1. Calculating FV Using Compound Interest
We can now start talking about the time value of money,
present values and future values, but this time in terms of compound interest.
Starting with the present value and moving forward in time to find the
future value, well, this is known as compounding.
We start with $100 as our principal or present value. The interest rate
is 5% compounded annually and n is 3 years. Mathematically it looks like
this, $100 multiplied by bracket, 1+5% close bracket.
To reach the end of year 2, we multiply $105 by bracket 1+5% close
bracket to get 110.25 and by year 3 becomes 115.76.
Because each year we are multiplying the amount at the start of the
year by 1+5%. To find the amount at the end of each year,
we can actually rewrite this as $100 multiplied by bracket, 1+5% close bracket,
all raised to the power of 3. Now, in general terms,
using 1 for the compound annual interest rate and n for the number
of years, the formula becomes the future value equals the present value
multiplied by bracket 1+I close bracket raised to the power of n.
2. Let's practice!