LESSON 1 – FUTURE VALUE, PRESENT VALUE AND INTEREST RATES

1 THE CALCULATION OF FUTURE VALUE (OR CAPITALIZATION)

If we own an amount of money we do not need to spend, for example 100 euros, we
can either put it in a box or deposit it in the bank so as to earn an extra income. Let us
imagine the bank offers paying a return of the 5% at the end of the year for depositing
our money. Then, the future value of our investment will be higher thanks to the
interests received for having lent that money to the bank.

The relationship between current value or present value (PV) and future value (FV) can
be mathematically expressed in the following way:

FV = PV + Interests

Thus, if we have 100 euros and the bank pays us a 5% return per year for our deposit,
once the year has gone by, the final value will be:

FV = 100 + (100 × 0.05) = 105€

Consequently, the amount of money received from the bank at the end of the year will
be 105 euros. If we had not deposited the money in the bank, but had placed it in a
drawer instead, we would have continued having 100 euros, but with the advantage that
this money would have been available to be spend at any moment.

Once the year has gone by, we could do three different things:

 Withdraw the money and spend it.

 Deposit again the 100 euros in the bank.
 Deposit the 105 euros in the bank.

In the first case, there is nothing to calculate as we withdraw the money from the bank
and, therefore, it stops producing interests.

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In the second case, we deposit again the 100 euros in the bank, producing 5 euros of
return annually. Thus, at the end of the second year, we will have obtained a total return
of 10 euros. As we withdraw the interests every year, its annual value is constant, it is
always:

100 × 0.05 = 5  PV × i = Interests

If the deposit has a duration of “n” years, the total amount of money obtained as interest
return will be:

n × PV × i

As we can see, the final amount of money is proportional to the initial quantity invested,
the number of periods (years) and the interest rate. Thus, the initial capital PV, has
turned into:

FV = PV + n × PV × i  FV = PV (1 + n × i)

This resulting formula is the formula of the simple interest, which calculates the final
return of the invested capital in those cases where we do not reinvest the generated
interest.

In the third case, the value of our investment will continue increasing in the following
way:

FV1 = PV + PV × 0,05 = PV × (1 + 0,05) = 100 × 1.05 = 105€

FV2 = FV1 + FV1 × 0,05 = FV1 × (1 + 0,05) = 105 × 1.05 = 110.25€

FV3 = FV2 + FV2 × 0,05 = FV2 × (1 + 0,05) = 110,25 × 1.05 = 115.76€

Hence, the investment will be increasing throughout time due to the interests, and these
interests, in turn, will be producing even more interests. The final value of the first year
(FV1) depends on both: the present value (PV) and the interest rate. The final value of
the second year (FV2) will depend on the final value of the first year and, also, on the
interest rate, and so on so forth. Thus, we can directly relate the final value of our
investment to its present value. Because if:

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 FV2 = FV1 × (1 + 0,05) and FV1 = PV × (1 + 0.05)

Then:

FV2 = PV × (1 + 0,05) × (1 + 0,05) = PV × (1 + 0.05)2

If we do this successively, we will get to the following general expression, which is the
formula of the compound interest.

FVn = PV × (1 + i)n

In which “n” indicates the number of years of the investment and “i” the interest rate
expressed as a percentage. Thus, the value of an investment at the end of a specific
period depends on the present value, the interest rate at which it is invested and on the
number of investment periods (years in this case). From this last formula we can easily
deduce that the highest the interest rate and the longest the period of the investment
is, the highest the final value results.

2 THE CALCULATION OF PRESENT VALUE (OR DISCOUNT)

Up to now we have seen that if we deposit our money in a bank, or invest it in any other
way, we will have the chance of increasing our capital. Furthermore, we have seen how
much cost it would have disregarding the opportunity of investment. Hence, we will not
be willing to invest 100 euros for a year, if at the end of this period we obtain less than
105 euros, quantity the bank would give us.

Nevertheless, this does not mean that we cannot accept investments that produce less
than 105 euros at the end of the year. Rather, it means we should not invest the quantity
of 100 euros in them. We can calculate how much we could invest in an investment that
produces, for instance, 103 euros at the end of the first year if we want to obtain, at
least, a 5% return, as in the case of the bank deposit.

If investing 100 euros produces 105, or what is the same 100 × (1 + 0.05), at the end of
a year, how much should we invest if at the end of the year we are going to obtain 103?
The problem is solved by using a simple rule-of-three:

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 103 × 100 103
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = = 98.1€
100 × (1 + 0.05) (1 + 0.05)

Then, we should not invest more than 98,1 euros if we do not want to earn less than in
our first investment. If we did, we would incur in an opportunity cost, since we would
not be earning money we could otherwise be earning.

Now, let us suppose they tell us that the investment produces 103 euros, not every year,
but every two years. Then, the amount of money we would need to invest would be:

103 × 100 103

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = = 93.4€
100 × (1 + 0.05) (1 + 0.05)

In general terms, we could say that the present value (PV) of future money can be
expressed as:

𝐹𝑉
𝑃𝑉 =
(1 + 𝑖)

This is the resulting expression, considering that the interest at which we are operating
is a compound interest. In fact, for any operation longer than a year, the compound
interest formula is always used. In any case, if we were to consider a simple interest, in
which we did not reinvest the interests produced year after year, the calculation would
be the following:

𝐹𝑉 103
𝑃𝑉 = 𝑖𝑛 𝑜𝑢𝑟 𝑐𝑎𝑠𝑒 → 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = 93.6€
(1 + 𝑖 × 𝑛) (1 + 2 × 0.05)

As we can see, the compound interest produces a higher return when it is invested for
more than a year.

If the investment is for a year, the simple and the compound interest coincide because,
in this case, there is no possibility of reinvesting the interests since these have not been
generated yet. Moreover, multiplying mathematically by one produces the same result
as to the power of one.

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 3 CALCULATION OF THE INTEREST RATE OF AN INVESTMENT IN THE CASE OF

COMPOUND INTEREST RATES

Let us suppose we find a person who assumes the compromise of paying back, in a year
time, 110 euros if we lend him the 100 euros, we presently own. At first, we do not know
the interest rate offered, but calculating it is not difficult. Indeed, we know the value of
our money today, the final value we want to obtain and the formula which relates one
with the other. Thus, we can state the following:

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)

Therefore:

110 = 100(1 + 𝑖)

In this case our unknown number is “i” and working out its value is quite easy:

110 110
1+𝑖 = →𝑖= − 1 = 0.10 → 10%
100 100

And if it were a two-year period instead of one, we would equally apply the compound
interest formula, which in this case would be:

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)

Where working out the value of (1 + 𝑖) :

𝐹𝑉
(1 + 𝑖) =
𝑃𝑉

And we can work out “i”, by calculating the square root:

𝐹𝑉
𝑖= −1
𝑃𝑉

Thus, as long as we know the amount of cash we invest and the amount we will be
obtaining in return in a number of n years, we could state that the general expression
to obtain the annual compound interest of an investment, will be as follow:

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 𝐹𝑉
𝑖= −1
𝑃𝑉

When we talk about interest rates, we understand that we are talking about annual
interest rates. However, it could happen that the return of an investment is offered at
an interest rate which refers to periods different from a year. Further on, we will see
how to calculate those equivalent interest rates, that is, how to change the rate referred
to a period different from the year.