Subject: SS-BF-II-12 BUSINESS FINANCE

Week: 9
Topic: Time Value of Money: Future Value
Compounding is a method used to answer a simple question: What is the future value of
money lent (or borrowed) today? The question is forward looking; we stand in the present
(today) and ask a question about the future.

We can start with:

(A) Amount repaid = principal + interest.
The amount of interest can be expressed as
(B) Interest = principal × interest rate.
Substituting Equation (B) into Equation (A) yields
(C) Amount repaid = principal + (principal × interest rate).
Because each term on the right- hand side of Equation (C) has a common factor, it can
be rearranged and rewritten as
(D) Amount repaid = principal × (1 +i)
where i is the interest rate
We can rewrite Equation (D) as
V1 = V0 (1+i)
where V1= the funds to be received by the lender (paid by the borrower) at the end of
year 1 (a future value); and V0= the funds lent and borrowed now (a present value).
Imagine now that someone borrows for two years instead of one year and makes no
payments to you until two years pass. Here is where compounding comes into play.
Compounding refers to the increase in the value of funds that results from earning interest
on interest. More specifically, interest earned after the first year is added to the original
principal; the second year’s interest calculation is based on this total.

We can rewrite the formula as:

V2 = V0 + iV0 + i(V0+iV0)

The funds to be received at the end of two years, V2, consist of the original amount of
funds lent out, V0, plus the interest earned the first year on the original amount, iV0, plus
the interest earned the second year on the amount of funds owed at the end of the first
year [i(V0+iV0)].
In the second year, you earn interest not only on the principal but also on the interest
earned in the first year. In effect, the interest earned in the first year is reinvested.
If the interest rate is consistent for 2 years we can rewrite the formula as:
V2 = V0 (1+i)2
Or a general formula for consistent interest rate:
Vn = V0 (1+i)n