Time Value of Money: Finding the Rate of Return to Meet Financial Goals

In order to be smart and calculative in personal finance matters, understanding the time value of money is an essential part of the learning process.
Starting today, I will be posting a series of computation method related to time value of money on every Wednesday. Today, we will learn to find the rate of return required to meet a financial goal.

Common Problems

• You have set aside RM10,000 for your future dream home down payment. You want to have at least RM15,000 after 5 years time to purchase your dream house. What is the rate of return required if you were to invest the initial RM10,000 in order to get RM15,000, 5 years later?
• You invested RM5,000 in a balanced unit trust fund that gives an average of 10% return per annum. How long you must keep the money invested in order to have RM10,000 to fund your child’s tertiary education?

Photo by wmjas

Theory

Use this formula:

FV (Future value) = future value of investment at the end of period
PV (Present value) = present sum of money set aside for the investment
i = rate of interest/rate of return
n = number of periods
It can be modified to determine the rate of return required. In this case, we know the value of FV, PV and n. What we want to compute is i.
You can use the interpolation method or the trial and error method using excel spreadsheet. But I would prefer the easiest route using financial calculator.
Use this Financial Calculator provided by Money Chimp

Solutions

Example 1:
You have set aside RM10,000 for your future dream home down payment. You want to have at least RM15,000 after 5 years time to purchase your dream house. What is the rate of return required if you were to invest the initial RM10,000 in order to get RM15,000, 5 years later?
PV = RM10,000
FV = RM15,000
n = 5 years
i= ?

i = 8.45%
Example 2:
You invested RM5,000 in a balanced unit trust fund that gives an average of 10% return per annum. How long you must keep the money invested in order to have RM10,000 to fund your child’s tertiary education?
PV = RM5,000
FV = RM10,000
i = 10% p.a.
n = ?
Use this financial calculator:

Input the value as shown in the image above. Click NP.

n = 7.27 years

Exercise

1. A unit trust agent told you that one of his customer who invested 5 years ago had achieved 200% total return this year. What is the rate of return per annum?
2. Your mother told you that a cup of coffee at the local kopitiam costs RM0.10 only when she is 20 years old. Now she is retired at age 55. The price of a cup of coffee now is RM1.00. What is the average inflation rate per year?
3. Let’s say you have RM100,000 in your investment portfolio. Due to consistent monitoring and investment research, you are able to get an average return of 15%p.a. for the past 5 years. If everything goes according to plan, how long will it take for you to become a millionaire?