Time value of money is one of the most fundamental concepts in finance. Simply put, this concept states that “a dollar today is worth more than a dollar tomorrow." According to this concept money in hand today is worth more than money that is expected to be received in the future. Text books on finance tell us that rationale behind this concept is straightforward: A dollar that you receive today can be invested such that you will have more than a dollar at some future time.
To clarify further, suppose you have won $10,000 and are given two options, a) receive the money now or, b) receive the money after three years. Which option would you choose? If you're like most people, you would choose to receive the $10,000 now because you can do much more with the money if you have it now because over time you can earn more interest on your money. Now suppose that the going interest rate is 4.5%, then you should receive $11,411.66 after 3 years, if you decide to take the second option. Therefore, $10,000 of today is worth $11,411.66 after three years given the interest rate at 4.5%.
Time value of money results from the concept of interest and serves as the foundation for all other notions in finance. It impacts business finance, consumer finance and government finance.
As a student of finance I have read this concept many times and many times I have wondered is it a flawed concept because it only takes into consideration justification and utility for existence of the key financial institutions; the banks. Suppose if $100 of today is worth the same tomorrow then the banks would certainly be out of the picture as they will have no other utility then besides being just a custodian of depositors money.
There is much more to the concept of time value than meets the eye, because it takes us to the heart of the problem: greed. Just because a dollar today is worth more than the future, we want more and more returns on our future money as we can get. Just because the banks are offering 4.5% interest on our money we try our best to invest somewhere where we can get more than the going interest rate or otherwise our money will fall prey to inflation.
Economists have always argued that a little inflation is always good because it makes economies grow. On the other hand, in order to remain over and above the inflation rate, a person has to struggle all his life otherwise his money will simply won’t grow.
If we do consider a world where value of tomorrow’s dollar is same as today’s, wouldn’t we be better-off being out of that rat race for more money? Here we should also consider whether it is really worth the struggle just to keep the financial sector up and running? With 89 banks failing in the US alone, can the financial pundits really be trusted to give us right concepts about finance or are they just making us run around in circles?
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