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Future Value

Moneyzine Editor
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Moneyzine Editor
2 mins
November 6th, 2024
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Future Value

Definition

The term future value is used to describe the worth of an asset at a later time. Future value is a nominal sum of money received in the future, assuming a given rate of interest earned.

Calculation

Future Value (Simple Interest Formula) = PV x (1 + (R x T))

Where:

  • PV = the present value of the asset

  • R = the rate of interest earned in each period

  • T = the fraction, or number of periods, the interest is earned

Future Value (Compounding Formula) = PV x (1 + R)T

Where:

  • PV = the present value of the asset

  • R = the rate of interest earned in each period

  • T = the number of periods over which the interest is earned

Explanation

As the name implies, future value provides the analyst with insights into the worth of an asset at a future point in time. Unlike present value calculations, future value is not corrected for inflation and is stated in nominal dollars.

A future value calculation is frequently performed when investors want to understand the value of their money at a later date. This calculation can be performed using a simple interest or compounding formula:

  • Simple Interest: involves applying the rate to principal only

  • Compounding Interest: involves applying the rate to both principal and interest that has been earned but not yet paid or withdrawn

Example

Lindsey has the choice between two investments. She can place $10,000 in Fund A for five years, promising simple interest of 10% per year. Alternatively, Fund B promises to provide a return of 9.50% compounded monthly for five years. Lindsey would like to determine the future value of each investment:

Fund A (Simple Interest)

= $10,000 x (1 + ( 0.10 x 5)) = $10,000 x (1 + 0.5) = $10,000 x 1.500, or $15,000

Fund B (Monthly Compounding)

= $10,000 x (1 + 0.095/12)5 x12 = $10,000 x (1 + 0.007919)60 = $10,000 x 1.605, or $16,500

Note: In this example, monthly compounding requires the interest rate to be stated in months (9.5% / 12, or 0.007919) as well as the number of periods (12 months x 5 years, or 60 months)

Related Terms

  • The term simple interest is used to describe a calculation involving the application of a rate to principal. Simple interest would be equal to the financing charge associated with the outstanding principal of a loan in one period of time.
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    Moneyzine Editor
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  • Compound Interest
    The term compound interest is used to describe a calculation involving the application of a rate to both principal and interest that has been earned, but not yet paid or withdrawn. Compound interest would be equal to the growth of principal for two or more periods, if that growth is added back to the principal at the end of each period of time.
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  • The true cost of a loan is measured by the annual percentage rate, or APR. This is the annualized cost of a loan, which not only takes into consideration the interest charges on the loan's principal, but also application fees, points, and insurance.
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  • The term principal can have several meanings. It can refer to the remaining balance on a mortgage or loan, the owner of a privately owned company, or even the par value of a bond. When the term principal is used in this publication, it's often referencing the outstanding balance on a loan.
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  • Effective Interest Rate or Yield
    The term effective interest rate is used to describe the actual rate of interest received when compounding is applied to a nominal rate of interest. The effective interest rate is useful when evaluating alternatives involving various nominal rates applied to different compounding periods.
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  • The term ordinary annuity refers to a series of payments, or receipts of money, occurring at consistent intervals of time with an interest charge applied once per interval. With an ordinary annuity, the payment or receipt of money occurs at the end of each interval.
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  • Annuity Due
    The term annuity due refers to a series of payments, or receipts of money, occurring at consistent intervals of time with an interest charge applied once per interval. With an annuity due, the payment or receipt of money occurs at the beginning of each interval.
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