Friday, 4 November 2011

Time value of money

I didn't come from a business background.  Everything I learned in the MBA came as fresh insight, things that I had never thought about or considered before.  Whenever I would go to class I would come home and tell my wife, my friends, everybody about the amazing new thing I learned!  This is a really really basic financial concept but when I first learned it, it was such a revelation to me that I had to share it. I post it here because I'm sure many people I know are still unaware of it.



Winning the Lottery

Let's say you win the Lottery - $30 million!  Hooray! Now you have the option:  You could get $1 million per year for 30 years or $15 million today and that's it.  Which do you choose?

Most people I know would choose $1 million per year for 30 years.  Seems like more.

But imagine you invest your money in a relatively safe investment that gives you 10% interest.  With the $15 million you would be getting $1.5 million dollars a year in interest forever, which is more than $1 million per year for 30 years.

Time value of money

The reason this happens is because of what is called the Time Value of Money.  Money today is worth more than money tomorrow because you can invest it to make more money.  There are various math formulae you can use to figure it out that I won't get into but the basic mechanics work like this:

Say you have the ability to invest in something that is risk free (like a government bond).  Let's say it gives you 5% interest (it won't but let's just go with it to make the math easier).  Let's also say you have $1000 dollars to invest. 
If you invest your $1000 in the risk free government bond, in one year you will have $1050.  That means that $1050 in one year is worth the same as $1000 today.

Did you follow that?  It's a bit counter-intuitive at first, but the idea is that if someone offered you either $1000 today or $1050 a year from now it would be the same because you could invest your $1000 with no risk and get the same amount.

Similarly, if someone offered you $1049 a year from now, taking the $1000 today would be better because you could get more in a year by investing risk-free.

Finally it means that if you take your $1000 and just hide it under your bed for a year, you've lost $50.

Scale

These amounts might not seem like much, but imagine you were a business and instead of $1000 it was a billion dollars.  Putting that amount in a warehouse somewhere instead of investing it risk-free would then mean losing $50 million.  Doesn't seem so insignificant anymore, eh?

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