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Financial Accounting: Help and Review18 chapters | 235 lessons

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Lesson Transcript

Instructor:
*Michael Cozad*

Michael is a financial planner and has a master's degree in financial services.

This lesson will give an overview of and explain the future value formula. Also in this lesson, various examples will be explored using the future value formula.

Have you ever wondered what something you have right now could be worth in the future? A savings account? Or maybe an investment you have made? Possibly another type of asset, like real estate?

The formula for **future value** answers these questions and tells you the estimated value of an asset in the future. After this lesson, the next time you plan to buy a new car, or a house, in a few years' time, you will have a much better answer as to how much to save, rather than just 'throwing out a number.'

Before diving into the formula, let us assume that Aunt Bee, a big-time saver, has decided to open a savings account with a 5% interest rate, compounded annually. She wants to know how much her account will be worth in 10 years after she makes this one-time deposit of $1,000.

The formula we use to figure this out is:

**FV = X * (1 + i)^n**

where:

**FV** = future value

**X** = original investment

**i** = interest rate

**n** = number of periods

Now, let's consider the problem at hand. We are trying to figure out the future value. The original investment is $1,000; the interest rate is five percent, and the number of years is ten. Now, we simply fill in the variables and solve the equation.

FV = $1,000 * (1+ 5%)^10

FV = $1,000 * (1.05)^10

FV = $1,000 * 1.62889

FV = $1,628.89

Using the formula, which assumes the savings account pays a consistent 5% interest rate, Aunt Bee will have $1,628.89 at the end of 10 years.

Let's look at a practical example. Given today's low interest rates, Aunt Bee may be hard-pressed to find a savings account paying 5%.

So, let's say your spouse mentions that in four years they would like to buy a home in one of America's fastest-growing communities. You research the area and learn that home prices are expected to rise 7% per year. Today, your ideal house costs $125,000. What can you reasonably expect a similar home to cost in four years? To solve this problem, remember that you must first plug the numbers into the formula, FV = X * (1 + i)^n. In this example, the original investment is the $125,000 that the house costs, the interest rate is seven percent, and the number of years we are looking at is four.

FV = $125,000 * (1+ 7%)^4

Now, we simplify and solve the formula:

FV = $125,000 * (1.07)^4

FV = $125,000 * 1.3108

FV = $163,850

Using the formula, you can reasonably expect that a similar home will be on the market for $163,850 in four years.

There are a couple of things to keep in mind when using the formula. One, if the interest is stated more often than annually, you need to change the interest rate and number of periods.

Two, an easy way to deal with the 'carrot' is to multiply out that side of the formula. For example, in the example about the house, (1+7%)^4 is really: (1+7%)*(1+7%)*(1+7%)*(1+7%).

Three, you can solve for any of the variables. Future value is just one of the variables, and is the major concept of this lesson.

Using the **future value** formula can assist individuals in calculating the estimated value of an asset in the future. Assets that are commonly valued are investments, such as savings accounts or real estate.

The **future value formula** is:

FV = X * (1 + i)^n

where:

**FV** = future value

**X** = original investment

**i** = interest rate

**n** = number of periods

When using the formula, there are a few guidelines to take into consideration. One, if the interest rate is stated as more often than annually, you need to change the interest rate and number of periods. Two, an easy way to deal with the 'carrot' is to multiply out that side of the formula. Three, you can solve for any of the variables.

Last, it is important to note that because interest rates are typically subject to change, the formula should be taken as a 'best guess' and not a guarantee of a future value.

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Financial Accounting: Help and Review18 chapters | 235 lessons

- The Differences Between Accrual & Cash-Basis Accounting 6:20
- Using Accrual Accounting to Make Financial Statements More Useful 5:47
- Accrued Expenses & Revenues: Definition & Examples 4:30
- Preparing Financial Statements 7:35
- Temporary & Permanent Accounts: Definition & Differences 4:57
- Real Accounts vs. Nominal Accounts: Definition, Differences & Examples 4:55
- Debt Financing: Definition, Types, Advantages & Disadvantages
- Deficit Financing: Definition & Concept
- Differential Cost in Accounting: Definition, Analysis & Formula 5:21
- Direct Labor: Definition & Cost Formula
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- How to Calculate Yield to Maturity: Definition, Equation & Example 5:14
- Unearned Revenue in Accounting: Definition & Examples 4:46
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