Time Value Of Money: A Dollar Today Is Not A Dollar Tomorrow
“Time is what we want most but what we use worst.” — William Penn
MENTAL MODEL
A dollar today is not a dollar tomorrow. The time value of money refers to the fact that there is a greater benefit to receiving a sum of money now than later. Even if the sum is identical. Money sooner than later is more valuable. Dollars you receive today can be invested to earn a positive rate of return, producing more dollars tomorrow. That’s where the adage comes from: a dollar today is worth more than a dollar in the future. The time value of money is one of the opportunity costs of saving instead of spending money. It’s also why interest is paid: it’s literally the compensation for the loss of the alternative use of your money.
Investors make a living on the basis of the time value of money. They forgo spending their money now, expecting a favorable net return on investment in the future. Ideally, the increased value is high enough to both offset inflation and the opportunity cost of spending money now. Knowing what you know now, which is the better choice: (a) receiving 1,000 dollars today, (b) receiving 1,000 dollars a year from now, or (c) receiving 1,100 dollars three years from now? Obviously, (a) is the only viable option. The second, (b), is out of the question. And (c) would be considerable if our inflation rates were way slower or if the period were reduced. You have to account for the opportunity cost as well: all the fun things you can do straight away when you pick (a) as opposed to (b) or (c).
The time value of money is a core financial principle and a fundamental of accounting. Money you have today can be invested, earning you more money. Money tomorrow will likely buy you less than it does today. Money could disappear before you’re scheduled to receive it: until you have it, it’s not a given. Essentially, any sum of money is only as valuable as how long you have to wait to use it. The sooner, the more valuable the same lump sum is. There are lots of variables to take in: current value, future value, interest rate, inflation, number of compounding periods, and amount of time in the investment. You now know that a project that brings in 20 million within a year is more lucrative than one which promises the same sum within three years. The faster the earnings hit your bank balance, the better.
Proving this is very simple in practice. Imagine you have a 50 dollar bill. You are at the supermarket. Compare the cart of veggies you could have gotten with that bill 10 years ago, as opposed to now. Feel the difference? There’s the time value of money in action. Understanding it is necessary to make sound financial decisions, especially long-term.
Real-life applications of time value of money:
Investing and savings: when planning for retirement, education, large purchases, or just handling personal finance, you should calculate how much you need to save now to achieve a desired future sum. Determining how much to set aside today to have 500,000 dollars in 30 years requires you to take in annual returns and expected inflation rates, not just dividing the number of days by the sum;
Loan amortization and mortgages: lenders use the time value of money to set interest rates and repayment schedules. They leverage this as a “financial product” where borrowers get access to funds they wouldn’t otherwise and they receive interest. This is why it’s crucial to calculate payments on a mortgage and understand how interest accumulates over time;
Capital budgeting: companies evaluate decisions on potential projects or investments by comparing the present value of expected future cash flows to the initial investment. Firms call this a discounted cash flow. This helps companies decide whether or not to launch product lines;
Bond pricing and valuation: bonds are valued by discounting future coupon payments and the principal to their present value. A bond with a face value of 1,000 dollars, paying 5 percent annually, for 10 years, is valued on how much these future payments are worth;
Leasing versus buying: companies and individuals should compare the present value of leasing an asset versus buying it to decide which option is cost-effective long-term. Evaluating whether to lease say, office equipment, by comparing the purchase price to the lease price and expected usage time, can be a low-effort way to save money.
How you might use the time value of money as a thinking tool: (1) establish a clear financial objective—funding studies, retirement, capital investments—to know the target and scope of your time value calculations; (2) select a discount rate that reflects the risk of future cash flows—the higher the rate, the higher the risk—which could be something like your company’s weighted average cost of capital; (3) use the time value of money to compare financial options—buying, leasing, renting, owning, borrowing; (4) plan for inflation and taxes, as well as leaving headspace for unexpected expenditures, as these will reflect the real value of money over time; (5) review and update as data changes, since your financial calculations are only as accurate as the circumstances you based them on; (6) use the time value of money as one tool among many in your financial decision-making toolkit—try risk assessments, budgeting, diversification, for a holistic strategy.
A dollar today is worth more than a dollar tomorrow. This isn’t merely a well-known saying. It encapsulates the time value of money perfectly. Reinvesting earnings has exponential power for growing wealth. Use this tool to make informed financial decisions. Don’t be afraid to do a time-value calculation when someone is delivering a sales pitch to you. You might save yourself years of stress.