The time value of money is one of the essential concepts of finance. – What it means? and why it’s so important?
The time value of money comes down to a very simple idea a sum of money in the present is worth more than that same sum at a future point in time, the reason for that is that there is a base assumption that some rate of return can be earned on that money between now and whatever point in the future, that same sum is proposed to be issued to take a simple example.
If I offer you a hundred dollars today or a hundred dollars one year from now you would clearly prefer to have the hundred dollars today. Interest rates are about five percent, so to use that as an easy round number. You got that hundred dollars today you could put it in the bank and hope to earn five percent interest over the course of the year at the end of the year, you would have 105. Well the person that agreed to take that hundred dollars one year in the future is basically short five dollars, that they otherwise could have had this has major implications for individuals for companies and for economies at a personal level. You should always look at promises for capital through the lens of when that money will arrive to you a paycheck.
Today is very very different than the potential for a payout from your startup equity a couple years down the line or perhaps at an indeterminate time in the future. So when someone agrees to work at a startup and part of their perceived
compensation is the potentiality that their equity will turn into capital at some point in the future not only do you need to discount that value by the probability that liquidity event will actually happen the company gets acquired or goes public.
But you also need to discount it on the basis the time that it will take for that capital to actually reach your bank account could you just make more in salary invest. It get a rate of return on that investment and potentially make the same amount over that course of time and have access to that capital in the intervening years that’s the time value of money at an investor level at an institution level.
Someone that manages a pension fund will also be very conscientious to the time value of money some of their pensioners may retire next year and, so an investment that will not be liquid until 10 years in the future is not as valuable to the pension fund. That needs to pay out its pensioners starting next year companies navigate this issue all the time, when you sign a contract for a software for a service it’s very common that they will give you a free annual membership..
Right now in the present versus agreeing to a monthly subscription the reason for that is that the company knows they’re growing at a accelerated rate and if they can get proportionately less capital, but get it all right now in the present they will be able to compound that and grow faster than the discount rate that they’ve offered you for being a monthly subscriber. Once you learn this concept you’ll realize time value of money is everywhere and if you learn how to use it effectively it can help to make you rich.
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