Quantitative Methods of Evaluating Businesses and Investments - Time Value of Money
In addition to being able to understand the financial statement, IAs must also have the ability to estimate the value of an investment in the future.
When planning investment strategy, it's useful to be able to predict what an investment is likely to be worth in the future, taking the impact of compound interest into account. This formula allows you (or your calculator) to do just that:
Pn = P0(1+r)n
Pnis future value of P0
P0 is original amount invested
r is the rate of interest
n is the number of compounding periods (years, months, etc.)
Note in the example below that when you increase the frequency of compounding, you also increase the future value of your investment.
P0 = $10,000
Pn is the future value of P0
n = 10 years
r = 9%
Example 1- If interest is compounded annually, the future value (Pn) is $23,674.
Pn = $10,000(1 + .09)10 = $23,674
Example 2 - If interest is compounded monthly, the future value (Pn) is $24,514.
Pn = $10,000(1 + .09/12)120 = $24,514
As part of your investment planning, you might also need to calculate the present value of investments. For example, if your clients want to retire with $1 million in their investment accounts, it would be useful to know how much they need to save each year to reach that goal.
You can simply reverse the future value formula like this:
P0 = Pn
(1+ r) n
Pn = $23,674
P0 is the present value of Pn
n = 10 years
r = 9%
Example: How much would somebody need to invest now if they wish to have $23,674 10 years from now based on a return of 9% compounded annually?
P0 = $23,674 = $10,000
(1+ .09) 10
Exam Tips and Tricks
A typical time value of money question will look something like this:
If $10,000 is invested at 6%, compounded monthly, it would be worth $18,194 in 10 years. $18,194 would be the investment's _____________.
- Internal rate of return
- Present value
- Expected return
- Future value
Rates of Return - Internal Rate of Return
The correct answer is "d" - the ending value of the investment is known as the future value.
Pn = $10,000(1+.06/12)120 = $18,194
ProfessionalsIt's useful to be able to predict what an investment is likely to be worth in the future.
ProfessionalsFINRA/NASAA Series 66 Section 1 - Time Value of Money. This section discusses concept of the time value of money and hence the present and future value concepts.
Fundamental AnalysisFuture value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
ProfessionalsFINRA/NASAA Series 66 Section 1 - Net Present Value. This section discusses the concept of Net Present Value and its calculation.
Investing BasicsInterest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple interest or compound interest.
InvestingThe effective annual interest rate is a way of restating the annual interest rate so that it takes into account the effects of compounding.
Bonds & Fixed IncomeInvestopedia explains the natural log and exponential functions used to calculate this value.
ProfessionalsIt is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.
Investing BasicsFind out why time really is money by learning to calculate present and future value.
Forex EducationDetermining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
Compound Interest is interest calculated on the initial principal ...
Discrete compounding refers to the method by which interest is ...
The rate of return, usually expressed as a percentage, that represents ...
The interest rate charged on a loan or realized on an investment ...
1. The estimated value of all assets and liabilities of an acquired ...
Effective Annual Interest Rate is an investment's annual rate ...
Find out why the rule of 72 does not accurately reflect the growth caused by continuous compounding, and which number can ... Read Answer >>
Learn how mutual funds can grow wealth over time through the magic of compound interest by reinvesting dividends back into ... Read Answer >>
Find out more about compounding interest, what it measures and how to calculate the amount of compound interest accrued using ... Read Answer >>
Understand why the time value of money is an important concept for investors. Learn when present value and future value calculations ... Read Answer >>
Understand the benefits of compounding interest, and learn the types of investments that offer compounding in addition to ... Read Answer >>
Understand what compound interest is and how the compounding of interest applies to the benefit of investors or creditors, ... Read Answer >>