THE ART OF COMPUTING FUTURE AND PRESENT VALUES

It should be noted that this is the same result shown in exhibit 3, with only one
calculation to perform. Other time periods and interest rates can easily be used
where appropriate.
There appears, then, to be a relationship between the table of the compound
sum for $ 1.00 and the table of the sum of an annuity of $ 1.00 for n periods.
Remembering that the value of ordinary annuities with compound interest is
computed immediately after the last deposit is the key to explaining the
relationship between these two tables. Returning for a minute to Exhibit 3, note
that the period 1 deposit earned 1.102 times the original deposit, the period 2
deposit earned 1.05 times the original deposit, and the period 3 deposit earned
1.0 times, or no interest. This because the last deposit of an ordinary annuity is
immediately taken into account in the annuities total value. By adding these
three compound sum of $1.00 interest factors. (1.102+1.05+1.0), the very
same interest factor obtained from a table of the sum of an annuity of $ 1.00
for n years, 3.152, is found. This table, then, is nothing more than a
combination of the compound interest factors in a table of the compound sum
of $ 1.00.
Review this procedure again. The first row in a table of the sum of an annuity of
$1.00 for n years is the last payment immediately credited to the total value of
an ordinary annuity. Under a 5% assumption, the period two interest factor of
2.050 is simply the end of year one compound sum of 1.05, plus the 1.0
interest factor for the immediate credit of the last payment. Likewise, the
period three interest factor of 3.152 is the end of year two compound sum of
1.102, plus the end of year one compound sum of 1.05, plus the 1.0 interest
factor for the immediate credit of the last payment.
Hence, a three period ordinary annuity earns interest for only two periods. Note
that this compound ordinary annuity of $ 100 per period has a higher future
value than the simple ($315.20 versus 315.00).
Ordinary annuities always earn interest for one period less than the stated
number of periods. When all deposit amounts are equal, the time intervals are
equal, and all deposits earn interest, the annuity is an annuity due.
Exhibit 4 shows the calculations involved under these assumptions using a
table of the compound sum of $1.00.
EXHIBIT 4 ANNUITY DUE (COMPOUND INTEREST)
Interest
Earning
Periods
Deposits

0
$100
Earns
interest for
three periods

1
$100
Earns
interest for
two periods

2
$100
Earns
interest for
one period

($100)
(1.158)*

($100)
(1.102)*

($100)(1.05)*
$105.00
$110.20
$115.80

Compound Amount of an Annuity Due at 5% for 3 Periods $331.00

From table of the compound sum of $ 1.00. Some interest factors are
rounded.

As with the ordinary annuity, the answer was obtained by applying the
appropriate compound interest factors to the periodic deposits; only this time
each deposit earned interest. The future value was determined one year after
the last deposit.
Fortunately, the table used in simplifying the calculations for an ordinary
annuity can be modified for use in computing the future value of an annuity
due. Since the difference between the two annuities is the interest is earned on
the last deposit of an annuity due, just add one period and subtract 1 from the
interest factor found. For this example, look up the interest facto for 5% for four
periods and subtract 1. Thus, 4.310 1000= 3.310. (Note that this is the same
figure that would be obtained by adding the individual compound sum of $1.00
interest factors at 5% for each of the separate three periods. Why?)
Why subtract one? This is for the deposit that was not made immediately
before the future value was computed. This adjustment of subtracting out the
1.0 interest factor does not apply. This is an annuity due and all deposits earn
interest.
The key factor in using the sum of an annuity for $ 1.00 for n years or periods
is that the amounts are equal and that the time intervals are equal. If the
above conditions do not hold, the table for the compound sum of $ 1.00 must
be used for each deposit. That is, the computations must be performed
(depending on the type of annuity) as they were in Exhibits 3 or 4. For
example, an investment of $ 00 is made at the end of the first year, $200 at
the end of the second year, and $100 at the end of three years?
V= $100 (1+.10)2+(1+.10)1 +$100
V=$100 (1.210) + $200 (1.100) + $100
=$441
The interest factors 1.210 and 1.100 were obtained from the table for the
compound sum of $1.00. Since there are unequal amounts between time
periods, the table for the sum of an annuity of $1.00 for n periods is not
appropriate. (If there were three interest earning periods, what would the
answer be?)

Present Value

The present value method involves the translation of amounts of money

received or spent in future time periods to present value dollars, i.e., $100
received a year from today is worth less than $100 today since the use of the
money is not possible until the end of the year. The present and future values
are related mathematically and conceptually. Determining the value in a future
period is the opposite question to what is the value today of money received at
some point in the future. The important advantage of translating future sums to
todays values is that it allows the comparison of doing something today or
doing it in a future period. An earlier example indicated that a choice of $100
today, assuming no other influences. Unfortunately, all financial decisions are
not as immediately obvious and the use of the present value technique
provides a method to compare funds received at different points in time.

Simple Interest

The formula for computing the present value of a sum of money received in a
future period at simple interest is

s
1+rt

Where P = present value (principal)

R = simple interest rate
T = time (annual)

And from the previous section S = P(1+rt).

Consider a situation where $100 is received in a year and a half and the
present value (todays value) is desired with 10% simple interest. The
computations would be as follows

s
1+rt

Where P = present value (principal)

R = simple interest rate

T = time (annual)
And from the previous section S = P(1+rt).
Consider a situation where $100 is received in a year and a half and the
present value (todays value) is desired with 10% simple interest. The
computations would be as fallows

$ 100
1+.10( 11/2)

$86.96

approximately

If the money were to be received in one year, the computations would be

$ 100
1+.10( 1)

$90.91

approximately

Since the money in the first example was to be received in 1 years, the
fractional period was utilized.
Just as the future value was computed for annuities and unequal series of cash
flows, the present value of these types of payments or receipts can be
computed as well. For example, what is the present value of $100 at the end of
each of three years at 5% simple interest?

$ 100
$ 100
$ 100
+
+
1+.05(1) 1+.05(2) 1+.05(3)

$ 95.24+ $ 90.91+ $ 86.96

$ 273.11
The above method can be used for a series of payments or receipts which are
unequal in dollar amounts or time periods. For example, suppose three
payments are to be received. The first is $100 at the end of one year. The
second is $200 at the end of 1 years, and the third is $300 at the end of 2
years. What is the present value of this series when simple interest is 10%?

$ 100
$ 100
$ 100
+
+
1+.10( 1) 1+.10(1 1/2) 1+.10 (21 /2)

$ 90.91+ $ 173.91+$ 240.00

$ 504.82
In this instance, fractional periods were involved and the period in which
interest was earned varied for each of the deposits.

Compound Interest

The present value of future amounts discounted at compound interest reflects

the fact that interest becomes principal and also earns interest in subsequent
periods. The equation for the present value of a single amount at compound
interest is

v
(1+i) n

Where
P = the present value (principal)
V = the amount in a future period
i= the compound interest rate
n = the time period
If $100 is to be received at the end of a year, what is the present value of this
amount when interest is compounded at 10%?