Discounted future value is a time value of money technique that takes a future dollar amount and puts the value in current dollars. The purpose of this technique is for making dollar-to-dollar comparisons when making decisions. A dollar today does not have the same value of a dollar in the future, most likely due to inflation, which erodes a dollar’s purchasing power. A basic formula allows individuals to determine the discounted future of a single or several amounts of money from future periods. Different alterations are possible in order to create a formula that best fits a situation.
When individuals think about the time value of money, interest is perhaps the most common item that comes up. Here, a principal dollar amount placed in a savings account or investment accrues money over time, increasing the base principal amount. Simple interest adds to the base principal amount on an annual basis, in most cases, while compound interest adds to the base principal plus annually accrued interest. Discounted future value works backward, taking the final dollar amount earned, saved, or generated from an activity and discovers what principal is necessary to create the future value. For example, if an investor desires a final value of $10,000 US Dollars (USD) for a stock purchase, the discounted future value formula can tell him or her what principal amount to invest right now.
The future value formula for a single dollar amount has two different basic formulas, one for simple interest and one for compound interest. For simple interest calculations, an individual should divide the principal amount by one plus the interest rate times the number of periods the investment will last. An example is a $100,000 USD principal investment that lasts for 10 years with an eight percent interest rate. The mathematical formula here is $100,000 USD / [1 + (10 * 0.08)], which results in a discounted future value of $55,555 USD. In short, investing a principal amount of $55,555 USD using the given data above will result in a future value of $100,000 USD in 10 years.
Discounted future value for compound interest is slightly different. The denominator of the formula is one plus the interest rate divided by the number of time interest compounds in a year, raised to the power of the total investment period, times the number of interest compounds each year. So, the mathematical formula – using the information from above – looks like this: $100,000 USD / [1 + (.08/12)10 * 12]. The interest for this investment is expected to compound 12 times a year, that is, monthly. The discounted future value is then $45, 053 USD for this investment, which carries the same meaning as the discounted amount above.