 5 percent interest compounding annually to have $25,000 at the end of 10 years, which hypothetically is what will be needed to pay for their child's first year of college at that time. Present value can be used to determine the amount that’s needed to invest at the current time to have the necessary funds in 10 years.
Investors can calculate the future value or present value of money to better understand their investment options or to make a decision on whether or not to take out a loan. For example, consider the time value of money impact of saving for retirement if the retiree wants to have a certain lump sum saved at their retirement age of 65. An investor that saves $2,400 annually from age 19 to 26 and then stops investing new money but lets the current investment continue to grow at a 12 percent annual growth rate will have a lump sum of $2,523,474 at age 65. The growth of the investment for ages 19 to 26 can be calculated using a spreadsheet by inputting numbers within the future value formula. Calculations can also be completed using a financial calculator or manually by using the future value formula.