TIME VALUE OF

MONEY
What Is Time Value?
If you're like most people, you would choose to
receive the $10,000 now. After all, three years
is a long time to wait. Why would any rational
person defer payment into the future when he
or she could have the same amount of money
now? For most of us, taking the money in the
present is just plain instinctive. So at the most
basic level, the time value of
money demonstrates that, all things being
equal, it is better to have money now rather
than later.

What Is Time Value?
But why is this? A $100 bill has the same value
as a $100 bill one year from now, doesn't it?
Actually, although the bill is the same, you can
do much more with the money if you have it
now because over time you can earn
more interest on your money.

What Is Time Value?
Back to our example: by receiving $10,000
today, you are poised to increase the future
value of your money by investing and gaining
interest over a period of time. For Option B,
you don't have time on your side, and the
payment received in three years would be your
future value. To illustrate, we have provided a
timeline:

What Is Time Value?
What Is Time Value?
If you are choosing Option A, your future value
will be $10,000 plus any interest acquired over
the three years.
The future value for Option B, on the other
hand, would only be $10,000.
So how can you calculate exactly how
much more Option A is worth, compared to
Option B?
Let's take a look.

Future Value Basics
If you choose Option A and invest the total
amount at a simple annual rate of 4.5%, the
future value of your investment at the end of
the first year is $10,450, which of course is
calculated by multiplying the principal amount
of $10,000 by the interest rate of 4.5% and
then adding the interest gained to the principal
amount:

Future Value Basics
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a
one-year investment with a simple
manipulation of the above equation:
Original equation: ($10,000 x 0.045) + $10,000 =
$10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] =
$10,450
Final equation: $10,000 x (0.045 + 1) = $10,450

Future Value Basics
The manipulated equation above is simply a
removal of the like-variable $10,000 (the
principal amount) by dividing the entire original
equation by $10,000
Future Value Basics
If the $10,450 left in your investment account
at the end of the first year is left untouched
and you invested it at 4.5% for another year,
how much would you have?
To calculate this, you would take the $10,450
and multiply it again by 1.045 (0.045 +1). At
the end of two years, you would have $10,920:

Future Value Basics
Future value of investment at end of second
year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to
the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)

Future Value Basics
We can see that the exponent is equal to the
number of years for which the money is
earning interest in an investment. So, the
equation for calculating the three-year future
value of the investment would look like this:

Future Value Basics
Present Value Basics
If you received $10,000 today, the
present value would of course be
$10,000 because present value is
what your investment gives you
now if you were to spend it today. If
$10,000 were to be received in a
year, the present value of the
amount would not be $10,000
because you do not have it in your
hand now, in the present.
Present Value Basics
To find the present value of the $10,000
you will receive in the future, you need to
pretend that the $10,000 is the total
future value of an amount that you
invested today. In other words, to find the
present value of the future $10,000, we
need to find out how much we would
have to invest today in order to receive
that $10,000 in the future.

Present Value Basics
To calculate present value, or the amount that
we would have to invest today, you must
subtract the (hypothetical) accumulated
interest from the $10,000. To achieve this, we
can discount the future payment amount
($10,000) by the interest rate for the period. In
essence, all you are doing is rearranging the
future value equation above so that you may
solve for P.
Present Value Basics
The above future value equation can be
rewritten by replacing the P variable
with present value (PV) and manipulated as
follows:

Present Value Basics
Let's walk backwards from the $10,000 offered
in Option B. Remember, the $10,000 to be
received in three years is really the same as
the future value of an investment. If today we
were at the two-year mark, we would discount
the payment back one year. At the two-year
mark, the present value of the $10,000 to be
received in one year is represented as the
following:

Present Value Basics
Present value of future payment of $10,000 at
end of year two:


Present Value Basics
Continuing on, at the end of the first year we
would be expecting to receive the payment of
$10,000 in two years. At an interest rate of
4.5%, the calculation for the present value of a
$10,000 payment expected in two years would
be the following:
Present value of $10,000 in two year:


Present Value Basics
Of course, because of the rule of exponents,
we don't have to calculate the future value of
the investment every year counting back from
the $10,000 investment at the third year. We
could put the equation more concisely and use
the $10,000 as FV. So, here is how you can
calculate today's present value of the $10,000
expected from a three-year investment earning
4.5%:

Present Value Basics
Present Value Basics
So the present value of a future payment of
$10,000 is worth $8,762.97 today if interest rates
are 4.5% per year. In other words, choosing
Option B is like taking $8,762.97 now and then
investing it for three years.
The equations above illustrate that Option A is
better not only because it offers you money right
now but because it offers you $1,237.03 ($10,000
- $8,762.97) more in cash!
Furthermore, if you invest the $10,000 that you
receive from Option A, your choice gives you a
future value that is $1,411.66 ($11,411.66 -
$10,000) greater than the future value of Option
B.
Present Value of a Future
Payment
Let's add a little spice to our investment
knowledge. What if the payment in three years
is more than the amount you'd receive today?
Say you could receive either $15,000 today or
$18,000 in four years. Which would you
choose? The decision is now more difficult. If
you choose to receive $15,000 today and
invest the entire amount, you may actually end
up with an amount of cash in four years that is
less than $18,000.
Present Value of a Future
Payment
. You could find the future value of $15,000,
but since we are always living in the present,
let's find the present value of $18,000 if
interest rates are currently 4%. Remember that
the equation for present value is the following:

Present Value of a Future
Payment
In the equation above, all we are doing is
discounting the future value of an investment.
Using the numbers above, the present value of
an $18,000 payment in four years would be
calculated as the following:
Present Value



Present Value of a Future
Payment
From the above calculation we now know our
choice is between receiving $15,000 or
$15,386.48 today. Of course we should
choose to postpone payment for four years!
The Bottom Line
These calculations demonstrate that time
literally is money - the value of the money you
have now is not the same as it will be in the
future and vice versa. So, it is important to
know how to calculate the time value of money
so that you can distinguish between the worth
of investments that offer you returns at
different times.