Money’s value changes with time.
Money tomorrow is worth less than money today because:
Inflation erodes money’s buying power. (When your great grandparents were children, the amount of money that would have bought them a fine quality restaurant meal will buy you a cut-price supermarket sandwich.)
If there is risk in the cash flow people can achive from investing their money, then the value of cash flow must be reduced to take account of the fact that it’s not 100 percent certain.
Most people prefer to enjoy what their money can buy today rather than delay enjoyment for one or more years.
The effects of time on the value of money need to be taken into account when assessing investments. Key concepts are Present Value, Future Value.
For example, consider the following situation.
An investor can achieve a guaranteed interest rate each year of 7 percent. What is worth more to this investor: $100 today to invest at 7 percent or a guaranteed payment of $200 in 6 years time?
Financial tables or calculations enable us to find the present value of $200 from 6 years in the future with a 7% interest rate environment.
PV = FV / (1 + i)n
PV = Present Value
FV = Future Value
i = interest rate
n = number of years
In our example,
PV = 200 / (1 + 0.07)6
i.e. PV = $133.27
The present value of the sum promised in six years time is higher than today’s $100 and the investor should choose this option to maximise his return.
Present value is the current worth of a future sum of money or sums of money at a specified rate of return.
When we assess the present value of a future sum, we need to choose an approprate discount (interest) rate.
In the example above, the discount rate is 7%. The higher the discount rate chosen by the investor, the lower the present value of the future money.
Using an appropriate discount rate is essential in the valuation of future cash flows and this can be as much of an art as it is a science.