Master the Art of Business
A world-class business education in a single volume. Learn the universal principles behind every successful business, then use these ideas to make more money, get more done, and have more fun in your life and work.
A dollar today is worth more than a dollar tomorrow. Calculating the Time Value of Money is a way of making choices when dealing with Opportunity Costs. The more profitable options you have to invest that dollar, the more valuable it is.
Time Value of Money can help you determine which options to choose and how much you should spend, given the alternatives.
Would you rather have a million dollars today, or a million dollars five years from now? The answer is obvious: why wait? Having the money now means you can spend it now, or invest it now.
A million dollars, invested at a Compounding interest rate of 5%, will be $1,276,281.56 five years from now.
Why give up the extra quarter of a million dollars if you don't need to? A dollar today is worth more than a dollar tomorrow.
How much more depends on what you're planning to do with that dollar. The more profitable options you have to invest that dollar, the more valuable it is.
Calculating the Time Value of Money is a way of making choices in the face of Opportunity Costs. Assuming you have various options of investing funds with various returns, Time Value of Money can help you determine which options to choose and how much you should spend, given the alternatives.
Let's go back to the million dollar example: assume someone offers you an investment that will deliver $1 million in one year's time.
What's the maximum amount you should be willing to pay for it? Assuming your Next Best Alternative is an investment with a 5% interest rate, you shouldn't pay anything more than $952,380. Why? Because if you took that amount and invested it in your next best alternative, you'd have a million dollars.
$1,000,000 divided by 1.05 (the 5% interest / discount rate) equals $952,380. If you can buy this investment for less than that amount, you'll be ahead.
Time Value of Money is a very old idea-it was first explained in the early 16th century by the Spanish theologian Martín de Azpilcueta. The central insight that a dollar today is worth more than a dollar tomorrow can be extended to apply to many common financial situations.
For example, Time Value of Money can help you figure out the maximum you should be willing to pay for a business that earns $200,000 in profit each year.
Assuming an interest rate of 5%, no growth, and a foreseeable future of 10 years, the "present value" of that series of future cashflows is $1,544,347. If you pay less than that amount, you'll come out ahead as long as your assumptions are correct. (Note: this is the "discounted cash flow method" we discussed in the 4 Pricing Methods.)
The Time Value of Money is an extremely versatile concept, and a full exploration is beyond the scope of this book. For a more in-depth examination, I recommend picking up The McGraw-Hill 36-Hour Course in Finance by Robert A. Cooke.
"They always say time changes things, but you actually have to change them yourself."Andy Warhol, renowned artist
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Master the Art of Business