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The time value of money
How much is money worth? That depends on when you get it. That is the concept known as the time value of money.
Let’s imagine that you have £100. Let’s also imagine that the interest rate you could get for putting that £100 in the bank was 5% per annum. (I know that is a stretch at the moment, but it makes the example easier to follow).
So you put your money in the bank and in 12 months time, £100 has grown into £105.
Now let’s imagine someone says to you, “I’d like to buy this thing from you for £100, but I’d like to pay that £100 to you in a year’s time.” That sounds OK, right? £100 is £100 however you look at it.
Not so fast.
You know that you could take that £100 and put it in the bank and it would turn into £105 in a year. This buyer is offering to give you £100 in a year, which means that you are £5 out of pocket.
To turn it around, you should figure out how much money you would need to put in the bank today to get £100 in a year. Assuming a 5% interest rate, that figure would be £95.23.
(I worked this out as £100/(1+5%.)
So the person asking you for a year to pay is in fact asking your for a discount of £4.77.
The value of compounding
That discount only applies over one year. If you were to put your money in the bank for many years, you would benefit from compound interest. If you put the money in the bank for 10 years, it would grow by 62%, not 50%. Similarly, the discount is bigger if someone promises to pay you in 10 years time. The effect is even more pronounced if the interest rate is higher than 5%.
The role of the time value of money in valuation
In corporate finance theory, the time value of money is critical to understanding the value of a company. The value of a company today is based on the discounted value of the future cashflows of the company. That means “the money that the company is expected to make in the future, adjusted to reflect both the time value of money and the risk that the company is taking”.
Wikipedia: The Time Value of Money
Flickr: 401 (K) 2012