Present Value

I have a basic financial concept to share today.  The concept is Present Value (PV) and its brother, Future Value (FV).  I think everyone has a basic inkling of this concept, they just may not apply it to their decisions in a conscious way.

The best way to illustrate the concept is thinking of a friend that wants to borrow money.  Lets say your friend wants to borrow 100 dollars (assume no risk).  What if your friend says that he will pay you back next week, what if he says that he will pay you back in 2 years?

At this point there is another concept that is important to discuss, opportunity cost (the benefit that you give up by making a choice).  In this case, you give up the use of this 100 dollars for 2 years, you are giving up the opportunity to use the 100 dollars now.  If you are saving up for something, you will now have to put that on hold.  If the delay is only one week, its not as of big deal, as if it was 2 years.

Getting back to our topic, would you rather have 100 dollars today, or in 2 years?  If you said today, then you have illustrated present value.  The value today is greater than the same amount in the future.  Now what about 100 dollars today or 150 dollars in 2 years?  Now are you be willing to wait for 2 years?  What this proves is that timing of cash receipts affects the value today.  If you invest 100 dollars today, your hope is that next year you will have more, so if you invest at 10%, you would say that the future value of my 100 dollars is 110 dollars.  The present value of 110 dollars in the future (at 10%) is 100 dollars.  Here is the math behind that.  100 (PV) * (1 + 10%) = 110 (FV).

The implications of future value is not limited to your lending / investing, but also taxes and how you spend your money (because of the opportunity cost).  Because of the investment growth and time, the future value of money today is quite great.  Going back to our math, lets say that you invest 1,000 dollars today, and you are 30 years old.  When you are 65, assuming a return of 0% (spending today), 5%, 8% and 10%, here are the results.

1000 * (1.00)^35(years) = 1,000 dollars (or an old computer, really old).

1000 * (1.05)^35(years) = 5,516 dollars

1000 * (1.08)^35(years) = 14,785 dollars

1000 * (1.10)^35(years) = 28,102 dollars

Which would you rather have? This is a stupid question, but really, what would you give up to get it?  It’s why investment fees are so important to consider, and making sure that money you spend today is worth it to you.

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