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The Money Prof
Monday, June 1 2015
Time Value of MoneyDid you know money has a time value? Receiving cash today (called present value dollars) is worth more than receiving cash in the future. In fact, the longer you have to wait for the cash, the lower its value. This is called opportunity cost.
There are basically three reasons why present value dollars are worth more than future dollars. First and most important, is the faster you can receive the cash, the faster you can invest it, realizing returns. Secondly, if prices are rising (inflation), receiving cash allows you to buy products at lower prices than in the future. Finally, business risk is reduced when receiving cash. Waiting for payment can result in not getting paid at all.
Let's go back to the first reason why cash is worth more than future dollars: taking advantage of early investing. Here is an illustration. Person A promises to pay Person B $10,000. If received in cash, the present value of $10,000 is $10,000 (no opportunity cost). Now, let's assume Person A pays Person B the $10,000 at the end of 5 years. An assumption has to be made as to what is the opportunity cost (what rate of return could have been earned with cash). We will use 7% in this example. We then discount the $10,000 by 7% annually over a 5 year period. We find that the present value of $10,000 received at the end of 5 years is now only $7,129.
Stating this another way, that $7,129 in cash is equivalent to receiving $10,000 at the end of 5 years (given a 7% discount rate). If the discount or opportunity rate was higher than 7%, the present value would be less than $7,129. If it was lower than 7%, the present value or cash value would more than $7,129. Compounding has much to with opportunity cost. As an investor, compounding works much in your favor, when receiving payments. Conversely, as a borrower (or payer), compounded interest will increase your costs.
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