Just another 5 year-old who needs help.
In: Economics
It’s about interest, and how money ‘grows’ over time because it can collect interest.
If you have $2000, that’s great; you can buy $2000 worth of stuff.
But if you get $2000 right now and put it in a savings account for a year, you’ll get like 1.5% interest on it so after a year it’s worth $2030. Let it sit for two years, and it’ll grow to $2060.45.
Based on math like that, people will say things like “$2000 now, is worth as much as $2060.45 in two years”.
The general TVM idea is “it’s better to get money sooner because you could potentially get some interest on it”, and if you want to get specific you have to do some interest calculations and then you can say “this much money now = that much money in 5 years”, or whatever.
It’s the financial version of “a bird in the hand is worth two in the bush.”
Money you have right now is worth more than the same amount in the future because of its potential to be used now and/or grow.
Yes interest is one potential use, but you can also use it to pay off debt now vs later, purchase real estate or other assets that can appreciate, start a business that can be grown, etc.
Interest equals principal x rate x time
Put in 100 bucks for 1 year at 5% per year you get $5 interest
Time value of money is this and things like compounding interest, where the interest is incorporated into the principal every y number of months.
It’s literally just calculating how much a sum of money is/was/will be worth at different points in time
The basic motivation is this: would you rather have $100 today or $100 ten years from now?
You’d rather have it today. There are all sorts of reasons why you’d prefer it now (future inflation, ability to invest money and earn returns/interest, uncertainty about the future), but ask any five year old and they’d probably prefer it now too.
Now ask yourself: how much money would they have to pay you in ten years to take that option over $100 today? There must be some number, right? Surely you’d take $1 billion in ten years over $100 today. So you work backwards from that. At some point, you’ll say: “I’ll take X amount, but no lower.” So let’s say that number is $1000. In a sense, that $1000 in ten years is “equivalent” to $100 today.
You can express this equivalence using a percentage called the discount rate. In this case, the discount rate is 25.9%. What that means is that if you were given $100 today, invested that in an account that paid you 25.9% every year, then reinvested it into that same account, you’d end up with $1000 in ten years. This is an example of compounding interest.
If you continue to study this topic, you’ll learn about all the factors that can change. You can adjust the timing of cash flows, the number of payments, what determines your discount rate, etc. But it all starts with this basic idea that a $1 today is worth more than $1 in the future.
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