How Does Time Value of Money Work?
Since you’re reading posts on a financial blog, odds are you have heard of the time value of money.
But have you ever wondered how it works or why it exists?
As a barebones definition, the time value of money is the idea that a sum of money is worth more now than that same amount in the future.
The primary reason this is true is because of inflation and because opportunities for productivity exist.
Basically, all that means is that there are people without money who are incentivized to obligate themselves to pay back more for the money they can borrow today so they can turn it into something more profitable than the amount they borrow it for.
And…
There are also people who are willing to trade away money they have today in exchange for the promise of receiving more later.
Because both of these people have this incentive, money is more valuable in the future than it is now.
This is much easier to understand with an example.
Your Big Idea
Let’s pretend that it’s 2003, your name is Steve Jobs, and you have a great idea.
You’ve been around computers your whole life and you want to build a product that crams an incredible amount of computing power into a device that fits in your hand.
You decide to call it an iPhone.
Now you are confident in your ability to actually produce this world-changing product, but you also know that it is going to take a huge capital investment to get it going.
You’re going to need lots of expensive and smart people to develop the technology, build the factories, and source materials to turn your idea into a reality.
The rub is you won’t have any of the money you need until after you begin selling the product.
What’s a guy to do?
Well, one option is that you could take out a loan to get things going.
This is known as financing through debt.
So, you go down to the bank and ask Mr. Banker to give you $10 million to get you going.
The good news is Mr. Banker has lots of cash and he wants it to earn interest, not just rot in his vault while inflation deteriorates its value.
He tells you he’ll give you a loan, but you’ll owe him 10% annually on whatever you borrow.
This 10% is called interest and it’s typically quoted on an annual basis, but that doesn’t necessarily mean the loan is repaid that way.
So, for every $1 million you borrow, you’ll owe $100,000 per year in interest to Mr. Banker.
There’s just one problem. Mr. Banker has concerns about the future success of the iPhone and he is only willing to loan you $5 million. Even worse, no one else wants to loan you money because they think you’re leveraged enough to Mr. Banker.
So, where can you get the other $5 million you need?
What if you trade partial ownership in your company for cash?
This is called financing through equity.
Seizing on this idea, you host a trade show to present your iPhone idea to investors. They love your iPhone and your cool beard and decide to buy up your $5 million in stock giving you the capital you need to get things going.
They are giving you this money because they believe the shares of stock they own in your company will soon be worth much more than the amount of cash they are exchanging to buy those shares.
This is riskier than the debt opportunity, but there’s also much more upside if things go well.
In the end, you get your $10MM of capital, you pay back Mr. Banker the money you borrowed plus interest, and your investors share in the remarkable profits your new product is producing.
Everyone is happy and it was all possible because of the time value of money.
Why Do You Need to Know This?
The reason it’s important for us to understand the time value of money is that our financial assets are constantly exposed to the corrosive power of inflation.
If you’ve ever heard your parents or grandparents remark about how inexpensive a gallon of gas was when they were a kid, you’ve heard someone describe this phenomenon.
I doubt inflation is news to you, but it does mean you need to take steps to defend your finances against it.
The most common way to do this in our economy is to invest it.
Earlier we talked about Mr. Jobs financing his invention through debt. This could be a loan from a bank, but typically as an investor, you’ll use savings accounts, money markets, CDs, treasuries, or bonds to lend money to institutions in exchange for a promised interest rate.
Debt investments are typically lower risk than stocks and, as a result, typically produce lower returns.
The other method we talked about was investing through equity.
This is basically achieved by purchasing part ownership in a company through stocks. While you can buy individual stocks, it’s a much wiser idea to buy a broad basket of stocks through a mutual fund or exchange-traded fund to provide diversification while still leaving the door open for the higher returns available in stocks.
The Formula
To calculate the future value of an investment, just use the formula FV = PV(1+r)^n, where FV = future value, PV = present value, r = interest rate, and n = the number of periods or years you’ll be receiving the interest.
So, if you invest $10,000 and expect a 10% rate of return and want to know what it will be in 10 years, just plug those numbers into the formula and you’ll see that it will be worth $25,937.42. Not bad.
You’ll notice that your investment far more than doubled in ten years. You might have expected it to return $1,000 per year for ten years, leaving you with $20,000.
But it’s more than that because of compounding interest.
For an explanation of how compounding interest works, please check one of our earliest posts on the website: Why is Compound Interest Important?
