Time is Money
The Time Value of Money
The Fundamental Principle of Finance
Time is money, literally. If there is a prospect of receiving a certain sum, then the sooner you receive it, the more it is worth. There is risk in waiting. A bird in the hand is worth two in the bush. Interest rates describe this function between present value and future value. This is the fundamental concept of finance. We will explore this relationship between present and future value from different angles and I will phrase it in different ways in order to let it sink in, but this in a nutshell is the fundamental concept underlying all of finance.
This is the underlying principle of how banks function, how stocks and bonds are priced, how assets and companies are valued, how projects are analyzed, and how you should think about money.
A bird in the hand is worth two in the bush. Receiving money today is worth more than getting the same amount in the future; and the value of the prospect of receiving money diminishes the further into the future the promise to deliver money. The rate at which a dollar in the future decreases relative to a dollar today is inversely proportional to the rate at which a dollar invested today will increase in the future. The future and the present value are two sides of the same coin (pun intended) and they are related by the interest rate.
The concept of the time value of money explains why interest is paid or earned. Interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of money. Risk has to do with the uncertainty of being repaid and interest rates reflect the level of this uncertainty or risk.
It also underlies investment in stocks or company assets. An investor is willing to forego spending their money now if they expect a favorable return on their investment in the future. The return required is related to the perceived risk of getting one’s money back in the future; the higher the perceived risk, the higher the required rate of return. An investor is willing to part with their precious capital when greed overcomes fear.
The interest rate on an investment is often referred to as the yield and often is calculated as return on investment or ROI.
The concept of the time value of money dates back at least to Martín de Azpilcueta of the School of Salamanca. Martín de Azpilcueta (Azpilikueta in Basque) (December 13, 1491 – June 1, 1586), also known as Doctor Navarrus, was an important Basque theologian, and an early economist and the first person to develop monetarist theory. He invented the mathematical concept of the time value of money. It’s an idea that is about 500 years old.
This blog post is distilled from our book MBA ASAP Understanding Corporate Finance. It is available from Amazon as an eBook for Kindle, paperback or audiobook. The audiobook is also available from Audible. Check it out!
Here is a cool summary of the Time Value of Money ideas in an Infographic