Question

The literature in Brigham and Ehrhardt (2016) illustrates that compounding is a process of balancing and building additional funds over time. For example, if $200 is invested with a 15% interest rate compounding yearly for a total of 5 years, the value of the investment (Future Value) would be $255.26 because of the interest compounding on top of the balance (with its interest) each year. When investing money, it has the potential to multiply given enough time.

Net Present value is the initial value needed to determine what a future value of an investment would be. This value is then multiplying in different ways, with the result being the final (future) value of the equation. The previous example uses a Present Value of $200, the beginning amount that can be manipulated to find the Future Value. When considering investing, it is wise to understand how much will need to be invested for a desired return. For example, if Mary wants to start a savings account and want to have $255 in five years, she must first be informed that she would have to initiate the account with $200. This way, if she wants a better return on her investment, (she can place a larger value in the account), add more money periodically, or seek other investment opportunities. Various formulas are used in determining how fast the money will grow. Which options would be the best way for Mary wanting to increase her wealth?

Answer 1

Here Mary’s objective is to maximize the increase in her wealth. Note that increase in wealth = future value (FV) – present value (PV).

The ideal way for Mary to is add more money periodically. For instance suppose that Mary puts in $200 initially and then adds $6 each year at the end of the period. Here PV = $200, PMT = $6, nper = 5 and rate = 15%. Thus FV can be computed using the “FV” formula in excel and the syntax will be: FV (15%, 5, -6, -200). This formula will give a value of $442.73

Thus by initially investing $200 and then putting in $6 each year (interest rate is 15%) Mary will get $442.73 after 5 years. Alternatively she can consider other options whose interest rate is greater than 15%.