Time Value of Money – What Does That Mean?
It’s the idea that having a dollar today is worth more than having a dollar in the future. That’s because the dollar you have today can buy something today or earn interest while the dollar you don’t have can’t be spent or earn interest until you get it in the future.
Let say you have a choice between a promise to receive $1,000 in 10 years or to take $1,000 today – wouldn’t you definitely choose the $1,000 now? That’s because you can either spend it or invest it. If you spend it now it will buy more than the same $1,000 in 10 years because inflation makes things cost more. If you invest it, you’ll have the earnings during the next 10 years you’d be waiting.
Another way of looking at it is how much would you pay someone today for them to give you $10,000 in 10 years? You wouldn’t pay them the whole $10,000 today would you? You’d pay less than that because tying up your money for ten years means you can’t use it or invest it.
That’s the idea of the value of money over time. Having it in your hand now is worth more than the promise of having it in the future. The exact difference in how much more it’s worth today depends on how long you’d have to wait, what you can do with the money now and the interest rates used to calculate the investment.