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
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
Rates of Return - Internal Rate of Return
InvestingFuture 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.
InvestingInterest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple interest or compound interest.
InvestingInvestopedia explains the natural log and exponential functions used to calculate this value.
InvestingFind out why time really is money by learning to calculate present and future value.
InvestingThe effective annual interest rate is a way of restating the annual interest rate so that it takes into account the effects of compounding.
InvestingDetermining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
InvestingUnderstanding how money is made and lost over time can help you improve your returns.
InvestingHow much are your investments actually returning? Find out why the method of calculation matters.
Personal FinanceHere's what you need to know to grow your rainy-day fund.
InvestingCompound interest is often called one of the most powerful concepts in finance. Find out what it is and how it can work for you.