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Principles of finance, a la shmoop. The math of future values, discounting.

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All right people so here's a curve ball we pay five bucks to a palm reader and [Baseball hits a player in the face]

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she tells us that we're going to inherit a million dollars in 20 years. She has [Woman in a smoky room]

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such a good reputation that a real-live Bank actually comes to us and asked to

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buy us out of that money they offer to pay us today for that 1 million dollars [Guy in a suit at the door holding money]

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to be delivered in 20 years how much are they gonna pay us for that and if you're

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smirking well yes this is like the scumbags who offer to buy out uneducated [Someone winning on a scratch card]

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people when they won the state lottery obviously and not doing a lot of tax [Guy holding up his winning scratch card]

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planning or detailing or much of anything else good along the way. Well

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the bank here offers us five hundred grand for that money. Five hundred grand [5 million dollars going from the bank to the person]

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for a million bucks twenty years from now do you take it it? Feels like a game

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show right, well the first thing you do is race back to this unit to refresh [Shmoop finance unit on a computer]

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your memory on the following formula. Present value, what the future value is

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worth today equals future value divided by the quantity one plus the rate of [The formula being written on the whiteboard]

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return to the period and there's some risk we're gonna throw in there as well

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but stay tuned there's no extra charge for that risk coverage. So if we plug in

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the above numbers we get five hundred thousand equals a million bucks divided

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by one plus X to the 20th right this is twenty years of compounding we just have

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to solve for that X thingy and we're home free so let's think about it with [The x in the formula is circled]

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our rule of 72 in mind remember that rule of 72 yeah tattooed on your body. [The rule of 72 is shown on the whiteboard]

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Actually don't do that our lawyers are giving us evil looks here, the bank will

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pay us half today for something they'll get in 20 years. Well that means that

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they're thinking that 500 grand today is worth less than the million bucks in 20 years. [Equation showing the $500,000 is worth less than $1,000,000 in 20 years]

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The bank would not offer us five hundred grand if it didn't think it could do

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better with the 500 grand investing it on its own right, banks don't live for

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charitable purposes for you and me. So what rate of interest is imputed here if

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the 500 grand doubles in 20 years? Well we know that it has to be 72 over 20 to

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get us there right, so what is 72 divided by 20 in California well it's 3.6 [The rule of 72 formula is filled with the values]

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so that means the bank believes it can't do any better than that 3.6

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percent of your return on the money. Meaning they're happy to just get three [The 3.6% return rate is circled on the whiteboard]

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point six percent a year return on the 500 grand they're quote investing in

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your future million dollars twenty years from now. Yeah banks are not very good

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you could do a whole lot better than this right. Think about the history of

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the stock market right, there hasn't been a 20-year period in modern history [Stock chart of the S&P500 showing prices going up over time]

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where the market didn't go up seven eight nine ten percent a year with

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dividends reinvested you could probably do doubly as well, so there is risk

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here the million bucks isn't exactly guaranteed by the US government and yeah it [Government building is crossed out]

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came from a palm reader so there's a risk here in addition to all of this so

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what do you do? What do you do you? You take the 500 grand today absolutely one would [The money is taken off the guy in the suit]

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hope that you could invest it in an index fund and well get a whole lot

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better than three point six percent of your returns from it and note that what

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we did here was discount back the future value of a million dollars to be a [The future value is highlighted on the whiteboard]

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present value of five hundred grand today, got it? So go invest that money in an

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index fund and you know remember us fondly when you buy your Ferrari at the end. [Guy driving a Ferrari wearing sunglasses]

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So anyway there you go discounts they're useful for a whole lot more than an

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early bird special at a seafood restaurant. [Guy making jokes the the waiter in the restaurant]

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