Time Value of Money: or, I'm a Millionaire! It's Just in Future Dollars.

Business schools teach some pretty simple but extremely practical skills that can be useful in everyday life. For example, the time value of money is a simple concept where a set amount of money is worth less in the future than it is today. If given the chance, we would all take $10,000 today rather than $10,000 in 3 years, and would do this without thinking. Beside the fact that humans like immediate gratification, there is also a purely mathematical reason for choosing the $10,000 today. The reason for this is what Economists refer to as opportunity costs. An opportunity cost is your next best option forgone, such as taking the money now to invest so you have more than $10,000 in 3 years. Simply explained, if you had the $10,000 today you could deposit it into a CD at 3% and in 3 years you would have $10,927. That additional $927 is an opportunity cost of turning down the money now for $10,000 in 3 years.

Since opportunity costs are your next best alternative, that 3% is just an example. Perhaps you've found a sure-fire business plan (act now, time is running out!) that will make you a millionaire in 3 years and you just need $10,000 to start today. Your opportunity cost of passing on the $10,000 now just got a lot higher.

That first choice was easy, now for a harder question. Would you rather have $10,000 today or $20,000 in 5 years? The first thing to do is determine what kind of yearly return would turn $10,000 into $20,000 in 5 years. The answer is fairly close to 15%, so your decision should be based on just one thing. Is 15% the best return you think you could reasonably and safely make or do you have a reliable, risk weighted option that will return more than 15% a year? If you can't make more than 15% yearly some other way then the $20,000 in 5 years is your best decision. Another way of saying the same thing is that at a 15% return a year, $20,000 in 5 years is only worth $10,000 today.

By knowing how to calculate time value of money and your opportunity cost (discount rate and risk premium) you can make educated financial decisions when faced with time value of money questions. My hope for all of you is that you win the lottery and need to use time value of money calculations to decide whether to take the yearly payments or the lump sum. Or just pay a business student to do it.