And here we go. Once again, let's carry on with our introduction to finance by learning about future value in this lesson. future value is the opposite of present value. Calculating future value determines how much money we will have at the end of a specific investment horizon, based on the cash flow forecast. The most common application of this concept is for retirement planning, so let's weave this into this lesson. Once upon a time, there was a man named Bob.

Bob was modestly wealthy, but not wealthy enough yet to retire. But like many people he dreamed of moving to Florida and living life by a pool. His hope was to do this within the next five years. for argument's sake, let's say that Bob needs a million dollars to retire to live this glorious life but today he only has $500,000 in his bank account, the difference of $500,000 created It's somewhat of a dilemma for Bob as he wasn't quite sure how he was going to close the gap. In the investment world, there are many, many types of investment that Bob could invest his money into, all with different risk reward profiles. And what do we mean by risk reward?

Well, quite simply, it means that the more risk an investor assumes, the greater the expectation of return, Bob could put his $500,000 into government treasury bills or T bills. These are the debts of the government. If these happen to be us t bills, they are considered one of the safest investments on the planet, because they have the full backing of the US federal government. Hence, the risk of default is negligible. But the problem is because they're so damn safe investors are willing to invest in them with a very low expectation of return. Let's just say for argument's sake that it's 2% For a five year investment horizon, this means every year the government will pay interest that equates to a 2% return or yield on his investment.

So let's work the math. If Bob puts $500,000 into government treasury bills, how much will he have at the end of five years. To calculate this, we take the $500,000 and calculate the return each year assuming that the interest payments are reinvested back into buying even more t bills. This reinvestment assumption is called compounding. So in the first year, he makes $10,000. In the second he makes $10,200 in the 30, makes $10,404 in the fourth 10,612 and in the fifth $10,824.

So at the end of five years, Bob will have a retirement savings account of 552 Thousand $40 finance has a nifty formula that shortcuts this calculation the same way as we learned in our last lesson about calculating present value. By knowing the current or present value of our existing savings, the number of periods for investment and the expected investment return, we can quickly calculate the same amount. Excel also conveniently has a similar function. Now, let's see what we've got $552,000 he likes this isn't even close to our $1 million objective. We've got to do better. This is a situation that confronts almost every human being on the planet.

If we could all retire by just investing our savings in government bonds, we'd all do it. The problem is, it's rarely enough. So we're going to have to dig deeper into the world of finance for a solution. So what are Bob's options? Well, one option might be just to post Retirement buy a few years and let the money compound a little longer. Let's see how many years it would take before Bob could retire by solving for n the number of periods, it would be 36 years from today before his investment account would cross the $1 million.

Mark. Hi, crap, I'm not even sure Bob has another 36 years in them. So that's not a solution. Maybe Bob could continue working for five years and managed to set aside say an additional $50,000 in each of the next five years. Will that help? Now this is a slightly different situation, and we return to this idea of an annuity.

An annuity is a constant stream of payments, in this case, five equal payments of $50,000 each, we can build out our Excel model to accommodate this additional capital infusion, like so or we can incorporate The annual contribution into the XL future value function as illustrated in the formula bar. Or we can use another finance formula, the future value of an annuity to calculate the same amount and add it to the future value of the lump sum we calculated earlier. Regardless of our approach, our answer is exactly the same. And unfortunately, so is the outcome, it's still not enough for Bob to retire. The last option for Bob is to seek out a higher rate of return. And to do that, we need to look forward to investment with more risk and investment that gives Bob a higher rate of return than 2%.

Let's use our future value formula to solve for the rate of return needed by Bob to achieve his retirement goal. You could just play with the rate of return until the value of cash at the end of year five is a million dollars. You can solve for this rate of return using the Excel rate function. It looks like Bob is going to need a compound rate of return of 15%. To meet his investment goal, we now need to scour the investment universe looking for some sort of investment instruments that will give Bob an acceptable chance at generating that sort of return. He's got a lot of choices, including stocks and bonds, which we will look at more In our next lesson.

In this lesson, we learned that the opposite of present value is future value, which is helpful when we need to figure out how much money we'll have at some point in the future, say the day you retire. Secondly, determining future value requires an expected rate of return and investment horizon and the amount of any initial or annuity investment contributions. And finally, we can solve for the required rate of return. If we know desired future value, the investment horizon and the profile of the contributions. That's all for this lesson. Until next time,