Congratulations – you have won a cash prize! You have two payment options: A – receive the cash prize now OR B – receive it in three years. Which option should you choose? A quick evaluation of the ‘Time Value of Money’ (TVM) will give you the answer.
What is Time Value?
If you’re like most people, you would choose to receive the cash prize now. After all, why would any rational person defer payment into the future when he/she can have the same amount of money now? This is at the most basic level of the TVM concept, and it demonstrates that, all things being equal, it is better to have money now than in the future.
So, Which Cash Prize Should You Choose?
Although the cash prize remains the same, you can do much more with the money if you have it now because over time, you can earn a rate of return on it. Back to the above example: by receiving the money now, you are poised to increase the future value of your money by investing and earning a rate of return over a period of time. For Option B, you don’t have time on your side – the payment received in three years would be your future value. The timeline below illustrates this.
By choosing Option A, your future value will be the cash prize, plus any rate of return earned over the three years. On the other hand, the future value for Option B, would only be the amount of the cash prize.
In addition to the rate of return consideration mentioned above, the same amount of money owned in the future will have less spending power due to inflation in the economy. Also, there is a risk that any future payment will not be received – if you have the money now, there is no such risk involved. After considering the TVM principle, it becomes clear that Option A would be the smarter choice!
Application of Time Value of Money Principle
There are many applications of the TVM principle. For example, we can use it to compare the worth of cash flows occurring at different times in the future, to find the present worth of a series of payments to be received periodically in the future, or to find the required amount of current investment that must be made at a given rate of return to generate a required future cash flow. All of this is necessary when it comes to estimating the value of a company, which will be discussed as part of a following write-up within the series.