Time Value of Money
If I asked you, “Would you would like $100 today or $100 in a year from now?”, you would probably answer I would like $100 today, please. You understand there is time value to money. Money today is worth more than the same quantity of money in the future. Why is that?
There are three things that influence the time value of money: Inflation. Utility, and the Rate of Return.
Inflation is the loss of purchasing power over time. In Canada, the target rate of inflation is 1 – 3% per year. The target rate of inflation is set by the Bank of Canada and is influenced by the total money supply governed by the Bank of Canada. The Bank of Canada doesn’t actually set the rate of inflation – the market does that. The Bank of Canada sets the target rate and then enacts transactions, prints more money, or buy back money, to influence how much money is available and subsequently the inflation rate. If the rate of inflation is 2%, then the $100 will only buy $98 worth of stuff one year from today.
The second thing that influences the time value of money is Utility. Utility is an economic concept that refers to the enjoyment of the use of something. If you have $100, you can use it for your enjoyment. You can buy things, you can consume things, you can enjoy looking at the $100 under your mattress. It is your $100 to enjoy as you wish. However, if instead, I have your $100, then I get the enjoyment of it. And I can choose how to enjoy that money the way that I desire. We can measure the value of the enjoyment or the utility of the money by looking at how much an investor is willing to give up to enjoy the use of something.
For example, let’s say I am planning to go camping next summer and I need a new tent. The tent I want usually sells for $100. Idly searching the ‘net in September, I see that the camping supply store is having a great sale on tents. I can get the tent I want now for 10% off or $90. But I won’t need the tent for another 12 months. I can hold onto my money and buy the tent next summer for full price. Or I can spend the money today and look at the tent for the whole year before I actually get to use it. The utility value of that purchase decision is $10 or 10%.
The third thing influencing the time value of money is a rate of return. If you own the $100 you could invest it and earn a rate of return relative to the risk of the investment. If you are very risk-averse, you might invest in a guaranteed investment certificate, a GIC, or in a Bank of Canada secured investment which might pay 2% – 3%. If you like a little more risk, then you may choose to invest it in real estate or maybe the stock market and potentially earn a higher rate of return than a guaranteed low rate of return. If I am in possession of your $100 then I am the one who earns the rate of return on the investment and you forego that financial reward.
Money has time value. Money today is not worth as much as money in the future. We can measure the exact value difference through an understanding of inflation, utility and rates of return on investments.