Economic Discussion
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Guys let’s have a discussion about a super important economic concept. We see this at work behind the scenes in our everyday life. It is called “time value of money”. Let’s take a look:
Would you rather have five dollars today or five dollars and fifty cents in a year from now? I would wager that most said that they would prefer five dollars today. Whether or not you are conscious of it, you probably understand the time value of money. For various reasons, money is more valuable in the present than it is in the future. There are all sorts of equations and thought processes that seek to explain the phenomenon; however, it is quite simple in my mind. The logic is based off what you can do with the money in the meantime.
As we all know, money can be used for many things. It can be saved, spent, invested, etc. All of these activities provide benefit to the transactor. Traditionally, the time value of money is founded on the benefit of saving that money and earning a compounded interest rate. Here is the fancy equation that I was referencing previously:
FV = PV x [ 1 + (i / n) ] (n x t)
Where future value equals present value, times one plus the interest rate earned, divided by the number of compounding periods per year (this can vary), to the power of number of compounding periods per year, times number of years.
The key takeaway from the equation is simply that there is value in having money now versus having money in the future, as there is a small amount of money that can be made in the meantime. Moreover, the amount of value is fluid and undetermined. If your money is simply held in a savings account, you will typically earn a little bit less than 1% per year. Though this does not seem like much, it is not moot. Time value of money becomes even more realized if you are being more aggressive with your money. Say that you are invested in a mutual fund that seeks to earn a conservative 7% per year. In this case, your money becomes even more valuable in the present, as you can take more advantage of having that money now. But going back to the 1% interest in a traditional savings account, having $1,000 now would be equal to having $1,010 in a year.
We have already examined how having the ability of saving and investing money creates value in having money sooner rather than later. Additionally, I suggest there is a third thing that gives present money value – that thing is spending. This mechanic relies more on human psychology than mathematical formulas. Having a desire for something, whether it is a house, car, pair of shoes, TV, etc., has the ability to distort logic. We have all been in a situation where we know that something will be on sale soon, or have a decreased price in one way or another in the future, however we did not have the ability to delay our urge, and ended up buying this thing immediately, ultimately costing us money. This is certainly human; however, it does demonstrate how having the ability to buy something now also serves to give present dollars added value over future dollars.
Time value of money is an accepted fact and can be leveraged. Does anyone know about any businesses that our using the phenomenon to support their business model? I would be really interested to learn. Let’s discuss!
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Albert Einstein famously said that compound interest is the most powerful force in the universe. He said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
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- Do your own Finance homework. Just kidding…
- There is not always value in having money now. There are variables to consider, such as inflation, opportunity cost, risk-free return, expected return. If I offered you $2,000 today, or $2,200 one year from now, which option would you choose? Depends on what utility you can get from that $2K today and if you can do better than 10% interest per year. 3. On the other hand, if you are broke and need to buy food now, $2,200 a year from now is meaningless. You would take the $2K now.
You can’t abstract the concept from real world application. Time value of money is a concept that allows you to compare alternate scenarios. For example, is it worth paying more points for a mortgage to get a lower interest rate?
What business leverages the time value of money? Any business offering zero percent financing. It is conceivably less expensive overall (discounted cash flows) to pay interest on a loan and get a discounted purchase price than it is to pay a higher purchase price at zero percent interest.
And that’s another part of the analysis. You have to look at the present value of future cash flows to do a complete analysis.
Some bond prices are based on the expected future value of the bond. Some bonds are priced below face value and pay their full face value at maturity. The difference between the purchase and redemption prices is the interest earned on the bond. Bond traders use this fact to sell bonds at a value higher than their face value when the interest rate on the bond is greater than the current risk-free market interest rate. Same concept as time value of money.
I knew that MBA would come in handy someday…
– Z –
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@sonofzeus exactly!! thanks for the input
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@zerenia wow this is super informative and insightful. thanks for participating!
