Finding out the time value of money involves calculating either the future value or the present value of the amount.
The future value of money is the compound interest the sum earns for the specified period, assuming the money remains untouched.
For example, if $10,000 is deposited in the bank, and earns 5 percent interest in the first year, and 6 percent interest in the second year, the future value of $10,000 after two years is:
$10,000 x 5% +$10,000 = $ 10,500 at the end of year 1
$10,500 x 6% +$10,500 = $ 11,130 at the end of year 2
When the interest rate is constant, the formulae to calculate future value of a sum of money is
Original amount (1+annual interest rate)^number of years.
The present value of money is the discounted value of the money, or the sum, which invested today, would grow with interest to the amount in question. The formulae to calculate present value of money is Future value / (1+interest rate) ^ number of years.
For instance, to determine the present value of $10,000 obtainable after two years at 5 percent interest:
$10,000 / (1+5)^2 = 10,000 / (1.05*1.05 ) = 10,000/1.1025 = $ 9,070.3
Thus, the present value of $1000, assuming 5 percent interest, is $9,070.3.
Now assume an investment that requires 10 monthly payments of $20,000 and promising a lump sum return of $300,000 at the end of five years. A quick calculation reveals a total investment of $200,000 and a return of $300,000, or a return of 50 percent in five years. The actual rate, however, varies.
The actual rate of return is the rate at which the present value of the return equals the net outgo. In this case, the interest rate is approximately 8.5 percent, for the present value of $300,000 at 8.5 percent per annum for five years is $199513.6. Factoring in the present value of the future installments would distort this figure slightly.