Time Value of Money: Basic Concept【Dr. Deric】

Summary

In this educational video, Deric introduces the fundamental concept of the time value of money, emphasizing why receiving money today is preferable to receiving it in the future due to its potential to generate earnings. He explains the importance of this concept for comparing cash flows across different periods and discusses future value (FV) and present value (PV), along with the methods for calculating them, including equations, financial tables, calculators, and spreadsheets. Deric also touches on the significance of timelines, cash flow patterns, and the difference between simple and compound interest, all crucial for making informed investment decisions.

Takeaways

• 🕒 The concept of time value of money is based on the principle that money available now is worth more than the same amount in the future due to its potential to earn returns.
• 💰 People generally prefer to receive money today rather than in the future because of its present earning capacity and the ability to invest and grow wealth immediately.
• 📈 The decision to choose between receiving money now or in the future depends on the interest rate one could potentially earn on the money if received today.
• 🔢 Future Value (FV) is the concept that translates the value of money today into its equivalent value in the future, involving the process of compounding.
• 💼 Present Value (PV) is the concept that translates the value of future money into its equivalent value today, involving the process of discounting.
• 📊 There are four computational aids for time value of money calculations: equations, financial tables, financial calculators, and electronic spreadsheets like Microsoft Excel.
• 🗓 A timeline is a crucial tool for solving time value of money problems, helping to visualize cash flows over time and understand the sequence of events.
• 💹 Cash flow patterns can be categorized into three basic types: a single amount, an annuity, or a mixed stream, each with different implications for investment decisions.
• 🏦 Investment decisions should consider the time value of money, comparing cash flows at a single point in time to determine if an investment is wise.
• 📈 Simple interest is calculated based on the original principal amount, without earning interest on interest.
• 🌐 Compound interest is calculated on the total balance, including previous interest earned, leading to an increasing amount of interest over time.
• 👋 The video concludes with a reminder that all time value of money questions will apply compound interest for calculations.

Q & A

What is the basic concept of time value of money?

The time value of money is the concept that a sum of money available at the present time is worth more than the same amount in the future due to its potential earning capacity. Essentially, $1 today is worth more than $1 in the future because of the interest or investment returns it could generate.

Why would someone prefer to receive $10,000 today rather than in five years?

Someone would prefer to receive $10,000 today because the money can be invested and potentially earn returns, making it grow in value over time. Receiving the money now allows for immediate use and the opportunity to benefit from its earning potential, rather than waiting for it in the future.

How does the concept of time value of money allow for the comparison of cash flows from different periods?

The time value of money allows for the comparison of cash flows from different periods by converting future cash flows to their present value or present cash flows to their future value. This makes it possible to evaluate and compare the worth of cash flows at a single point in time, regardless of when they occur.

What is the significance of knowing the interest rate when choosing between receiving $1,000 today or $1,100 one year from now?

Knowing the interest rate is crucial because it helps determine whether it's more beneficial to receive the money now or later. If the potential interest rate is higher than the implied rate of 10% in the example, it would be better to receive $1,000 today and invest it to earn more than the $100 difference. Conversely, if the interest rate is lower, it would be more advantageous to wait for the $1,100.

What is meant by the future value (FV) in the context of time value of money?

Future value (FV) refers to the amount of money that a given sum of money will grow to in the future, taking into account the interest it will earn. It translates the value of $1 today into its equivalent value at a later time, through the process of compounding.

What is present value (PV) and how does it differ from future value?

Present value (PV) is the current worth of a future sum of money, given a specific interest rate. Unlike future value, which calculates the amount money will grow to, present value calculates the amount of money that, if invested today, would accumulate to a future sum. It involves discounting future cash flows back to their value today.

What are the four computational aids mentioned for calculating time value of money questions?

The four computational aids for calculating time value of money questions are: using equations, financial tables, financial calculators, and electronic spreadsheets such as Microsoft Excel. These aids help in performing the necessary calculations to understand the time value of money.

Why is drawing a timeline important when solving time value of money problems?

Drawing a timeline is important because it visually represents the sequence and timing of cash flows. It helps in organizing the information and understanding the time periods involved, which is crucial for accurately calculating the time value of money.

What are the three basic patterns of cash flow mentioned in the script?

The three basic patterns of cash flow are a single amount, an annuity, and a mixed stream. A single amount refers to a one-time cash flow, an annuity involves equal cash flows over a series of periods, and a mixed stream has varying cash flows over time.

How does the concept of compounding differ from simple interest in the context of time value of money?

Compounding involves interest being calculated on the initial principal as well as on the accumulated interest of previous periods, leading to interest on interest. In contrast, simple interest is calculated only on the original principal, without any interest being earned on previously earned interest.

What is the decision-making process when evaluating an investment that will produce cash flows over multiple years?

When evaluating an investment with cash flows spread over multiple years, it's important to compare the cash flows at a single point in time. This can be done by either converting all cash flows to their future value at the end of the investment period or by discounting all cash flows back to their present value at the beginning of the period. This allows for an accurate comparison of the investment's profitability.