Computations involving the time value of money can be viewed from either of two perspectives: (1) the future value of a sum of money received today or (2) the present value of a sum of money received in the future. The following sections discuss these two perspectives.
In our discussion of the time value of money, we stated that $1 invested at a given interest rate for a period of time will grow to an amount greater than $1. This dollar amount is called the future value.
As in the example above, $1 invested at a 10 percent per year interest rate will grow to $1.10 ($1 X 1.10) at the end of one year. This $1.10 is referred to as the future value in one year of $1, given a 10 percent interest rate. In such a situation, an individual would be indifferent as to receiving $1 now or $1.10 in one year. A simple interest calculation for one year is as follows.
If we wish to compute the future value of $1 at the end of more than one period (say, two years), given a 10 percent interest rate, we use the notion of compound interest. That is, in the second year, the 10 percent interest rate is applied to both the original $1 principal and the $0.10 interest earned in the first year. Here, the future value of $1 at the end of two years, given a 10 percent interest rate compounded annually, is equal to $1.21. An individual ...