Overview of Present and Future Value Concepts
Return on an investment over time is known as interest, while the actual baseline amount of an investment associated with a loan or a borrowing is known as the principal. Lenders loan money with the expectation of earning interest on the loan while also ensuring the return of their principal. Borrowers expect to receive funds to use in their enterprise but likewise expect to pay back the principal plus the interest that accrues over time. The interest rate is typically stated as a percentage of the principal that reflects the cost of borrowing money, expressed in annual terms. For example, a $1,000 loan that carries a 6% stated rate of interest is expected to accrue $60 of interest each year the loan remains outstanding, or 6% of the principal amount. Therefore, after one year the economic value of the investment would be $1,060: the original principal of $1,000 plus $60 of interest. If such an investment remained outstanding for another year, the total value would be $1,123.60 . This effect, the repetitive calculation of interest earnings, means that an original fixed sum of money invested across time can earn interest many times over, each time interest is calculated. This is known as compounding. It can be valuable to own an investment that continues to compound on itself over a long period of time.
A lump sum of money or a fixed regular payment stream paid in the same amount every period for a period of time, known as an annuity, can be measured at a present value or a future value. Present value is the amount a sum of money is worth now, in the present. Future value is what a sum of money will be worth at a future point in time, given the effects of interest. If the rate of interest and compounding frequency are known, present value and future value can be calculated. A common practical use for the time value of money is estimating funds needed for an individual to retire. If the amount the future retiree plans to invest now is known and they can estimate the rate of interest or earnings on their investment, they will know how much money they will have to use after retirement.
Present Value of a Single Amount
To begin working with time value of money calculations, it is important to first distinguish the information available and the information needed to be calculated. If the amount in hand now or due in the future is a single sum rather than a repeated cash flow, it's called a lump sum. If the amount in question is a fixed, repeated cash flow made every period, it is an annuity. If the current amount is known, then present value is known, and calculations can be done to determine future value. If the future value is known, then calculations can be performed to determine present value.The present value of a lump sum can be computed using future value (FV), the stated interest rate (r), and the number of periods the lump sum will compound.
Given that she now has 10 years for her money to compound, Sara only needs to invest $22,336 today in order to have the $40,000 she needs for her new car 10 years from today.A table, rather than a calculator, can be used to solve time value of money problems. Using the one period example, find the interest rate r of 6% and the period n of 1. A table provides a factor of 0.943. By multiplying 0.943 by the future value of $40,000, present value can be calculated. There are some minor differences in calculated answers and the table answers because of rounding.