Time Value of Money (concept explained)

So if you've taken any accounting courses or any basic finance courses, you've probably been exposed to something called the time value of money. So we hear this concept a lot and it's something very important to the foundations of finance and to some degree accounting. So we want to talk about, well, what does this mean from a conceptual point of view? What is the concept here? What are we talking about when we say that money has a time value? So let's look at this through an example. So let's take an example here. Let's say that I offer you two options. Okay, now one of the options is going to be that I give you $100 cash today, $100 today. And then in the other option, we're gonna say that I give you, let's change colors here again. Let's say I give you $100 one year from now, one year from now. Now, let's just assume for a moment that when I say I'll give you the $100 one year from now, that that's certain. That's not something that I might not pay it or something like that. It's guaranteed. You either get $100 today or you get $100 one year from now. But either way, there's no risk associated with it. You're going to get the $100. So let's look at these two options. Now, which would you prefer? Now, you might say, well, I just prefer the $100 today because I just want the money. I have something I'm already gonna spend it on. But let's just forget about that for a moment. Let's assume that you don't necessarily have anything you wanna buy, but you do want the $100. Well, you might think, well, I'm indifferent, whether I get it today or whether it's one year from now. But let's think about this because the money has a time value. Now, let's illustrate this. So let's look at a little timeline here. So here, in this option, we're getting the $100 right here, which we'll call, that's today, right here. This is today. And then over here, this is one year from now, one year. Now, let's go down to our other option and we'll have a little timeline. And again, we've got right here is today. And you're not getting anything today. There's nothing here because you're getting it one year from now. You're going to be handed, right here, $100. Now, let's think about things here for a moment. So when we get the $100 here today, what can we do with that money? Well, you could go out and spend it or something, but let's just assume that you didn't spend it. Well, what else could you do? You could invest that money. Now, let's say that you invested in something and you ended up getting a 5% return. Let's say you took it to the bank and you got a 5% return on some kind of investment. Now, what's going to happen is that at the end of that year, you don't have $100 anymore. Well, what do you have? You're going to have 100 times 1.05, which is going to be, that's going to be $105. So we see that if you get the money today, if you get it sooner rather than later, there's a value to getting it earlier because it can be invested to earn a rate of return. And then at the end of the period, you end up having more money than what you started with. Now, when we look at the other option, where you get $100 at the end of the year, you didn't have the option of investing it here because you didn't have the money. So when you get the money sooner rather than later, it has more, there's more value there because you can go ahead and invest the money and earn a return on it. So that's what we're talking about when people say that the time value of money, they're just basically saying that money is something that if you're looking at cash flows, cash flow today or cash flow in the future, a cash flow today, all else equal, the same amount is going to have more value because it can be invested for that return. So now you might be thinking, well, how does this have real world applications or what are we thinking about? But let's say we've got some project that the firm is thinking about. That project, you might say, okay, well, we're gonna buy this machine and it would generate cash flows over a period of let's say five years. So you can look at these different years and you can go and say, okay, here's your one, two, three, four, five, and you can say, okay, well, we estimate that in year one, if we get this machine, we're gonna have $100 in cash flow in year two, 175, year three, 200, 300, and then let's say in the last year it only generates 50. But what you can do is say, okay, well, now we know we're estimating these cash flows, but now what we wanna do is we wanna say, okay, well, like for example, a year in year five, that $50, we can't just add all these together and say, okay, well, now we've got this sum and this is how much it's gonna generate from this. We have to take into account that $50 five years from now is not worth the same as $50 today. So what we're gonna do is account for this time value of money. And TV, maybe not the best acronym I have there, but the time value of money, we're gonna look at this and we're gonna say, well, what if we can just go ahead and say we earn a 5% interest on all our investments, then we can say, okay, let's figure out what that $50 five years from now is worth in terms of today's dollars. And when we do that, what we're doing is called discounting cash flows. So we're discounting cash flows. So that 50 here, this is a cash flow in year five. And what we're doing is we're saying, what's the rate of return we could have earned on that on money today, let's say 5%, 7%, whatever it is. And then let's use that to go ahead and discount this number and say, so it's gonna be something less than 50 because maybe it's 30 or 35 or whatever, depending on your discount rate, could have been invested today to get 55 years from now. So when we talk about discounting cash flows, what we're doing is we're using the time value of money concept and some other formulas that we're gonna talk about in other videos to take future cash flows and figure out what are they worth today.