by Would you rather have $100 today or $105 in one year? Making the right or wrong decision could have huge long-term ramifications. In this post we’ll explore the concept and importance of time value of money to determine the optimal solution.
Contents
1. Time Value of Money Example
First, would you rather have $100 dollars today or $100 dollars in one year?
The answer should be easy. If you had $100 dollars today, you could invest that money in stocks , savings, or bonds and turn it into more money by next year. For example, if you put $100 in savings with a 5% interest rate, you would have $105 dollars in one year. So of course you would take the $100 now.
But what if the question was: Would you rather have $100 dollars today or $105 dollars in one year? Since $105 in one year has the same time value of money as $100 today, assuming a 5% interest rate, both answers are financially equal.
As we can see, $100 today is NOT equal to $100 in one year (or even tomorrow). Money has an associated time value due to the opportunity cost of putting it into an investment, or savings, etc.
2. Calculating Present Value
Continuing on the same example,
- Choice A: $100 today
- Choice B: $105 in one year
- Discount rate: 5%
The present value (PV) of Choice A is $100 because it’s worth $100 today.
What is the present value of Choice B?
In this case FV = 105, r = 0.05, and n = 1 (one year in our example)
When we plug in the numbers, the PV of Choice B is $100.
Because Choice A and Choice B have the same PV of $100, they are equivalent.
You can use excel to perform calculations or you can use this Present Value Calculator.
Additional info:
When you convert a value from a Future Value to Present Value, the rate of return used is called the Discount Rate.
3. Calculating Future Value:
Let’s examine the same example where:
- Choice A: $100 today
- Choice B: $105 in one year
- Interest rate: 5%
The future value (Choice B) is $105 in one year.
What is the future value (FV) of Choice A?
In this equation I = 100, R = 0.05, and T = 1
The future value of Choice A is $105 in one year.
Since Choice A and Choice B have the same FV of $105, they are equivalent.
Once again you can use excel to perform calculations or you can use this Future Value Calculator.
4. Other Calculations
Calculating future value from present value, and vice-versa is straight forward using the equations above.
If your contributions are made on an annual basis, you can calculate the value of your annuity using these calculators:
The Bottom Line
Understanding the importance of time value of money will help you compare streams of money in different time frames like, should you:
- Go to grad school?
- Invest in a 401(k) or brokerage account?
- Rent an apartment or buy a house?
When you need to weigh decisions using the same time base (whether present value or future value), just pull up the applicable calculator. You’re just a simple calculation away from determining the best financial choice for you.
Making a series of good financial management decisions can have a huge long-term impact on your finances and bring you closer to financial freedom!
Let me know in the comments below!
What investment decisions have you made based on your understanding of the time value of money?
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