Money Now vs. Money Later – Time Value of Money
Money Now vs. Money Later
This blog discusses time value; the concept that a dollar today is not necessarily worth the same as a dollar tomorrow (or a month, year or decade from now). In most cases, a dollar received today is actually worth more than a dollar received in the future. But why is that the case?
(Originally Posted August 14, 2017)
Would you rather receive $1,000 today or receive $1,000 a year from now? The answer seems pretty obvious – almost everybody would take $1,000 today.
But would you rather receive $1,000 today or receive $1,100 a year from now? By just slightly changing the question, the answer isn’t quite as clear. If you asked a group of people, you’d likely receive a mixed response. Why was the first question so simple, and the second question so complicated?
Welcome to the world of the time value of money.
Time value is the concept that a dollar today is not necessarily worth the same as a dollar tomorrow (or a month, year or decade from now). In most cases, a dollar received today is actually worth more than a dollar received in the future. But why is that the case?
The main principal is that money received today can be invested to earn income sooner than money received in the future. Seems obvious, but the implications are far reaching. If you make a one-time investment of $1,000 in the stock market today and the market is returning 7% per year, then one year from now you’ll have $1,070. Two years from now you’ll have $1,145. Ten years from now you’ll have $1,967. Twenty-five years from now you’ll have $5,427. And fifty years from now you’ll have $29,457. Because of compounding interest (interest being earned on interest), the initial investment grows exponentially over time.
So back to the original examples – would you rather have $1,000 today or $1,100 a year from now? This depends on what return you can earn on your investments. $1,000 today versus $1,100 a year from now implies a 10% return. If you can achieve a higher return in other ways, then it’s better to receive the $1,000 today. But if 10% is the best return you can achieve at your desired risk level, then you’re better off to wait and receive $1,100 a year from now.
Likewise, would you pay $1,000 today to receive $1,100 a year from now? The same principal applies – this is a 10% return and it depends on what return you could receive elsewhere. This principal applies whether you’re saving for retirement, speculating on the stock market or investing in new equipment for your business. If you could invest $500,000 in new equipment for your business and you expect it would increase profits by $25,000 per year indefinitely, is this a good investment? The answer depends on what returns you could achieve elsewhere.
Determining your desired rate of return is key for choosing between different investments, whether they be personal savings or business investments. As Albert Einstein allegedly said, compound interest is “the most powerful force in the universe”. You definitely don’t want to be missing out.
If you’re thinking of expanding your business or buying a new business, give the team at Davis Martindale a call. We’d love to help determine your expected return.