Concept of time value of money

15 JANUARY 2022

Imagine that you are given two options to choose from: option 1 is to get your one month’s worth of salary or business revenue now, while option 2 is the same as option except you get the money one month from now. Which one would you choose?

The most common expected response would be option 1. Why wait one month for the same amount of money when I can choose to receive it right now? Option 2 has no apparent advantage over option 1.

Now, let’s reoffer the two options again, but with a slight modification: option 1 remains the same, with you getting one month’s worth of salary or business revenue immediately today, while for option 2, you’ll still get the one month’s worth of money one month from now, PLUS 25%. Which option would you select now?

Adding that 25% in option 2 changes the considerations, and makes waiting for an additional one month a little bit more attractive and sensible than option 1. The pause you took to reconsider the modified option 2 in the reoffer explains pretty much what the concept of time value of money is.

Time value of money simply describes that a particular option’s monetary value changes depending on the timing of its cash flows. The earlier your money is returned from an investment, the higher its perceived value to you now, all other things held constant. While opportunity cost defines the monetary value given up because you chose one option over the other, time value of money defines the monetary effect of the cash flow timing of such decisions.

Waiting to get your money in the future rather than now also exposes you to financial risks, such as the risk of reduced value due to inflation or market fluctuations, and the risk of not getting your money at all due to unfulfilled obligations or worthlessness due to bankruptcy.

These financial risks you assume in exchange for tying down your money in investments should be compensated by the income you expect from such financial decisions, such as interest on fixed income or capital gains on investments in listed shares of stocks.

Next time you’re faced with an investment decision, don’t forget to factor in the time value of money effect of your options and choices.

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