A personal finance blog dedicated discussing such topics as budgeting, asset allocation, 401K, IRA, cash flow, insurance, financial planning, portfolio management, and other areas in personal finance.


Tuesday, April 26, 2005

The Time Value of Money - Part II

In my last post in the "Financial Planning Basics" Series, I introduced the concept of the time value of money. Today we'll take it a bit further by talking about some of the formulas involved in making different calculations. None of these formulas are hard to understand, however, you may have to get used to them if you haven't seen them before.

Future Value of a Single Sum

Future value = amount X (1 + i)n

amount = lump sum amount invested today
i = expected interest rate or growth rate
n = number of periods (years) that the money will grow

Here's an example:

Say you have $1,000 and you want to invest it. You expect to get a 10% rate of return on this money and expect to invest it for 10 years. How much can you expect it be worth in 10 years?

Future value = $1,000 X (1 + .10)10

Future value = $1,000 X (1.10)10

Future value = $1,000 X 2.593

Future value = $2,593

amount = $10,000
i = .10 (10% expressed as a decimal)
n = 10 years

This example shows us that if you invest $1,000 for 10 years at a 10% rate of return, it will grow to $2,593.

Now, there is a flaw with this formula. Can you figure out what it is? The problem is that it assumes a straight line growth rate of 10%. That is not reality. So, it is important to keep in mind when using this calculation is that it is only an estimate.

That's it for now. Next time we will take this formula a bit further when we talk about future value of multiple cash flows. Ooooh, how exciting!