The calculation of the future value of an investment is one of the most basic calculations in finance. It allows you to determine the value of an investment in the future. The future value calculation is based on the basic principle of time value of money that states a dollar in your hand today is worth more than a dollar to be received tomorrow.
The future value of a single sum of money is important to businesses because it allows for the calculation of the rate of return on an investment.
If a case is made to invest money into a new project such as an acquisition, or an equipment purchase with a long holding period, it's important to have a way to calculate the potential return or profit you'll gain.
Calculating the future value of an investment is the method you use to generate return. Using this method, you can see the effects of time and the interest rate on your investment.
What Is the Future Value of an Investment?
The future value of a lump sum of money allows a small business owner to evaluate an investment, taking into account the current market rate of interest and the amount of time the investment will be held.
For example: You deposit $100 in the bank and the bank applies interest to your deposit every quarter. While you leave your money on deposit, that $100 will continue to grow based on the interest rate on your deposit and the term of the loan.
If instead, a business owner deposits to a bank account and, subsequently makes a regular deposit on an ongoing basis, Those payments are called an ordinary annuity.
Another term for future value is compounding. Compounding occurs when you earn interest on top of interest.
How Do You Calculate the Future Value?
There are three methods you can use to calculate the future value of an investment. The first method is to use the mathematical equation. The other two methods are also based on the equation since it is the basis for the principle of time value of money.
Using the future value formula:
PV = the present value of the investment or the beginning value
FV = the future value of the investment after t or the number of periods the deposit is invested
I = the interest earned on the investment
t = the number of time periods in months the deposit remains invested
Here is an example using the future value formula:
FV = ( $100 + $5 ), or $105
If you deposit $100, at the end of one year with the interest rate of 5% and if the number of years is 1 year, then you can read the formula as follows:
"The future value (FV) at the end of one year equals the present value ($100) plus the value of the interest at the specified interest rate (5% of $100 or $5)."
How Future Value Works
To determine the value of your investment at the end of two years, you would change your calculation to include an exponent representing the two periods:
FV = $100 ( 1 + 0.05 )² = $110.25
The continuing periods mean you continue the calculation for the number of payment periods you need to determine.
Future Value Using a Financial Calculator
Incidentally, you can use this formula with any calculator that has an exponential function key. However, using a financial calculator is better because it has dedicated keys corresponding to each of the four variables you'll be using, thereby speeding up the process and minimizing the possibility of error. Here are the keys you will press:
- Press N and 2 (for 2 years' holding period)
- Press I/YR and 5 (for the interest rate of 5%)
- Press PV and -105 (for the amount of money we are calculating interest on in year 2)
Take note that you need to set the investment's present value as a negative number so that you can correctly calculate positive future cash flows. If you forget to add the minus sign, your future value will show as a negative number.
Press PMT and PMT (there are no payments beyond the first one)
Press FV, which returns the answer of $110.25
Future Value Using a Spreadsheet
Spreadsheets, such as Microsoft Excel, are well-suited for calculating time value of money problems. The function that we use for the future value of an investment or a lump sum on an Excel spreadsheet is:
The "rate" is the interest rate, "nper" is the number of periods, "pmt" is the amount of the payment made (if any, and it must be the same throughout the life of the investment), "pv" is present value, and "type" is when the payment is due. The payments due value is either a one (beginning of the month), or zero (end of the month).
To use the function in the worksheet, click on the cell you wish to enter the formula in. Enter the formula below and press enter.
You should receive a value of $105.
Limitations of Future Value
The future value calculations are estimates of the value of an investment in the future. There are certain situations where future value calculations may be misleading:
- If interest rates are fluctuating rapidly, future value may not give an accurate answer since it is only sensitive to interest rate changes if they remain steady over the chosen time period.
- In an inflationary economic environment, the purchasing power of future cash flows is declining. In this case, future value calculations are only an approximation.
- If currency values are fluctuating, future value calculations may not accurately reflect the actual value of an investment.
- The calculation of future value determines the rate of return on an investment, all things held the same.
- Compounding, another word for future value, occurs when interest is paid on interest.
- There are certain economic climates that erode the power of the future value calculations.