Time Value of Money Explained Part I
The Lemonade Stand Life Lesson on Time Value of Money
We’ll start out our small business financial management lesson with a little intro into the time value of money using an example from my younger years. When I was little, my sister and I used to run a lemonade stand in the summer. We would pack up the table, chairs, lemonade, sign and our money box into the wagon and bring it out to the end of our driveway. There we would sit, waiting patiently for a car to drive by. Unfortunately for us, we lived on the outskirts of a town of about 4000 people and would only have about one car drive by every 15-20 minutes. This made for long days but the people who drove down the dirt road usually tended to stop and pay extra (I think they just felt bad for us with our poor lemonade stand location). At the end of our day, we would count that great amount of money we had made and head in for dinner.
Now let’s say that I made $10 at the stand over the last week and my parents offered me a choice on what to do with the money. One option is that I could have the $10 that I made today but I would have to put it in a savings account. The other option that I had was to give them the $10 in profits today and they would give me $10 back in one year. Since I would get the same amount back in a year that I gave them today, having them pay me the $10 in a year was easier than having to go to the bank so let’s say I would have chosen that option.
So let’s take a look back to see if I would have made the right decision. In this example, I had two choices which was to either get the $10 now (putting it into a savings account) or having to wait a year to receive the $10. Let’s assume that I could get 5% interest in the savings account.
For the first option, after 1 year I would have received the following amount in interest in the savings account:
$10 x 5% = $10 x 0.05 = $0.50
If we add the interest to the original amount of $10, I would have had a total of:
$10 + $0.50 = $10.50
Another way to write this out is to multiply the $10 by 1 plus the interest rate like this:
$10 x (1 + 5%) = $10 x (1 + 0.05) = $10 x (1.05) = $10.50
So if I ended up taking the money right away and putting it into the savings account, I would have ended up with $10.50 in one year. Compare this with the second option where I chose to receive the $10 in a year. By choosing to take the money right now rather than wait a year, I made a total of $0.50. This is an example of the time value of money where having the money today is worth more than having it in a year.
Why a Dollar Now Is Always Better
This last example illustrates that having a dollar now is always better than receiving a dollar in the future (known as the time value of money). We like having money now since we could always invest the dollar today and receive some interest off of it rather than waiting to receive the dollar in the future. This is part of the reason why each of us has to pay interest on any loans that we receive since we’re getting the benefit of getting the money today.
Let’s try another example. Say we could either get $5000 today or we could get the $5000 in one year. Let’s also say that the current interest rate that we could get from a savings account is 3%.
If we took the $5000 today and invested at 3%, the total interest that we’d have after one year would be:
$5000 x 3% = $5000 x 0.03 = $150
Adding this interest to the original $5000 that we put in the savings account, after one year we’d have a total of:
$5000 + $150 = $5150
As shown above, the other way that we can calculate it is by multiplying how much we have today by 1 plus the interest rate:
$5000 x (1 + 3%) = $5000 x (1.03) = $5150
Since the other option would be to receive the $5000 in one year, we can see that getting the $5000 today is worth $150 more than it would be to receive it in a year. The difference in value between getting the money today or in one year is the amount of interest we could earn on that money. If the interest rate was higher, the time value of money would have actually been worth even more to receive the money today than in one year. In the opposite scenario, if the interest rate that we could get on our savings account was lower, the benefit of having the $5000 today would also decrease.
Key Takeaway: Having a dollar today is worth more than a dollar tomorrow since we can earn interest on the dollar today. This is talked about in finance terms as the time value of money.
In the next section we’ll cover some concepts including the present and future value of money which we’ll use to apply to numerous topics in upcoming lessons.