If you were offered the choice of being paid $100 today or $100 a year from now, you would probably choose $100 today. After all, even at today’s low interest rates, your $100 might earn a small return over the next year. This simple example illustrates an important concept: that the value of money changes with time. A dollar received today is worth more than a dollar received a year from now – and is worth even more than a dollar received five years from now.
There are at least three reasons why today’s dollar is more valuable.
First, it can be invested to earn interest or dividends, as in the example above.
Second, future dollars may have their value eroded by inflation.
Third, the further into the future a payment is due, the greater the risk or uncertainty associated with receiving it.
The concept of the time value of money is important in many personal and business financial decisions. For example, you may have to choose between receiving a lump sum from a pension plan or a stream of payments in the future. In your business, you may be deciding whether to buy a new piece of equipment which will bring increased revenues in future years. Both of these decisions involve comparing the value of present and future dollars.
Finance professionals have developed a technique called present value for making such comparisons. The technique involves “discounting” the value of future dollars to reduce them to their equivalent value in current dollars. If you are faced with a decision that involves the time value of money, contact our office for assistance.