Time Value of Money 43Exhibit 2.1a Future value interest factor
An Illustration
Suppose you open a bank account with Rs 5,000. The bank pays 9 percent interest p.a. What would be the
account balance at the end of 6 years; and, after 8 years? The answers:
Balance at the end of 6 years = 5000(1.09)^6 = Rs 8385.50
Balance at the end of 8 years = 5000(1.09)^8 = Rs 9963The concept of compounding could be used in several other areas. Here’s one:
The current production of Steel Company of India is 3 million tons.
The output is expected to grow at 8 percent p.a.
The output would grow to 3(1.08)^5 = 4.4 million tons in 5 years.
The annual growth rate is called compound growth rate.In the earlier example of the bank, we calculated the interest on the outstanding balance and not on the
original principal of Rs 1,700. We assumed that interest receipts would also be reinvested. If interest were to
be calculated on the original principal year after year, the amount would not compound. The interest in this
case is called simple interest. Whenever we say interest, we keep in mind the compound interest—not
simple interest.
The value of Re 1 for different interest rates and time periods is available in the form of the Future
Value Interest Factor table (Table A.1 at the end of this book). A section of the same table is reproduced
in Exhibit 2.1.