How to Assess Profitability of Investments with Present Value and Future Value - dummies

How to Assess Profitability of Investments with Present Value and Future Value

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Accountants use present value (of cash inflows and outflows) and future value (of assets or cash) to gauge how profitable (or not) an investment is likely to be:

  • Present value calculations indicate the profitability of long-term investments. A CPA may compute the present value of a series of cash inflows and outflows to determine whether a long-term investment is likely to be profitable.

    If the sum of the present values of the inflows and outflows is a positive number, an accountant is likely to recommend that the company proceed with the project, assuming other factors under consideration support that decision.

  • Future value calculations project how much money a company will need in order to pay a debt due in five or ten years. If a business needs to make a large investment in the future (for example, spending to replace a piece of equipment), future value calculations can tell the firm how much money it needs to invest each year.

The difference between present values and future values is a tough concept to grasp. One way to grasp the difference is to calculate a future value and then work backward with that result, using present value tables. This method reveals how the two concepts are connected.

Spotting trends in present and future value tables

Calculators are great for figuring present and future values, but you need present and future value tables to understand these concepts. You need to see, on a chart, where the present and future values come from. By looking at a chart, you can spot trends. The higher the future value rate (interest rate), the more each dollar is worth when you calculate future value.

So, find a set of present and future value tables on the web and use them. Here’s an example:

Periods 8% 9% 10%
1 1.08000 1.09000 1.10000
2 1.16640 1.18810 1.21000
3 1.25971 1.29503 1.33100
4 1.36049 1.41158 1.46410
5 1.46933 1.53862 1.61051
6 1.58687 1.67710 1.77156

Appreciating the impact of compounding interest

With compounding interest, you earn a return on two amounts:

  • Principal: You earn interest on your original investment (principal amount). For example, if you invest $1,000, you earn interest on that $1,000 for every period you leave the money in that account.

  • Interest: You “earn interest on interest” that you earned during prior periods. For example, if you earned $20 interest in one period, you earn interest on that $20 at the end of the next period.

As an example, suppose you invest $1,000 in an account that earns 10% interest per year, compounding annually. Once a year, your total investment (principal amount plus prior interest payments) will be credited with 10% interest.

The following example takes you through three years of compounding interest on this investment:

You invest $1,000. At the end of year one, you’ve earned 10% interest. The present value factor for 10%, 1 year is 1.1, so the total investment at the end of year 1 is:

$1,000 × 1.1 = $1,100

At the end of year two, you’ve earned another 10% interest, this time on $1,100.

Now, you could calculate your total investment after year 2 by multiplying $1,100 × 1.1 or you could multiply your original investment of $1,000 by the present value factor for 10%, 2 years, which is 1.12 or 1.1 × 1.1 = 1.21:

$1,000 × 1.21 = $1,210

You leave the entire $1,210 in the account. At the end of year three, you’ve earned another 10% interest. The present value factor for 10%, 3 years is 1.13 or 1.1 × 1.1 × 1.1 = 1.331.

Total investment after year 3: $1,000 investment × 1.331 = $1,331

If interest weren’t compounded, the $1,000 invested at 10% would earn only $100 each year. At the end of three years, the total would be $1,300, which is $31 less than the same amount with compounded interest.