Time Value of Money Part 1 (Concept)

In this video I start talking about the Time Value of Money. This is the central idea behind all of Finance. Don’t miss this one!

VIDEO SUMMARY:

This video is on the “Time Value of Money.” We are going to talk about the concept. Then we’ll walk through an equation. And then we’ll walk through an example that shows how you would use this concept in application. Now I know a lot of people kind of skim over this concept. Calculators make it pretty easy to calculate. There’s two buttons on a calculator. One of the buttons is PV for Present Value, and one button is FV for Future Value. These are built into Excel as well. So it’s pretty easy to calculate, and once students figure this out, they say “Well, I understand the concept. Let’s move on.” But I want to stay here a moment and really talk about what this concept means, because it’s very important for the rest of finance.

The main idea is that risk and interest rates are related ideas. In general, the more risk there is, the higher the interest rate should be. The reason this is, is because of the time value of money. The time value of money is a concept that basically says a dollar today is worth more than a dollar tomorrow. So why is this? You might have heard the quote “a bird in the hand is worth more than two in the bush.” And that is what we’re saying here. If I were to have a dollar in my hand, that would be worth more than you saying you would give me a dollar tomorrow. The reason that is, is because getting a dollar tomorrow has a certain amount of uncertainty. There’s some risk there. There’s no risk with me having the dollar in my hand right at this moment, because there’s all these possible things that could happen before you give me the dollar tomorrow. There could be some natural disaster that would prevent you from meeting me. You could get sick and not show up and give me the dollar. So there’s some possibility that I might not get the dollar tomorrow and therefore it’s not as valuable as a dollar in my hand right now.

The question then becomes, “how do I quantify the difference? How do I quantify how much more that dollar is worth today?” We do that in finance by predicting the future. You might say, “Well that’s ridiculous. No one can predict the future.” But in reality we are doing that all the time. We are always making assumptions about what we think is going to happen in the future. You might have a paycheck or some regular amount of income you receive each week. That assumption about the future is going to impact the purchasing decisions you make today. So we’re always predicting the future. All we are talking about here is just documenting what our assumptions are that we think are going to happen. In this particular example of a dollar today and a dollar tomorrow, we’re just looking at all the potential timelines of what could happen between today and tomorrow. Of those potential timelines, what percentage of those are negative? Or are going to result in me not getting that money? If we look at those options, and we say ten percent of those could result in not receiving the money, then we should expect an additional ten percent compensation for holding that risk. So the present value is the dollar plus the additional amount I should receive for holding the risk, or $1.10. You might say at this point, “Well, if a dollar today is worth more than a dollar tomorrow, why are you saying the present value is worth less than the future value of a $1.10?” Well I’m saying the same thing essentially, because if I were to say the future value is only a dollar and the present value is a dollar, you would say that’s ridiculous. You would want more money in the future and the reason why you want more money is because it’s not as valuable as holding the dollar in my hand. The dollar in my hand is worth a full dollar because I have a hundred percent certainty. As soon as you start taking away some of that certainty, it’s worth less and less. To compensate you for that risk, that ten percent risk, you’re going to receive ten percent interest, or $1.10.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.

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