A basic principle all business majors are acquainted with is the time value of money (TVM). This economic principle states that a dollar received today is worth more than one received tomorrow.
But why is that the case? Money is money and its value should presumably be preserved. The truth is, it isn't though, and intuition behind it is quite simple. Let’s suppose you were offered $500,000 today or $500,000 one hundred years later; which would you choose?
Clearly, the first option is better and it is so for the following three reasons:
1. Higher purchasing powers. Our buying power represents the actual value of our money measured in the services or commodities we can acquire. It is directly linked to the inflation rate and it is no secret that the trend is uprising. So, what does this mean? To simplify matters, just think about how much $100 dollars would get you in 1914 vs. how much it can get you today. Seeing that inflation rate has increased, people’s purchasing power has decreased and $100 today is worth less than it had been in 1914. So depending on the percentage increase in inflation rate and historical trends, we can safely assume that $500,000 today would certainly amount to much more in 100 years.
2. Opportunity cost. With money, opportunity cost mainly refers to your ability to invest the money instead of simply spending it as is. Getting those $500,000 dollars today means you can invest and acquire interest to later on provide you with the principal amount of money, i.e. $500,000 and the additional interest accrued.
3. No risk. Getting the money today ensures you already have it, so there is no worry as to when the money is received, because it already is.
As such, we can say that the sooner we get our money the better and the higher the interest rate, and the more money we’ll have later on. That being said, make sure you keep the time value of money in the back of your mind the next time you’re handling money issues, you just might be in for some big cash!
Watch the video below to learn more about the principle of TVM.