Importance of the Time Value of Money

Time value of money is integral in making the best use of a financial player's limited funds.

Learning Objective

Describe why the time value of money is important when analyzing a potential project

Key Points

Money today is worth more than the same quantity of money in the future. You can invest a dollar today and receive a return on your investment.
Loans, investments, and any other deal must be compared at a single point in time to determine if it's a good deal or not.
The process of determining how much a future cash flow is worth today is called discounting. It is done for most major business transactions during investing decisions in capital budgeting.

Terms

discounting
The process of determining how much money paid/received in the future is worth today. You discount future values of cash back to the present using the discount rate.
interest rate
The percentage of an amount of money charged for its use per some period of time. It can also be thought of as the cost of not having money for one period, or the amount paid on an investment per year.

Full Text

Why is the Time Value of Money Important?

The time value of money is a concept integral to all parts of business. A business does not want to know just what an investment is worth todayit wants to know the total value of the investment. What is the investment worth in total? Let's take a look at a couple of examples.

Suppose you are one of the lucky people to win the lottery. You are given two options on how to receive the money.

Option 1: Take $5,000,000 right now.
Option 2: Get paid $600,000 every year for the next 10 years.

In option 1, you get $5,000,000 and in option 2 you get $6,000,000. Option 2 may seem like the better bet because you get an extra $1,000,000, but the time value of money theory says that since some of the money is paid to you in the future, it is worth less. By figuring out how much option 2 is worth today (through a process called discounting), you'll be able to make an apples-to-apples comparison between the two options. If option 2 turns out to be worth less than $5,000,000 today, you should choose option 1, or vice versa.

Let's look at another example. Suppose you go to the bank and deposit $100. Bank 1 says that if you promise not to withdraw the money for 5 years, they'll pay you an interest rate of 5% a year. Before you sign up, consider that there is a cost to you for not having access to your money for 5 years. At the end of 5 years, Bank 1 will give you back $128. But you also know that you can go to Bank 2 and get a guaranteed 6% interest rate, so your money is actually worth 6% a year for every year you don't have it. Converting our present cash worth into future value using the two different interest rates offered by Banks 1 and 2, we see that putting our money in Bank 1 gives us roughly $128 in 5 years, while Bank 2's interest rate gives $134. Between these two options, Bank 2 is the better deal for maximizing future value.

Compound Interest

In this formula, your deposit ($100) is PV, i is the interest rate (5% for Bank 1, 6% for Bank 2), t is time (5 years), and FV is the future value.

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Defining the Time Value of Money

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