Investment CasesTime Value Of Money
Money today is worth more than the same amount later, so later cash counts for less.
Would you rather have £1,000 today or £1,000 in a year? Today, obviously: you could use it, earn a return on it, and you are sure to have it. That simple preference is the foundation of every investment case, and it means cash arriving later must be marked down before you compare it with cash spent now.
How to use it
- Choose a rate that reflects what your money could earn elsewhere and how risky the cash is; see Hurdle Rate.
- To value future cash in today's money, divide it by (1 + rate) once for each year you wait.
- At 10%, £1,000 in one year is worth about £909 today; in two years, about £826.
- Lay out every cash amount in a case by the year it arrives, then convert each one.
- Compare totals only after converting, never before.
Example
A hypothetical charity is offered a £50,000 donation now or £55,000 in two years. At a 10% rate, the later gift is worth about £45,500 today, so the earlier one is worth more, even before the risk that the later gift never arrives.
Watch out
- Adding up cash from different years as if it were the same money.
- Picking a rate to get the answer you want.
Underpins Net Present Value and Internal Rate Of Return. The economic idea of opportunity cost is covered in Economics Patterns.