Congratulations!!! You have won a cash prize! You have two payment options: A: Receive $10,000 now or B: Receive $10,000 in three years. Which option would you choose?
What Is the Time Value of Money?
If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that all things being equal, it seems better to have money now rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money.
Back to example: By receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value.
Time literally is money—the value of the money we have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that we can distinguish between the worth of investments that offer us returns at different times.