One of the underlying axioms of the study of finance is the rule that a dollar in hand today is worth more than the promise of a dollar in hand tomorrow, and a dollar in hand tomorrow is worth more than a dollar in hand in a year. The difference between the value of a dollar in hand today and the current market value of a dollar in hand tomorrow is the "interest rate," also referred to as the "time value of money" (TVM). To determine the future value of a stream of payments, each earning a reasonable market interest rate from the time you receive it, you must perform a time value of money calculation on a TVM calculator.
1. Purchase a time value of money calculator, or access a TVM calculator on the Web.
2. Familiarize yourself with the different functions. Specific abbreviations may vary somewhat from calculator to calculator, but each calculator should have a field or function for entering the following items: present value (PV), future value (FV), Payment (P) interest rate (I), number of compounding periods (N), and a function to enter how often the interest compounds. In most cases, you will use annual compounding figures.
3. Enter the present sum you have in hand that will be compounding into the box labeled "PV." Enter the amount of steady cash flow you expect to receive into the box labeled "P." Enter the compounding period into the box labeled "annual," unless you have a contract specifying monthly, weekly or daily compounding. If you do, select the appropriate box.
4. Enter your expected rate of return into the box labeled "I" or "interest." This figure should not be lower than the risk free rate of return you can receive from money market funds or guaranteed investment contracts (GICs). It should not be unrealistically high, either. If you are purchasing a fixed annuity, the insurance company should specify a guaranteed rate of return for you. Otherwise, a financial adviser can help you select a reasonable, conservative rate of return. As a proxy, you can use the rate banks are charging on 30 year mortgages in your market for a conservative rate of return.
5. Press the button marked "FV" or "Future Value." If you get an error, it may be because your "payment" should be a negative number.
- Remember, money paid to you is positive, while money you pay into an investment is negative. As long as you assign a different polarity to cash flows coming in as well as going out, you should have no trouble generating an expected future value of a series of equal cash flows.