Sunday, March 14, 2010

The Time Value of Money: A Peso Today is Worth More Than a Peso Tomorrow


A peso today is worth more than a peso tomorrow.
The time value of money, perhaps, is the most important lesson students of finance learn inside the classroom; unfortunately, it’s also something most of us everyday Juans tend to ignore, both consciously and unwittingly, in making day-to-day financial decisions.

Intuitively, we all know that it’s better to receive 1,000 pesos today than, say, one year from now. A lot of things can happen in that one year, things that can affect (often negatively) the value of our money. Perhaps the most obvious (and predictable) thing than can happen is for the prices of most goods and services to rise, thereby reducing the purchasing power of our 1,000; we all know what inflation is all about, and we all know that it is a fact of life. So, simply because prices of most things tend to increase over time, and 1,000 pesos, most probably, will be able to buy more gasoline or chicken or beer today than one year from now, a peso today is worth more than a peso tomorrow.

What else would make money more valuable today than if received at a later time? What can I do with my 1,000 pesos that will make it more valuable than 1,000 received one year from now? Well, I can always deposit my money in a bank account that pays 1% interest per year (this is the second worst thing you can do with your money; the worst thing, of course, is to let your money rot under your bed or in a piggy bank); after a year, I’ll have 1,010 pesos, just a tad better than if I received 1,000 at the end of that year. What this means is that by receiving money at a later date, I’ll be foregoing the opportunity to earn interest if I receive and invest the amount today, making a peso today worth more than a peso tomorrow.

How should all of this affect how we make financial decisions? Well, at the very least, we should try to get payments we expect to receive at the earliest possible date and take advantage of the extra time by either spending the money now and avail of lower prices, or by investing the sum today to earn returns in the future. Of course it also works the other way around: we also should try to delay making payments or cash outflows as much as we can, but without incurring very expensive penalties or consequences (excessively delaying payments to a friend or relative from whom you’ve borrowed money may irreparably ruin your relationship to him or her, and we all know that paying beyond the due date of your credit card bill will result very expensive penalty charges).

Finally, if you’re willing to do relatively simple time value of money math (I say relatively simple because it does not involve any calculus and it can be done with most calculators and spreadsheet apps), the concept can also help you make better purchasing and investment decisions. Next week, we’ll take a look at how we can use this simple concept to choose between different payment options and save significant amounts of cash.
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