Present and Future Value

Suppose you could choose between receiving a new flat screen TV today, and receiving the same TV one month from now. Unless you have unusual preferences, you would choose receiving the TV today. In general, we prefer present consumption over future consumption because we discount the future. How much we should discount the future is determined by the interest rate and the present value formula. The relationship between present and future value is often referred to as the time value of money, but it is important to eep in mind that it is what we do with the money !e.g. consumption or investment" that really matters. #ne of the easiest ways to see this relationship is to imagine you are putting money into a savings account at your local ban . If you put $%&& into the account now, you would li e to now how much money you will have in one, two and three or more years. This initial $%&& is referred to as the principal, and the e'tra income earned on the principal are interest payments. (e normally assume there is compound interest, meaning that the interest earned each period is applied to the principal and the interest income from all previous periods. If the ban calculates and pays compound interest on an annual basis, we can use the following formula)
FVt = PV !% + r " t ,

!%"

where *Vt is the future value in t years, +V is the present value and r is the interest rate !or yield" per annum. In this case the present value is $%&&. If the annual interest rate is ,- then r is e'pressed as a decimal so that the value of the deposit after one, two and three years will be !rounding to the nearest cent", .ear #ne) .ear Two) .ear Three)
FV% = PV !% + r " = $%&&!%.&," = $%&,
FV/ = PV !% + r " / = $%&&!%.&," / = $%%&./,
FV2 = PV !% + r " 2 = $%&&!%.&," 2 = $%%,.01 .

In general, to find the future value in t periods, multiply the present value by !% 3 r" to the t power. #ne can also thin of r as a growth rate for any variable which grows at a constant rate. Up to this point, compounding has occurred in discreet periods. 4ontinuous compounding is essentially ma ing the compounding periods infinitely small, so that interest is compounding continuously. In order to calculate future value when using continuous compounding the following e5uation must be used.
FVt = PVe rt

!/"

(e can do a simple e'ample using the concept of retirement savings. 6ssume you save $/,&&& for retirement your first year out of college when you are // years old and you plan to retire when you are 1, years old !t 7 82". 9et:s try this with interest rates of ,- and %&-.
rt !.&,<82 " = $%0,%1;.0/ ,- interest rate) FVt = PVe = /,&&&e rt !.%&<82" = $%80,2;;.,; %&- interest rate) FVt = PVe = /,&&&e

The $/,&&& you saved as a // year old will be worth $%0,%0& if it earns ,- interest and the $/,&&& would be worth $%80,8&& if you can earn %&-. It:s no wonder 6lbert =instein supposedly said, The most powerful force in the universe is compound interest. >ost people can easily grasp the idea of a present value growing through time to become a future value. (hat comes less easily for some is the intuition behind discounting a future value to arrive at a present value. *or any future value we can rearrange formula !%" to calculate a present value,
PV = FVt !% + r " t

!2"

*or e'ample, if the interest rate is 0-, what is the present value of receiving $%,& in ten years? (e simply plug the appropriate values into the present value formula to get,
PV = $%,& !%.&0"%& = $01./, .

The present value formula answers the following 5uestion) @ow much would I need to save now in order to have $%,& in ten years? Aased on an annual compound interest rate of 0-, the answer is $01./,. 6s an e'ercise, you can calculate the present value when the interest rate is %&-. .our answer should confirm that the present value is inversely related to the interest rate. +resent value is a useful way to compare different dollar amounts in different time periods. 6gain you have two options) receiving $/&& in two years !option 6" and $/,& in three years !option A". (hich is better? To answer the 5uestion we use the mar et interest rate to convert both options into present value. If the interest rate is %&-, the present values are,
PV A = $/&& !%.%"
/

$/&& = $%1,./; %./% $/,& = $%B0.B2 , %.22%

PV B =

$/,& !%.%"
2

so option A is better. Since the present values will change with different interest rates, we cannot say that option A is always betterC only that it is better with an interest rate of %&-. D='ercise) find the interest rate in which someone is indifferent between the two options.E