The concept of time value of cash is essential in financial decision making because…
“A bird in the hand is worth two in the bush”
This medieval saying still applies today. From today’s perspective, it is healthier to attain a certain payoff today than an uncertain one in the longer term. Because who knows what the longer term will bring? By understanding the meaning of the Time Value of Money (TVM), you possibly can determine learn how to use the TVM concept to your personal advantage.
What is TVM? Time value of cash, real life example
What if someone offered you $10,000 today or $10,000 in three years?
Of course you’ll take the $10,000 today. In fact, $10,000 received today is definitely more useful than $10,000 received in three years because:
They do not know if inflation affects the purchasing power of the $10,000.
You can Invest that $10,000 to earn more money. So if you happen to invest correctly, you should have greater than $10,000 in three years.
This example is a no brainer. But what if someone offered you $10,000 today or $12,000 in three years, which might you select?
The answer is: it depends. It is determined by what return or rate of interest you can get on that $10,000 over the subsequent three years. And that is where smart financial planning comes into play.
Why is the time value of cash necessary?
Imagine if you happen to could have $10,000 today or $12,000 in three years. What would you select?
To assist you make your decision, you might want to project what type of investment return you possibly can get on the $10,000 over the subsequent three years.
Let’s say you possibly can buy a zero-coupon bond with 5% interest and a maturity of three years. Take the $10,000 today and invest it within the three-year zero-coupon bond paying 5 percent interest. The future value of the bond might be $11,576.25.
Of course, since that is lower than $12,000, you’ll make the $12,000 in three years.
In fact, you would wish $10,366 today to equal $12,000 in three years, assuming a 5% return.
This easy example shows the importance of the time value of cash in on a regular basis life.
Time value of cash in financial decision making
Here’s how much your $12,000 payment expected in three years is value today.
Now let’s discount the worth of $12,000 we received in three years to today using the identical rate of interest of 5%. The $12,000 received in three years is value $10,366, or $366 greater than $10,000. So at a reduction rate of 5 percent, it’s higher to decide on the $12,000 in three years slightly than the $10,000 today.
Now if you happen to could get a return of greater than 5% on the $10,000your decision making would change. If rates of interest rose to 7%, you can buy the identical thing 3 12 months deposit At a 7% return, your original $10,000 could be value $12,250.
So today, take the $10,000 and higher invest it within the zero coupon bond with an rate of interest of seven%.
Here is one other option to confirm your decision. Take the $12,000 you received three years from now and discount it to today at the identical 7 percent. The $12,000 would only be value $9,796. Therefore, with a better rate of interest (discount rate), it is healthier to go for $10,000 today.
Use the time value of cash to choose between a lump sum payment and an annuity payment
The NPV concept may also assist you determine whether a lump sum payment or a withdrawal will occur pension with monthly payments is a greater option. The answer lies by which alternative gives you greater capital value or value today.
This is a wise measure for many who have the flexibility to earn interest on their retirement accounts or receive a lump sum payout.
What if you happen to had the alternative between receiving $10,000 per 12 months for 10 years or receiving $100,000 today? Now clearly, just like the previous example, you’ll take the $100,000 today because you possibly can Start investing that cash immediately. But what if you happen to were offered $80,000 today or $10,000 a 12 months for the subsequent 10 years? This alternative will not be that easy.
Let’s say you possibly can invest your money within the stock market and get a mean annual return of seven% over the subsequent ten years.
With a capital value calculator from Investopedia The $10,000 you received for 10 years, discounted at 7%, is value $75,152 today. If you compare that $75,152 to the $80,000 you received today, you could be higher off taking the $80,000 lump sum payment today.
Remember: When expected rates of interest change, the online present value also changes.
The importance of time value of cash when buying a automobile
The concept of time value of cash is essential in financial decision making for businesses and individuals. It includes the concepts of net present value and future value.
We simply used discounted money flow to find out how much money in the longer term could be value today. Companies use this method to investigate future projects. Investors use this to guage securities. And you need to use this metric to seek out out the true time value of cash.
This strategy could assist you determine whether it’s best to spend money today or save for the longer term.
Knowing what the time value of cash pertains to when buying a automobile can assist you make a better financial decision.
Let’s say you could have a alternative between buying a $25,000 automobile or a $35,000 automobile. Hypothetically, for example you pay in money. Take the $10,000 difference and picture you obtain the automobile for $25,000 and put the $10,000 into an investment that can earn you 6 percent per 12 months for the subsequent ten years. In 10 years, you should have a $25,000 automobile that can probably be value $8,000, plus the $10,000 invested that might be value $18,194.
Add the $25,000 depreciated automobile, now value $8,000, plus the $18,194 you made on the $10,000, and after ten years your automobile’s value might be plus who invested $10,000 $26,194.
If you had bought the automobile for $35,000, in ten years you’ll have a ten-year-old automobile value about $11,000.
Scenario one is value $26,194.
Scenario two has a worth of $11,000 (the 10-year-old automobile’s depreciation of $35,000).
This is an example of the trade-off between save or expenses.
They determine whether the costlier automobile is value $15,194 ($26,194 to $11,000) greater than the $25,000 model.
Why is the time value of cash necessary – summary?
Understanding the importance of the time value of cash in financial decision making can mean the difference between having what you wish throughout your life or living your dream now while finding yourself in financial trouble tomorrow.
The concept of the time value of cash can assist you understand what you might be giving up when making any financial decision.
When considering a purchase order, ask yourself: Are today’s expenses value less tomorrow?
Even if you happen to buy a latte each day, you can save $70,000 less in retirement if you happen to select to speculate that cash as a substitute!
Thinking before you spend will assist you avoid future financial regrets
