According to the time value of money, a dollar in hand today is worth more than a dollar received at a certain point in the future. That’s because you can take today’s dollar and invest it to earn interest and capital gains. The future value is a way of calculating the amount that an investment made today would grow to when invested at a specific interest rate. It represents how much an investor would need to receive at a future time in order to compensate for the lost opportunity cost of not being able to invest his money today.
Future value determines how much the present value of cash will be worth at a specified point in the future. It’s calculated using a simple mathematical formula.
Future value is a simple formula used to figure out how much an amount of cash will be worth at a specific point in the future. The idea is that $100 today is not worth $100 in a year’s time due to the time value of money – you could invest the $100 at a 3 percent interest rate, for example, and have $103 next year. The future value formula also calculates the effect of compound interest. Earning 0.25 percent per month is not the same as earning 3 percent per year because you can reinvest each month’s earnings to create additional income.
Suppose you are investing $10,000 today in an account that earns 10 percent interest, compounded annually. In year one, your investment would grow by $1,000 – that’s 10 percent of $10,000 – to $11,000. At the end of two years, the $10,000 investment will have grown to $12,100. Note how the investment earned $1,100 in the second year but only $1,000 during the first year. That’s because the interest is compounded, so you’re earning interest on the previous year’s cumulative account balance. In this example, the future value of your $10,000 investment is $12,100 after two years.
The equation for finding the future value of an investment earning compounding interest is:
FV = I (1 + R)t
- FV is the future value at the end of year t.
- I is the initial investment.
- R is the annually compounded interest rate.
- t is the number of years.
Using this formula, you can calculate the future value of your $10,000 investment in year 5 as follows:
FV = 10,000 (1 + 0.10)5 = $16,105.10.
Sometimes, an investor will need to calculate the future value of money when she’s making a series of deposits over a number of periods, rather than a one-time investment. Excel’s FV function is useful here because it includes additional parameters accounting for the time value of periodic payments. Suppose, for example, an investor deposits $2,000 per year over five years at a 10 percent interest rate, instead of investing $10,000 in one go. Excel’s FV formula looks like this:
FV(rate, nper, pmt, [pv], [type])
- Rate – the interest rate, 10 percent in our example.
- Nper – the number of periods over which an investment is made, 5 in our example.
- Pmt – the principal payment made each period, or $2,000.
- Pv – the present value of cash that you have today. In this example, it’s zero, since our investor has not made an investment yet.
- Type – this indicates whether payments are made at the beginning or end of a period; set this to 0 for payments made at the end of a period and 1 for payments made at the beginning.
In this example, plugging the numbers into Excel gives a future value of FV (0.1, 5, 2,000, 0, 1) = $13, 431.22.