Unit 2 – Time Value of Money
Lesson 2.1: Introduction to the Time Value of Money
Congratulations! You have just won a lottery that will pay you $1,000,000. However, after looking at the fine print, you discover that you are required to choose how you will accept this payment. You can either:
- Accept the $1,000,000 over 20 years ($50,000 per year); or,
- Take a lump-sum payment of $625,000
Why is the lump-sum payment in Option B a lesser number than the cumulative payments you would receive in Option A?
This is due to the focus of Unit 2: The Time Value of Money.
Time Value of Money (TVM) is a financial concept that describes why a dollar today is worth more than a dollar tomorrow. There are two main reasons why money in the present is worth more than an equal amount in the future: Inflation and Opportunity Cost.
- Inflation
Inflation is a phenomenon in which the prices of goods and services increase gradually over time. Ever wonder why the price for a burger and a co*ke was $0.05 in the 1950’s but today, the same meal would cost several dollars? This is the power of inflation: over time your Purchasing Power — the amount of things you can buy with a specific amount of money — is diminished by the constant increase in prices. Simply put, a dollar today will buy you less goods and services as time progresses due to inflation.
Measured as a percentage, inflation is accounted for by the rate of average price change for goods and services included within the Canadian Consumer Price Index (CPI). From groceries to electricity to haircuts, the CPI includes a wide variety of goods and services Canadians consume to provide a best estimate as to the effects of inflation. This is one reason why a dollar today should be worth more to you than a dollar in 10 years: because it will likely buy less things in the future.
As you can see in the graphic above, in Year 1, you are able to purchase $100,000 worth of goods and services with $100,000. However, in an environment with a steady inflation rate of 2.00%, by Year 30, $100,000 will be able to buy you only $54,548 worth of those same goods and services.
- Opportunity Cost
With money comes opportunity, and following this opportunity comes a cost over time. Opportunity Cost describes the benefits an individual forgoes when choosing one alternative over any others.
For example, you go to an ice-cream shop that serves three flavours: vanilla, strawberry, and chocolate. By selecting vanilla, you have forgone your opportunity to enjoy both strawberry and chocolate. In comparison, you go to an ice-cream shop that serves 100 flavours. By selecting one, you have now forgone the opportunity of enjoying the other 99 by your selection. As these two scenarios portray, the greater your choices, the greater your Opportunity Cost.
Transitioning back to Opportunity Cost’s relevance to finance, let’s say you invest in a savings account which locks your money in the account for a 1-year period, you receive a guaranteed interest rate, but you have now forgone any other use of this money for the next 12 months. You could buy something that you have wanted for a while, pay off some debt, or invested these assets, but instead you have chosen to put it into this savings account. Those other opportunities you have given up for the next year would culminate in conveying your Opportunity Cost.
As it relates back to our original example of the lottery win, in Option B you are provided a lump-sum payment less than the total income stream of Option A because you are now provided the opportunity to go out and invest this money over the course of the next 20 years, which may provide you with more wealth by the end of the 20 years.
In Lesson 2.2, we will go on to detail how the Time Value of Money Calculation is utilized in the financial planning process, and how the calculations for comparing scenarios are created.
FAQs
Time value of money is the concept that money today is worth more than money tomorrow. That is because money today can be used, invested, or grown. Therefore, $1 earned today is not the same as $1 earned one year from now because the money earned today can generate interest, unrealized gains, or unrealized losses.
What are the 3 main reasons of time value of money pdf? ›
There are three reasons for the time value of money: inflation, risk and liquidity.
What is the time value of money for dummies? ›
The time value of money means that a sum of money is worth more now than the same sum of money in the future. The principle of the time value of money means that it can grow only through investing so a delayed investment is a lost opportunity.
What is the time value of money solution? ›
The time value of money is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future.
What are the three main reasons for the time value of money? ›
Narayanan presents three reasons why this is true:
- Opportunity cost: Money you have today can be invested and accrue interest, increasing its value.
- Inflation: Your money may buy less in the future than it does today.
- Uncertainty: Something could happen to the money before you're scheduled to receive it.
Expert-Verified Answer. The future value of $100 compounded for 50 years at 10% annual interest is $28,938.41.
What is the key factor for time value of money? ›
Determining the appropriate discount rate is the key to valuing future cash flows properly, whether they be earnings or obligations.
Why do we study time value of money? ›
The time value of money is important because it can help you make decisions about how to best use your money. Should you invest it, save it, or spend it? By understanding the time value of money, you can make the most informed decision possible.
What best describes the time value of money? ›
Time value of money refers to the idea that having a dollar in hand now is more valuable than a dollar promised in the future. is earning interest on the interest previously earned. For example, say you invest $100 now for two years at an interest rate of 10.0%.
What is the formula for calculating the time value of money? ›
The Future Value (FV) formula in TVM is FV = PV * (1 + r)^n, where PV represents present value or the current worth of a future amount, r is the interest rate (annually growth rate), and n is the number of periods (e.g., years) the money is invested or borrowed for.
When you pay yourself first, you pay yourself (usually via automatic savings) before you do any other spending. In other words, you are prioritizing your long-term financial health.
How do you explain time value of money to a child? ›
A Dollar Today Is Better Than a Dollar Tomorrow
Time value of money simply says that a dollar received today is worth more than a dollar received in one day, one month, or a year, because the dollar received today can start earning interest immediately.
What is the formula sheet of time value of money? ›
Equation guide
| Future value of a lump sum: |
|---|
| FV = PV x (1 + r)n |
|---|
| Present value of a lump sum in future |
| PV = FV / (1 + r)n = FV x [ 1 / (1+ r)n ] |
| - | Present-value factor (FVF) table |
16 more rowsMar 19, 2017
3 Basic Types of Compounding Problems
These time value of money problems include finding the future value of a lump sum, the future value of a series of payments, and the payment amount needed to achieve a future value.
What is the time value of money calculator? ›
Time value of money calculator (TVM) is a tool that helps you find the present or future values of a particular amount of cash received in the future or owned today.
When was time value of money invented? ›
Time Value of Money is a very old idea-it was first explained in the early 16th century by the Spanish theologian Martín de Azpilcueta.
What is the concept of time value of money also called? ›
Of all the techniques used in finance, none is more important than the concept of time value of money (TVM), also called analysis.
What is the time value of money Quizlet? ›
The time value of money concept means that a dollar received today is worth more than a dollar received at some time in the future. This statement is true because a dollar received today can be invested to provide a return.
What are the objectives of time value of money? ›
Objectives of Time Value of Money
Compare cash flows: Compare income and costs that happen at different times accurately. Evaluate investments: Determine if investments are worthwhile based on future cash flows. Decide fair value: Calculate the present worth of future payments to find a fair value.
