MCR3U Working Backwards – An Intro to Present Value

Consider the problem of determining the future value of an investment into an account that pays interest at a
rate of 5% per annum compounded semi-annually for a total of two interest periods (in this case, 1 years since
interest is charged semi-annually [twice a year]).

If the investment was 100, the future value would be 100(1 + 0.05/2)2 = 100(1.050625) = 105.0625
If the investment was 200, the future value would be 200(1 + 0.05/2)2 = 200(1.050625) = 210.125
If the investment was 300, the future value would be 100(1 + 0.05/2)2 = 300(1.050625) = 315.1875

Notice that a common multiplier, in this case (1 + 0.05/2)2 [which is approximately 1.050625], is multiplied by
the original investment to arrive at the future value. Over the years, mathematicians have thought that it might
be valuable to tabulate different “multipliers” so that future calculations could be much easier.

For example, knowing that the 5%/a c.s.a for two interest periods multiplier is approximately 1.050625, one
could easily multiply this into an amount, say $550.00, to arrive at the future value of $550.00 when invested at
5%/a c.s.a for two interest periods – which is $550(1.050625)2 = $577.84. Obviously, you could check your
work by calculating $550(1 + 0.05/2)2.

Below, you will find one example of a table, which provides a variety of “multipliers” for different interest rate
and number of compound periods combinations. It should be mentioned that there are some downfalls with
using this table – such as the fact that it doesn’t provide every possible interest rate and number of
compounding periods combination – and therefore, there will always be a need to resort back to the basic
calculations. In addition, the multipliers are only accurate to a set number of decimal places – in this case four.
Having said that, there is value in being able to read the table and use the multipliers to arrive at a future value
rather quickly and easily.
For example, if you wanted to determine the future value of $1 000 invested at a rate of 6%/a compounded
semi-annually for two years, the number of compounding periods would be 4, the interest rate per period would
be 3 and the multiplier would be 1.1255 – resulting in a future value of $1 000 * 1.1255 = $1125.50.

Now if you wanted to find out how much today you would need to invest so that you have $1 000 at the end of
two years in an account that pays interest at a rate of 6%/a compounded semi-annually, you could use the same
multiplier but in the inverse way. That is, 1000 / 1.1255 = $888.49 is approximately the present value of $1000
in two years time. That is, if one was to invest $888.49 for two years at a rate of 6%/a compounded semi-
annually, they would have approximately $1 000 at the end of the two years. So you can see, that the chart can
be used in an inverse way (similar to the trigonometry charts) to find out the present value of an amount.

By the way, if you didn’t have the chart above, you could find the present value of $1 000 invested at 6%/a
compounded semi-annually by calculating 1000 / (1 + 0.06/2)2, which results in approximately $888.49

A simple way to remember all of this is that you need to multiply the amount by the appropriate “multiplier” to
move the amount into the future (ie. Find the future value of an amount) and you need to divide the amount by
the appropriate “multiplier” to move the amount into the backwards (ie. Find the present value of an amount).
If you can understand this concept, you are well on your way to understanding the very valuable concept of the
Time Value of Money – that is, “a dollar today is worth more than a dollar tomorrow”.

For practice, I would like you to attempt the following practice questions. If this is the first thing that you are
reading on this note, please go back and start at the beginning as carefully read the entire note before proceeding
to these practice problems.

1)
a) What is the multiplier for 8.5%/a compounded monthly interest for 7 years?
b) Determine the future value of $560 000 invested at the rate above for 7 years?
c) How much needs to be invested today at the rate above if we want $300 900 at the end of 7 years?

2) Some people argue that if you double the interest rate, then only half of the time is needed for the
investment to reach the same amount at the original rate. Is this true? Create a scenario to support or refute
this argument.

3) TheGagnonator would like to make a lump-sum investment today for his children’s education so that they
will have approximately $100 000 in 10 years time. As a result of his research, he has been presented with
three investment options: (1) invest at a rate of 8%/a compounded semi-annually (2) invest at a rate of
7.8%/a compounded quarterly or (3) invest at a rate of 7.5%/a compounded monthly.

a) Which option would be best for him to take?

b) A fourth option has been presented to him: If you were to multiply the three “multipliers” from options
(1), (2) and (3) together, divide by 500 and subtract 1, this result could serve as the interest rate
compounded every two years. Now that the fourth option is available to him, which of the four options
is best? What is the interest rate for option four? What is the multiplier associated with option 4?