There’s one question every investor should know the answer to: Is a dollar worth more today or tomorrow? The answer: TODAY! Why? Because it is better to invest sooner than later to gain as much interest over time you can.
There are certain Time Value of Money calculations people who work in finance know how to do using a financial calculator (yes, we have a special calculator) that will estimate the future value of a current investment or the present value of an investment that has already accumulated interest. I will cover terminology and variables associated with these calculations, but I will not cover the actual way to calculate Time Value of Money problems. Unless you have a financial calculator, you won’t need to know how to do the calculations.
Compounding is going from the present to the future. The future value of cash flow will be greater that the present value of cash flow due to accumulating interest over time. Discounting is going from the future back to the present. The present value of future cash flow will always be less than the future value. Confusing I know, but think about it this way: Gina just gave Jerome $125 a week after getting $100 from Jerome. Considering inflation and other factors, we can calculate how much Jerome’s $125 would be worth today minus the accumulation of interest and/or payments made over time.
The following are variables for the Time Value of Money problems:
- PV – Present Value
- FV – Future Value
- PMT – Payment
- N – Number of time periods
- I – Interest rate per period
- P/Y – Periods per year
A Lump Sum is a single payment and an Annuity is a series of equal payments. The future sum of an annuity takes a series of payments into the future. The present value of an annuity brings a series of payments in the future back to the present. Payments for an annuity can be made either at the end of each time period (ordinary annuity) or at the beginning of each time period (annuity due).
The main takeaway from this article should be: investing now is worth more in the future than waiting to invest later. Don’t get frustrated with trying to know the variables or concepts behind the Time Value of Money calculations. Focus on the terminology and the overall message of the value of money invested today verse the value of money invested in the future. However, if you do have a financial calculator and you want to know how to do Time Value of Money calculations or you have any questions, please comment below.