Welcome to Alanis Business Academy.
I'm Matt Alanis and this is The Time Value of Money.
The time value of money is the most important concept in all of finance.
This basic concept guides the decisions that investors, bankers, businesses, and many other
make each and every day.
So what is the time value of money?
The time value of money, commonly abbreviated as simply TVM, is the idea that money loses
value over time.
You may have heard the saying one dollar received today is worth more than one dollar received
tomorrow.
What this attempts to explain is the fact that the value of your hard earned money decreases
each and every day.
As an example, lets say that that your friend asked you for $500 with the promise to repay
you that same amount in twelve months.
Although you may be inclined to help your friend out this wouldn't be a great financial
decision.
But why?
You're still receiving that same $500 you loaned him or her twelve months ago.
The truth is, that although the numerical value of your $500 remains unchanged, you
incur several costs by not having it in your possession.
The first and probably the most obvious cost that you incur is inflation.
Inflation is the increase in the price of goods and services over a period of time.
Inflation generally runs at about two percent annually, although it has been quite less
as of late.
So if you hold your money for that period of time, what you can do with that money actually
decreases.
To help illustrate this point lets walk through a quick example based on the information that
I provided.
Assuming that your friend will repay you, lets calculate the value of your $500 after
twelve months.
To obtain the answer to this question we need to perform an action known as discounting
to determine the present value of the $500 that we are expecting to receive in twelve
months.
The financial equation to determine a present value is as follows: PV equals FV divided
by one plus i to the nth power.
In this equation, PV is the present value of our money and what we are trying to determine.
FV represents that future value of our money, which is $500 . i represents the interest
rate that we intend to discount or reduce our $500 by.
Generally for discounting purposes the interest rate represents what we could've received
if you had the money in our possession and put it to good use.
In this case, we are going to discount our money by an inflation rate of two percent
to reflect its diminished value.
The last bit of data we need is the number of periods or n, which will be one to reflect
the number of years we are going to discount our $500 by.
One plus our inflation rate of .02 to the first power is 1.02.
Our future value of five hundred dollars divided by 1.02 equals $490.20 rounding to the nearest
hundredth.
What this means is that the five hundred dollars we are receiving a year from now--assuming
we loan the money--is actually worth the equivalent of $490.20 today.
Although the numerical value is the same, our purchasing power has decreased since goods
and services are now more expensive.
The second reason that money decreases in value over time is due to opportunity costs.
An opportunity cost represents what you give up by loaning the $500 to your friend.
More specifically, the opportunity cost represents the next best alternative.
What that is depends upon your unique situation.
It could be investing in the stock market, placing the money in a savings account, or
even spending it on new clothes.
Unfortunately you incur an opportunity cost by giving up possession of your money.
Now as a result of both inflationary pressures and opportunity costs your $500 will be worth
less in twelve months.
This is why banks charge interest on loans and why consumers expect to earn some type
of interest when they place their money in a bank.
It's simply being compensated for the costs that they incur by not having the money in
their possession at this moment in time.
So instead of loaning your friend five hundred dollars outright, consider incorporating something
extra to account for the time value of money.
You may not win friend of the year, but at least you'll rest easy knowing you made a
sound financial decision.
This has been The Time Value of Money.
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