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Growth of $100 original amount at 10% per year. Blue shaded area represents the portion of the total that results from compounding of interest.

A brief introduction to key financial concepts is available at

. www.teachmefinance.com.

Figure 5.1 illustrates the growth of the compound interest in Table 5.1. Notice how the simple interest is constant each year, but the amount of compound interest you earn gets bigger every year. The amount of the compound interest keeps increasing because more and more interest builds up and there is thus more to compound.

Future values depend critically on the assumed interest rate, particularly for long-lived investments. Figure 5.2 illustrates this relationship by plotting the growth of $1 for different rates and lengths of time. Notice the future value of $1 after 10 years is about $6.20 at a 20 percent rate, but it is only about $2.60 at 10 percent. In this case, doubling the interest rate more than doubles the future value.

To solve future value problems, we need to come up with the relevant future value factors. There are several different ways of doing this. In our example, we could have multiplied 1.1 by itself five times. This would work just fine, but it would get to be very tedious for, say, a 30-year investment.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

5. Introduction to Valuation: The Time Value of Money

© The McGraw-Hill Companies, 2002

CHAPTER 5 Introduction to Valuation: The Time Value of Money

Future Value of $1 for Different Periods and Rates

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