Would you rather have $100,000 today, or $100,000 ten years from now?
This should be a no-brainer: why wait? Having the money now gives you more options. You can either:
- Spend it now, or
- Invest it now for the future
What would happen if you invested it for the future? How much would you have?
Here’s one possibility:
If you took that $100,000 and invested it at a compounding interest rate of 8 percent (read this post to find out which investment can provide 8 percent interest), you’d have $215,892.50 at the end of ten years. Why give up and extra $115,892.50 if you don’t need to?
On a side note, if you’d like to learn how this was calculated, read Tim’s post on calculating compound interest.
Introducing the Time Value of Money
The time value of money is a financial concept that says a dollar today is worth more than a dollar tomorrow. Exactly how much more, however, depends on what you decide to do with that dollar.
The more profitable options you have with that dollar, the more valuable it is to you.
Determining the time value of money is a way of making decisions in the face of opportunity costs. Opportunity cost is the value that you give up when you make a decision.
For instance, if you decide to put your money in a safe savings account, your opportunity cost is the potential earnings you give up by not being able to invest that money in the stock market.
If you have various options of investing money, and each option comes with a different return, the time value of money will help you figure out the best option to choose and how much you should spend.
The Time Value of Money in Action
Here’s an example: Let’s say someone is offering you an investment that will provide $1 million five years from now. What’s the most amount you should be willing to pay for it today?
That depends. Assuming your next best option is another guaranteed investment with a 3 percent interest rate, you shouldn’t pay anything more than $862,608.
Because if you took $862,608 and invested it in your next best option with a 3 percent interest rate, you’d earn $1 million dollars in five years. This means that if you can buy the first investment for less than this amount, you’ll earn a higher return on your investment.
And earning a higher return means that you make more money.
How This Was Calculated
Determining this amount was done using a different formula than the one in Tim’s post above. I used what’s known as a present value calculation.
PV = FV/[(1 + r)^n]
Now if you looked at this formula and just got confused, or if you’re just lazy and want an easier way to figure this out, simply copy this formula into an excel spreadsheet:
The 0.03 represents the 3 percent interest rate, the 5 represents the amount of years, and the 1000000 represents the $1 million you’d have in the future.
The time value of money is an old concept – it was first introduced in the early sixteenth century by Spanish theologian Martin de Azpilcueta. And the good news is that this knowledge that a dollar today is worth more than a dollar tomorrow can be expanded to apply to other common financial situations.
Making a Business Decision
Picture this: You’re thinking about buying a Cuban restaurant that earns $300,000 in profit every year. Assuming an interest rate of 3 percent, and a timeline of ten years, how much should you be willing to pay to buy this business?
To answer this question, we’ll use a variation of the present value equation. Here’s the equation to plug into your excel spreadsheet:
The 0.03 represents the 3 percent interest rate, the 10 represents the amount of years, and the 300000 represents the $300,000 you’d receive every year.
The present value of that series of future profits is $2,559,060. If you pay less than this amount, you’ll earn a higher return on your investment and make more money.
How will you use the time value of money concept to make wiser financial decisions?