Future Value
Future value is the value of money that an investor will get after a specified period at a specific interest rate. For example, if Firm A invests $10,000 for 3 years at a 10% interest rate, the amount to be received by Firm A after 3 years will be the future value of money. The Future value of an invested amount can be determined by using the following formula:
FV = PV x (1 + interest rate)Time
Where,
FV = Future Value
PV = Present Value
In the above example, the PV is $10,000, the interest rate is 10% and time period is 3 years. Hence,
FV = 10,000 x (1 + 0.10)3
FV = $13,310
Therefore, the future value of $10,000 invested for a period of 3 years at a 10% interest rate will be $13,310.
Present Value
As per the time value of money concept, the amount to be received today will have more value than the same amount to be received at a future date. Therefore, the present value of money represents the value of a future amount if it is received today. This can further be explained with the help of an example.
Suppose a firm sells a machine to a customer for $20,000 and it has two options for the payment; either it receives the entire amount today or it receives the same amount after one year. Of course, the firm will always want to receive the payment today as it can use this money for other purposes or it can invest the same amount and earn some extra interest on it.
Suppose the market rate of interest is 12%. If the firm invests this amount in the market, it may earn $2,400 on this amount. Therefore, the future value of this amount will be $22,400 ($20,000 + $2,400). It can also be said that the present value of $22,400 (to be received after one year) is $20,000.
Formula:
We have already discussed the formula for the future value of money. The same formula can be used to drive the formula for present value.
FV = PV x (1 + interest rate)Time
OR
PV = FV / (1 + interest rate)Time
Suppose you are promised $15,972 to be received in 3 years. If the annual discount rate is 10%, what is the present value of this $1,000?
PV = FV / (1 + interest rate)Time
PV = $15,972 / (1 + 0.10)3
PV = $12,000
So, the present value of $15,972 received in 3 years at a 10% discount rate is $12,000. This means if you were to receive $15,972 three years from now, it is worth $12,000 today, assuming a 10% annual discount rate.
