Why is it important to understand the time value of money?
Money takes on different values in different time periods. Economics, investments and personal finance often require the calculation of the value of money in different time periods.
The importance of the concept of time value of money (TVM), and the calculations that go with it, support economic decision making. In analyzing different options and conditions we are often presented with sums or flows of money in different time periods. TVM techniques allow us to put lump sums and flows in the same time frame where we can compare them.
Here is an example.
Would you rather have $1,000 today or wait 5 years and receive $1,200? If you need the money now, the answer is obvious - $1,000 today! But which choice is more rational?
Using TVM formulae, or a financial calculator, we can calculate the rate of return you would receive if you invested $1,000 today and received $1,200 in 5 years. (Putting the question this way allows us to compare $1,000 today vs. $1,200 in 5 years.) The answer is 3.7%.
Now, what do we say?
You would ask, "is this a good rate of return?" If you would receive 1.1% a year at your local bank, this is not bad. But if you can get 5% a year taking on the same investment rate risk, it does not look so good. You would be better off to take the $1,000 and put it in the 5% investment. It would grow to $1,276 in 5 years.
It is interesting that most American lotteries pay out winnings in a stream of yearly or monthly payments instead of the "advertised" lump sum. If you used TVM analysis, you would discover that the winner's return (from the original lump sum that the lottery corporation kept) is very small. So who wins?
The concept and calculations of TVM underlie many common transactions:
- the size of your monthly car payments;
- the amount you must save each year to have enough to go to grad school;
- the price of a bond;
- the number of years your $2 million dollars will give you financial security after retirement; and
- Net Present Value analysis.