The Concept of Time Value of Money is Important to Financial Decision Making Because …
“A bird in the hand is worth two in the bush”
This medieval proverb still holds true today. In modern terms, it’s better to have a certain payoff today than an uncertain one in the future. After all, who knows what the future holds? By understanding the importance of time value of money (TVM), you can find out how to hack the TVM concept for your own benefit.
What is TVM? Time Value of Money Real Life Example
What if someone offered you $10,000 today or $10,000 in three years?
Of course you’d take the $10,000 today. In fact $10,000 received today is actually more valuable than $10,000 received in three years because:
You don’t know whether inflation will damage the purchasing power of the $10,000.
You can invest that $10,000 to make more money. Thus, if invested wisely, you will have more than $10,000 in three years.
This example is a “no brainer”. But what if someone offered you $10,000 today or $12,000 in three years, which would you choose?
The answer is, it depends. It depends upon what return or interest rate you might earn on that $10,000 in the next three years. And that’s where some smart financial projecting comes into play.
Why is the Time Value of Money Important?
Imagine you can have $10,000 today or $12,000 in three years. Which would you choose?
To help with your decision, you must project what type of investment return you can earn on the $10,000 for the next 3 years.
Let’s assume you can buy a zero coupon bond paying 5% interest maturing in three years. Take the $10,000 today and invest it in the three year zero coupon bond paying 5 percent interest, the future value of the bond will be $11,576.25.
Since that’s less than $12,000, you’d naturally take the $12,000 in three years.
In fact, you’d need $10,366 today to equal $12,000 in three years, assuming a 5% return.
This simple example shows the importance of time value of money in everyday life.
Time Value of Money in Financial Decision Making
Here’s how to decide what your $12,000 payment, expected in three years is worth today.
Now let’s discount the value of $12,000 received in three years back to today, using the same 5% interest. That $12,000 received in 3 years is worth $10,366 or $366 more than $10,000. Thus, at a discount rate of 5 percent rate, you are better off choosing the $12,000 in three years over the $10,000 today.
Now, if you could earn more than a 5% return on the $10,000, your decision making would change. If interest rates went up to 7% and you could buy that same 3 year bond with a return of 7%, your original $10,000 would be worth $12,250.
So, you’d be better off taking the $10,000 today and investing it in the zero coupon bond paying 7%.
Here’s another way to validate your decision. Take the $12,000 given to you in three years and discount it back to today using that same 7 percent. The $12,000 would be worth only $9,796. Thus, at a higher interest (discount) rate, you are better off choosing the $10,000 today.
Use Time Value of Money to Decide between a Lump Sum Payout versus Annuity
The net present value concept can also help you determine whether a lump sum payout or an annuity with monthly payments is a better option. The answer lies in which choice gives you a larger net present value or value today.
This is a viable exercise for those who have the option of annuitizing their retirement accounts or taking a lump some payout.
What if you have the choice of receiving $10,000 per year for 10 years or $100,000 today. Well clearly, like the prior example, you would take the $100,000 today because you can start investing that money immediately. But what if you were offered $80,000 today or $10,000 per year for the next 10 years. This choice is not so easy.
Let’s assume that you can invest your money in the stock market and earn an average 7% annual return during the next ten years.
With a net present value calculator from Investopedia the $10,000 received for 10 years and discounted back at 7% is worth $75,152 today. Compare that $75,152 with $80,000 received today and you would be better off taking the $80,000 lump sum payment today.
Remember, if expected interest rates change, so will the net present value.
The Importance of Time Value of Money When Buying a Car
The time value of money concept is important to financial decision making for businesses and individuals. It includes the concepts of net present value and future value.
We just used discounted cash flow to determine what a future amount of money would be worth today. Businesses use this method to analyze future projects. Investors use this to value securities. and you can use this metric to figure out the true time value of money.
You might use this strategy to figure out whether to spend today or save for the future.
Understanding what the time value of money refers to when buying a car will help you make a smarter financial decision.
Let’s say you have a choice between buying a $25,000 car or a $35,000 car. Hypothetically, assume you are paying cash. Take the difference of $10,000 and imagine you bought the $25,000 car and invested the $10,000 in an investment which will earn 6 percent per year for the next ten years. In 10 years you will have a $25,000 car that’s probably worth $8,000 plus the invested $10,000, which will be worth $18,194.
Add up the depreciated $25,000 car, now worth $8,000 plus the $18,194 you earned on the $10,000, and after ten years, your cars value plus the invested $10,000 is worth $26, 194.
Had you bought the $35,000 car, in ten years you have a ten year old car worth about $11,000.
Scenario one is worth $26,194.
Scenario two is worth $11,000 (the depreciated value of the $35,000 10 year old car).
This is an example of the trade-off between saving or spending.
You decide whether the more expensive car is worth $15,194 ($26,194-$11,000) more than the $25,000 model.
Why is the Time Value of Money Important – Wrap up?
Understanding the importance of time value of money in financial decision making can mean the difference between a life of having what you need for your entire life or living the dream now, while relegating yourself to financial troubles tomorrow.
The time value of money concept can help you understand what you’re giving up every time you make a financial decision.
When considering a purchase, ask yourself is the spending today, worth a lower net worth tomorrow?
Even buying a latte every day can result in $70,000 less in retirement, if you chose to invest that money instead!
By thinking before you spend, you’ll avoid future financial regret
Read the full article here
