Project Cost / Finance Management

Lecture: 11

MSPM Bahria University

Future Value and Compounding
 Future value (FV) refers to the amount of money an investment will grow to over some length
of time at some given interest rate
 To determine the future value of a single cash flows, we need:
 present value of the cash flow (PV)
 interest rate (r), and
 time period (n)
 Number of compounding per year (t)

 FVn = PV0 × (1 + r)n

 FV= PV *(1+r/t)nt

 Future Value Interest Factor at ‘r’ rate of interest for ‘n’ time periods
 Examples on computation of future value of a single cash flow
Future Value (Graphic)

If you invested $2,000 today in an account that

pays 6%
6 interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?

0 1 2
6%
$2,000
FV
Future Value (Formula)

FV1 = PV (1+r)n
= $2,000 (1.06)2
= $2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
r = rate of interest per compounding period
n = number of compounding periods
Future Value (Example)

 John wants to know how large his $5,000

deposit will become at an annual compound
interest rate of 8% at the end of 5 years.
years

0 1 2 3 4 5
8%
$5,000
FV5
Future Value Solution

 Calculation based on general formula: FVn

= PV (1+r)n
 FV5 = $5,000 (1+ 0.08)5
 = $7,346.64

 General Future Value Formula

General Future Value Formula:

FVn = P0 (1+i)n

or FVn = P0 (FVIFi,n) -- See Table I

 Valuation Using Table I

FVIFi,n is found on Table I at the end of the

book or on the card insert.

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Using Future Value
Tables

FV5 = $5,000 (FVIF8%,5)

= $5,000 (1.469)
= 7345

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
Present Value and Discounting
 The current value of future cash flows discounted at the appropriate
discount rate over some length of time period
 Discounting is the process of translating a future value or a set of future
cash flows into a present value.
 To compute present value of a single cash flow, we need:
 Future value of the cash flow (FV)
 Interest rate (r) and
 Time Period (n)


PV0 = FVn / (1 + r) n
Present Value (Graphic)

Assume that you need to have exactly $4,000 saved 10

years from now. How much must you deposit today in
an account that pays 6% interest, compounded annually,
so that you reach your goal of $4,000?

0 5 10
6%
$4,000
PV0
Present Value (Formula)

PV0 = FV / (1+r)10
= $4,000 / (1.06)10
= $2,233.58

0 5 10
6%
$4,000
PV0
Present Value Example

Joann needs to know how large of a deposit to make

today so that the money will grow to $2,500 in 5 years.
Assume today’s deposit will grow at a compound rate
of 4% annually.
0 1 2 3 4 5
4%
$2,500
PV0
Present Value Solution

 Calculation based on general

formula: PV0 = FVn / (1+r)n
PV0 = $2,500/(1.04)5
= $2,054.81
Solution based on formula:

FV= PV (1 + r)n
=
1,000(1.03)32
=
2,575.10
 Present Value Single Deposit (Graphic)

Assume that you need $1,000 in 2 years. Let’s examine the

process to determine how much you need to deposit today at a
discount rate of 7% compounded

annually.
0 1 2
7%
$1,000
PV0 PV1
 Present Value Single Deposit (Formula)

PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2

= FV2 / (1+i)2 = $873.44

0 1 2
7%
$1,000
PV0
General Present Value Formula

General Present Value Formula:

PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
 Valuation Using Table II

PVIFi,n is found on Table II at the end of the book or on

the card insert.

Period 6% 7% 8%
1 .943 .935 .926

2 .890 .873 .857

3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
 Using Present Value Tables

PV2 = $1,000 (PVIF7%,2)

= $1,000 (.873)
= $873 [Due to Rounding]

Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Annuities

 A series of level/even/equal sized cash flows

that occur at the end of each time period for a
fixed time period
 Examples of Annuities:
 Car Loans
 House Mortgages
 Insurance Policies
 Some Lotteries
 Retirement Money
 Types of Annuity

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
 Annuity Due:
Due Payments or receipts occur at
the beginning of each period.
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
 Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 + FVAn

... + R(1+i)1 + R(1+i)0

25
 Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 + $1,000(1.07)1
+ $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
26
 FV of Ordinary Annuity-
Simple Formula

27
 Hint on Annuity Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.
28
 Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
i% . . .
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)
29
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070
$1,145
$1,225
FVAD3 = $1,000(1.07)3 + $1,000(1.07)2
$3,440 = FVAD3
+ $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440
30
 FV of Annuity Due-Simple
Formula

31
 Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
32
 Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 + $1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32

33
  Cash flow after 10 years= $7000
 I = 8%
 n=10
 Annuity Ordinary?

34
  Cash flow after 5 years= $6000
 I = 12%
 n=5
 Annuity Ordinary?

35
 Hint on Annuity Valuation
The present value of an ordinary
annuity can be viewed as
occurring at the End of the first
cash flow period, whereas the
Present value of an annuity due
can be viewed as occurring at
the Beginning of the first cash
flow period.
36
 PV of Ordinary Annuity -
Simple Formula

37
 Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .
R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)
38
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
39
 PV of Annuity Due-
Simple Formula

40
Perpetuities

 A series of level/even/equal sized cash flows

that occur at the end of each period for an
infinite time period
 Examples of Perpetuities:
 Consoles issued by British Government
 Preferred Stock