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Time Value of Money

Suppose you have $1000 in a bank account, earning 1% interest. You complain about this rediculously low interest rate to your friend Susan. She says, "I'll tell you what. Give me the $1000 right now, and in five years, I'll give you $2000." You trust Susan completely know she will pay you the $2000. Is this a good deal?

If you were to put $1000 in the bank, earning 1% interest for 5 years, you would end up with $1051.01. The formula for this is:

Present Value X (1 + (interest rate/100))(Number of Years)

Or in this case, $1000 times 1.01 to the fifth power, which comes out to $1051.01. So, even if Susan were to offer you one dollar more than the value we calculated, or $1052.01, you would still take her offer. Susan's $2000 is actually worth $1902.93 to you, because you'd have to put $1902.93 in the bank to get $2000 in five years. The formula to calculate this is:

Present Value
_____________________________
(1 + (interest rate/100))(Number of Years)

Or in this case, $2000 divided by 1.01 to the fifth power. So if you give your $1000 to Susan, your $1000 investment will be worth over $1900! In fact, even if there is a chance that Susan will not pay you back, this might still be a fantastic deal. You have found an undervalued opportunity.