…what is it worth in the future?
The future value of a lump sum is the amount of money that a sum of money today will grow to at a future date, assuming a certain rate of return.
To illustrate, suppose 3,000 is invested at 10% for a year. In this case at the end of the year the interest earned will be 3,000 x 10% = 300. Furthermore the lump sum will have grown to 3,000 plus 300, equals 3,300.
Generally the original lump sum (3,000) is referred to as the present value (PV) and is the value today, at the start of period 1. The final larger lump sum (3,300) is referred to as the future value (FV), and in this case, is the value of the lump sum at the end of year 1.
To illustrate, at the end of year 1 the future value is given by.
FV = PV + Interest FV = 3,000 + 3,000 x 10% FV = 3,000 + 300 FV = 3,300
If the amount of 3,300 remains invested for another year, then at the end of year 2, the future value is given by.
FV = 3,300 + 3,300 x 10% FV = 3,300 + 330 FV = 3,630
If the amount of 3,630 remains invested for another year, then at the end of year 3, the future value is given by.
FV = 3,630 + 3,630 x 10% FV = 3,630 + 363 FV = 3,993
Future Value of a Lump Sum Cash Flow Diagram
Additionally each cash flow stream can be represented in a cash flow diagram. As can be seen the original 3,000 is invested (cash out) at the start of period 1, and is returned (cash in) with interest as the larger lump sum 3,993, at the end of period 3.
It is important to realize that each year interest is being earned on the original sum and on the interest from the previous years. Consequently this type of interest is referred to as compound interest. To illustrate the compounding is shown in the table below.
Future value of a lump sum
| n | Period | 1 | 2 | 3 |
|---|---|---|---|---|
| PV | Opening balance | 3,000 | 3,300 | 3,630 |
| i | Interest @10% | 300 | 330 | 363 |
| FV | Closing balance | 3,300 | 3,630 | 3,993 |
Future Value of a Lump Sum Formula
To summarize it would be useful to write the future value of a lump sum answers above in terms of the original lump sum (3,000).
Future value at the end of year 1:
FV = PV + Interest FV = 3,000 + 3,000 x 10% FV = 3,000 x (1 + 10%) FV = 3,000 x (1 + 10%)1 FV = 3,300
Future value at the end of year 2:
FV = 3,300 + 3,300 x 10% FV = 3,300 x (1 + 10%) FV = 3,000 x (1 + 10%)1 x (1 + 10%) FV = 3,000 x (1 + 10%)2 FV = 3,630
As can be seen above the amount of 3,300 has been replaced with 3,000 x (1 + 10%)1 from the answer for year 1.
Future value at the end of year 3:
FV = 3,630 + 3,630 x 10% FV = 3,630 x (1 + 10%) FV = 3,000 x (1 + 10%)2 x (1 + 10%) FV = 3,000 x (1 + 10%)3 FV = 3,993
In similar fashion the amount of 3,630 has been replaced with 3,000 x (1 + 10%)2 from the answer for year 2.
To summarize:
End of year 1 FV = 3,000 x (1 + 10%)1 End of year 2 FV = 3,000 x (1 + 10%)2 End of year 3 FV = 3,000 x (1 + 10%)3
This can be continued indefinitely so for example at the end of year 20
FV = 3,000 x (1 + 10%)20 FV = 20,182.50
Furthermore if we replace our original lump sum of 3,000 with the more general term PV, the discount rate of 10% with i, and the number of periods 20 with n, we arrive at the future value of a lump sum formula as follows:
FV = PV x (1 + i)n
Variables used in the future value of a lump sum formula
PV = Present value, the value today at the start of period 1
FV = Future value, the value at the end of period n
i = Discount rate, the rate per period
n = Number of periods
Future Value of a Lump Sum Example
To illustrate the use of the formula suppose a lump sum of 4,000 is invested for 19 periods. Additionally assume and the interest rate per period is 6%. In this case at the end of the 19 periods, the value of the lump sum is given by the formula as:
FV = PV x (1 + i)n FV = 4,000 x (1 + 6%)19 FV = 12,102.40
To summarize, the future value concept forms the basis of many time value of money calculations. The formula allows any lump sum (PV) to be compounded forward a number of periods (n) at a discount rate of i per period.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.