Understanding time value of money

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time value of money

If someone asked you if it’s better to have $100 now or in 1 year, what would be your answer? As rational investors, we instinctively tend to choose the first option, but why? The answer is the time value of money.

The advantage of having money now vs. in the future is that you can invest that money and earn interest over that time. For example, if you invest those $100 at an annual interest rate of 5%, you would have $105 one year from now instead of $100 if you were to receive them in the future. The opportunity cost of waiting one year is $5.

Wait… Rate? Opportunity cost? Don’t worry, we’ll explain these terms more deeply.

What is the Rate of Return?

When talking about time value of money, rate of return is the net gain or loss of an investment over a period of time. An investment has a rate of return as long as it produces cash flows in the future or if you can sell it for a higher price than when you purchased it.

For example, if you buy a house and then rent it, the rent’s cash flows minus the initial investment represent the rate of return on the house. Also, if you sell the house for a higher price than what you bought it for, you earn a capital gain.

Remember that no one can predict the time value of money, so an investment can also have a negative rate of return. In order to calculate rate of return, you need to discount all the cash inflows from the investment using a discount rate and if the sum of all the discounted cash inflows and outflows is greater than zero, the investment is profitable.

Using the previous example, if you receive $100 now, those initial $100 are called the present value, whereas the $105 would be the future value of the investment. The more time you invest those $100, the larger the future value will be. Similarly, the more time you wait with those $100 in your pocket, the greater the opportunity cost.

What is Opportunity Cost?

Opportunity cost is the benefit or earning you miss out on when choosing one option over another. You can actually calculate the opportunity cost of one option over another, it’s just the difference of the expected rate of return of each.

As consumers, we do think about the opportunity cost of making certain decisions over others (like if I eat an entire box of donuts I will be happy, but my stomach will hurt).

However, when it comes to time value of money and analyzing the numbers, we don’t tend to perform the calculations necessary to determine if an investment will be profitable in the future. In other words, we don’t stop and think about the present value of an investment, but instead make ballpark calculations.

Opportunity cost also applies not just to your money, but also to your time. If a pizza place is handing out free pizza, but you need to wait in line for an hour to get a piece, the opportunity cost of that pizza are the activities you could do during that hour. If you can engage in a more productive endeavor, like catching up on your studies, that pizza is not really free and its opportunity cost are the other activities you could have been doing during that time.

Putting it all together

Once you understand what time value of money is and the concept of rate of return, you can use it to analyze the opportunity cost of various choices.

Going with a new example, let’s say a fuel-efficient car costs $25,000. If you buy it today, you are using $25,000 you could invest in something else, like buying stocks. If you buy the fuel-efficient car, you will be able to save on gas, and for this reason will get a 2% return on your investment over the next year (calculated by comparing the amount you are spending in gas now vs. the lower amount you will spend with the new car).

On the other hand, you can invest in the stock market where you could potentially get an 8% return over the next year. The opportunity cost of buying the car over investing in the stock market is 6% (8% – 2%). If you buy the car, you will forgo a 6% return that you could gain by investing that same money in the stock market.

This said, it is super important to keep in mind that the returns on the options you’re evaluating are always speculation. Nobody knows exactly what will happen in the future. When trying to obtain approximate values for the rates of return of diverse scenarios, you can use similar examples to obtain an estimate.

Using the example of buying a car vs. investing in the stock market, you can use the stock market’s average rate of return over the past 10 years to get an idea of its rate of return.

Moreover, the return on the investment in the car is more certain, as you already know what you’ll spend on gas with the new fuel-efficient car is less. You also know that if you want to sell the car in the future, you can get some money for it, whereas if the stocks you bought with the $25,000 decrease in value, you may not be able to get your investment back.

When calculating opportunity cost, you should also take into account the risk of each investment in addition to its potential returns. Maybe investing in the stock market has a potential higher rate of return, but buying a car could be a safer bet. Owning the car provides you with a physical asset you can bank on selling in the future, whereas you risk losing all your capital when investing in the stock market.

The takeaway

We have reviewed some very important concepts in finance. You should always consider time value of money when making a financial choice. It can be as simple as what brand of detergent to buy (think about what you are foregoing when choosing the more expensive brand) or more complicated, like whether or not to start a business (will the investment be profitable?).

The key takeaways are that you should think about the potential of holding money today rather than in the future and the opportunity cost of certain decisions over others.

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