The Time Value of Money
Have you ever wondered what the Time Value of Money really was? The Time Value of Money Concept is a concept surrounding the idea that any sum of money in the present is worth more than the same amount in the future. By taking into account variables such as interest rates, inflation, and risk, it is possible to calculate the worth of different sums in a given amount of time.
Many wrong financial decisions can be made by not using the Time Value of Money Concept. A simple example to explain the first point, which is that a sum of money in the present time is worth more than the same amount in the future, is to look at the money’s potential earning power. Basically, if 100 dollars were received today instead of in five years, it could be worth more if invested. That 100 dollars in current money could also be worth more than 100 dollars in the future because of inflation.
What exactly is inflation though? Inflation is talking about the general rising of the price of goods, which would reduce the “purchasing power” of each dollar, since you would need more dollars to buy the same goods. This concept can be explained pretty well with the example below.
A man wins the lottery and has a choice to earn 250 million dollars in lump sum, or 320 million dollars in annuity over 25 years(12.8 million dollars annually). Which would be the smarter choice? The lottery will always want you to pick the larger sum over a longer period of time, since it would be easier to pay. The fact that inflation over time makes money worth less means that every annual payment from the annuity option would be worth less than the previous. In this case by using the TVM concept, we can see that taking the 250 million dollars lump sum and properly investing it would likely be the better choice. In short, the earnings potential of the lump sum will result in you taking home more money than if you took the annuity.
In summary,
Inflation makes money worth less, which means a smaller sum now could be worth more than a bigger sum in the future
Properly investing money can yield high returns and beat inflation
The variables in these examples include the present and future value of money and the interest rate among others. By utilizing formulas, it is possible to find one of the variables using the others.
Understanding the Time Value of Money is important for managing money and investing smartly, as seen in the examples above, and learning the concepts surrounding it is extremely useful for planning out how money is spent.