Why is this statement true a dollar in hand today more than a dollar to be received next year?

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.

Money today is literally worth more than it will be in the future in terms of what it will buy you. In 1985, before you drove to the grocery store to buy a liter of milk for $0.98, you would complain about spending $0.54 per liter to fill up the tank of the car you had just purchased for $8,300. Today, milk costs an average of $2.20, you are more than happy to spend $0.90 per liter at the pump, and buying a new car will put a $32,500 dent in your bank account. You can largely thank inflation for this.

But inflation isn’t entirely to blame for rising costs nor does it explain why in 1985 the average home in Toronto sold for $109,000, whereas today the median home price in the city has now risen to $600,000! There are countless reasons why costs skyrocket with time, including popularity, world events, diminishing resources, natural phenomena, technology, etc.

Aside from stronger buying power, the higher value of money “now” can be further illustrated by how it can be “used” today to grow. Consider what would happen if you put a dollar in a time capsule versus putting a dollar in a typical interest-earning bank account. In 30 years, the bill in the time capsule may look pristine, but it will be worth exactly one dollar (which we’ve already shown might be enough to buy a stick of gum in the future), whereas the dollar you put in the bank will have more than doubled. This is a simple example of the magic of compounding interest, however, you can just as easily turn today’s dollars into something substantially more valuable by paying down debt, investing in a business, or buying a property.

Waiting to receive some pre-determined amount of rent from your cell site lease in ten, twenty, or even thirty years into the future is the equivalent of waiting for a sealed time capsule of money to open up. Just think, what will your rent be “worth” then? How much buying power and how many investment opportunities will slip through your fingers as the years go by?

Now, what would you do if you could unlock your time capsule today?

You have most likely heard of the phrase:

“Time Is Money”.

But how about the concept: time value of money (TVM)?

TVM is one of the most basic concepts in finance and investing.

It is taught in one of the first few lessons of Finance 101 courses since much of investing is built on this theory. 

The underlying concept of TVM is that one dollar today is worth more than one dollar in the future. And arguably, this is a reasonably intuitive idea.

In fact, when we talk about TVM, the word inflation might have popped into your mind.

However, inflation is only one of the reasons behind this idea…

Why Is $1 Worth More Today Than Tomorrow?

Here are four main reasons why.

1. Opportunity Cost of Investing

Would you prefer your boss to pay you now, or a year later? More likely, you would want it now! 

One of the disadvantages of being paid late is that you miss out on investment opportunities.

The foregone chances of investing would be the opportunity cost of growing your capital through investments.

Let’s say you bought Toto and (allegedly) won $9 million like this Seedly community member.

Which option would you choose:

1. Option One: A lump-sum payment right now worth $9 million now or
2. Option Two: A lump-sum payment of $15 million paid 10 years later.

Which is the better option?

TVM tells us that the first option: the lump sum paid out right now, is better even though it is a smaller amount.

Why might it be a better option?

This is because it gives you the ability to put the money to work earning interest or growing via some other investment vehicle like stocks or property.

Let’s illustrate this with an example.

Let’s say you took the $9 million and invested it into an investment product with an annual interest rate of 6 per cent.

Here is what you will end up with after 10 years.

A few caveats to this.

Past performance is not indicative of future returns. Please do your due diligence on any investment you may make in the future as every investment product will have a certain amount of risk involved.

2. Inflation

I remember how a plate of noodles only cost $0.40 back when I was in primary school!

But we’ll be hard-pressed to find such a cheap plate of noodles today.

My bet is that many of us have experienced inflation first-hand, especially if we have noticed how the prices of goods and services have increased over time. 

This seems bad at first glance, but in fact, an economy with low inflation is a good thing!

The corrosive power of inflation is why people invest since the purchasing power of your money decreases over time with inflation.

This simply means that the same amount of money can buy fewer goods in the future than you can now.

3. Risk

Risk is not just related to returns; it is related to time as well.

The longer you wait for it to be paid through dividends, repayment of debt or even salary, the higher the risk that you won’t receive the promised payment. 

Risk is present because it is harder for you to predict the payment ability of an entity much further in the future.

Also, many other events could happen in the meantime which may disrupt the ability of the entity to pay.

Finance and investment professionals have a way of uniting risk and time, in a neat idea called a “Discount Rate”.

But that would be an article for another day.

4. Opportunity Cost of Personal Growth

This is not a “finance” concept per se, but it is about investing in yourself.

Warren Buffet – in several interviews – always stressed the importance of investing in your own personal growth.

Using the money you have today rather than later, you can invest in books, courses, or activities to improve yourself.

Warren Buffet has also shared how knowledge is like compound interest. The more knowledge you have today, the more it will grow as you can grasp concepts more efficiently and make better (investment) decisions in the future. 

Exceptions To The Rule

The theory and reasoning behind the TVM is sound.

Here, I will not critique the TVM theory but provide two exceptions to the scenarios mentioned earlier.

1. Deflation

Deflation is in many ways the opposite of inflation, where the general price level of goods and services decrease over time.

This means that you can actually buy more with the same amount of money the longer you wait!

However, deflationary regimes are more of an exception to the rule. Central banks always try their best to avoid such scenarios, as deflationary pressures are generally awful for the economy.

2. When There Are No Good Investment Opportunities Around

Have you ever had the urge to do something when you had absolutely nothing to do? I certainly have, and I’m trying to kick this bad habit as I end up spending time and energy on needless things.

Blaise Pascal, a French mathematician and philosopher, said that

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”

The same principle can be applied to how we manage our money. Sometimes, we do need to sit quietly in a room with our money.

One of the key investment principles mentioned by famous investors is that we should wait for good investment opportunities to come.

In a recent shareholders’ meeting for Berkshire Hathaway, Warren Buffett was asked why his company held so much cash.

He responded that the amount of cash was left available so that the company could snag up good investment opportunities when they appeared. 

Sometimes, the best thing to do is nothing, especially when good investment opportunities aren’t around. 

How Can We Use Time Value Of Money To Our Advantage?

Start Your Retirement Planning Early

$100 today may not seem much, but after considering the effect of compounding, it will definitely be worth more in the future if you invest it.

So if you start planning for your retirement now, you’ll have a longer time horizon to grow your money and can enjoy your golden years the way you intend to.

Invest Your Money Wisely

As I brought up earlier, knowledge compounds.

By learning more today, you can accelerate your growth in the future. By spending more time on activities and events that will be truly beneficial to your growth today can potentially even further your career and your aspirations in the future. 

Also, we should not be too hasty to invest our money just because we feel pressured to do so.

Sometimes, holding cash may be the right thing to do while we search and wait for good investment opportunities. 

Present And Future Values Of Investments

The next time you assess the amount of dividends that a company can pay, take note of when the dividends will be paid to you.

The longer you wait for the dividends to come in, the more risk you are taking, and the less valuable the dividends would be worth today. 

Another potential application of TVM is in calculating the present value of loans, mortgages and savings.

For example, you can take into account the different durations of repayments to find out which loan has the highest value instead of just taking note of the quantum of the payments.

Closing Thoughts

A dollar today is worth more than a dollar tomorrow.

This is due to inflation, opportunity costs of investing, as well as risks.

There might be exceptions to this rule, such as when there is deflation and when we should hold cash instead of investing. 

Though the concept of TVM is intuitive and straightforward, it reminds us that preparing for retirement earlier is more manageable and that we should invest our money wisely. TVM is also a practical concept that can be applied to investing and the choosing of financial products. 

Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. ​Readers should always do their own due diligence and consider their financial goals before investing in any stock. The writer may have a vested interest in the companies mentioned.

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