Time value of money explained clearly and quickly.
After all, time is money, right?
What’s important about money, in the context of spending money,
saving money, or investing money?
First of all, how much are we talking about?
Second, money when?
We need to know both the amount as well as the timing of the money.
To explain that second item “timing of the money”, let’s search for equivalent amounts
of money in time.
Would you prefer $100 today, or $100 one year from now?
I am pretty certain you would say $100 today.
Why wait?
What about a choice between $100 today or $101 next year?
I would guess that you would still prefer the $100 today.
One year from now, the prices of goods or services that you want to spend the money
on could have gone up (that’s called inflation).
Inflation could tear up that extra dollar, or even more than just one dollar.
You might be worse off.
Plus let’s admit it: you probably don’t have the impulse control of having to wait
a whole year for just one additional dollar.
Better take the $100 right now!
How about $100 today or $110 next year?
I am pretty certain you would take the $110 one year from now,
as that sounds far more attractive.
OK, somewhere in between then.
How about a choice of $100 today or $105 one year from now?
Maybe you will say: I am fine either way.
If that’s the case, then we have just found the equivalent amounts in time, and identified
the time value of money for you!
The time value that we found for you in this example
is that $100 today equals $105 in one year.
$100 is the present value of $105 one year from now.
$105 is the future value (one year from now) of $100 today.
Now I am going mathematical on you.
$105 equals $100 times 1 plus 5% to the power 1.
The future value equals the present value times 1 plus the rate of return, to the power
of the number of years.
The present value equals the future value divided by 1 plus the rate of return, to the
power of the number of years.
That might be a big abstract mathematical leap, let’s review it with an example.
The future value equals the present value times 1 plus the rate of return, to the power
of the number of years.
Let’s expand our example to two years.
$100 today, multiplied by 1.05, is $105 one year from now.
That same $105 one year from now, multiplied once more by 1.05, is $110.25 in two years.
Or if you want to go straight from today to the future value two years from now, $100
today times 1.05 times 1.05 equals $110.25 two years from now.
1.05 times 1.05 is the same as 1.05 squared, which is the same as 1.1025.
We can also work in the opposite direction.
The present value equals the future value divided by 1 plus the rate of return, to the
power of the number of years.
$110.25 two years from now, divided by 1.05, is $105 one year from now.
That same $105 one year from now, divided once again by 1.05,
equates to $100 present value today.
Or if you want to go straight from two years from now to today, $110.25 divided by 1.05
times 1.05 equals $100 today.
1.05 times 1.05 is the same as 1.05 squared, which is the same as 1.1025.
Time value of money is the idea that money that is available at the present time is worth
more than the same amount in the future.
With the rate of return, you can convert from present value to future value, and the other
way around.
Time value of money is also the underlying principle for concepts such as Net Present
Value and Internal Rate of Return.
I hope you enjoyed this clear and quick explanation of the time value of money.
If you enjoyed this video, then please give it a like!
On this end screen, there are a few suggestions of related videos you can watch next.
Please subscribe to the Finance Storyteller YouTube channel!
Thank you.