The time value of money concept is pervasive in finance and business. It is a part of the cornerstone of finance when dealing with just about any area in the field, especially bond investing.

What is the Time Value of Money

The concept itself can be defined simply as the worth of one dollar in the present compared to the worth of one dollar in the future. As finance dictates, the worth of one dollar today is greater than the future worth of one dollar because of the ability to invest that one dollar at prevailing interest rates.

Due to interest rates and inflation, the value of money deteriorates as time progresses. As you can imagine, the greater the inflation rate and prevailing interest rates, the faster the value of money deteriorates in the future.

Take, for example, the prices of homes in the 1960's. A two bedroom one bath home could have been around fifty or sixty thousand dollars. That same home in recent years, the last decade let's say, would be approximately ten times that. That same home could sell for five hundred thousand dollars. That means that over the course of fifty years, the value of a single dollar invested into this piece of real estate could have appreciated ten times. In order for a single dollar to appreciate ten times over in fifty years it only has to be compounded at around 4.7% per year. That's not an extremely high compounding rate to produce such a tremendous result. However, this is what nearly always happens in real estate over the course of the decades. That brings us to the concept of compounding.

The Concept of Compounding

As was just mentioned, compounding requires a compounding rate, which is the average rate which the money will be compounded by over the course of the time horizon. The easiest example of compounding would entail certificate of deposits (CDs). Time deposits such as these have stipulated compounding interest rates which do not change over the course of the time horizon. Time deposits also have stipulated time horizons which the money shall be kept in the account for a stated amount of time unless the investor wishes to pull his or her money out with a fine or penalty. For instance, a CD now that pays two percent for three years would produce the following: A compounding rate of 2%, 3 years time horizon. If we should invest ten thousand dollars what would be the ending account value in three years time? The answer is 10,000*(1+.02)^3. Which equals $10,000*(106.12%)=$10,612. Not a very impressive number, yet the real estate compounded at just 4.7% for fifty years created impressive results. This is due to the time value of money as the money compounds, it grows exponentially.

The Concept of Discounting

Just as there is the concept of compounding, so to is there the concept of discounting. This is looking at projected values and discounting at an estimated rate which brings the value to the present day.

 

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