So Wimpy gets his burger today, but you have to wait until Tuesday to get paid back your money, the price of the burger. In the meantime, the cost to you is the interest lost from the opportunity to invest that same $20.
What’s exactly does the deal cost you?
Let’s say that the super-deluxe burger costs $20 and Tuesday is 6 days away. At 5% interest, Wimpy’s deal costs you about 2 cents. So money in your hand has greater value than the same amount of money you will get in the future.
You are giving up the chance to invest your money or use it in any other way. And clever Wimpy? He gets to eat his burger today.
In our example, the present value (value of money today) of that $20 that Wimpy borrowed is only $19.98. You lost 2 cents and Wimpy gained a juicy burger — without offering you a lick of interest for the loan.
What is opportunity cost?
Opportunity cost helps you think about investment decisions, like the one you made with Wimpy. When you choose to do one thing with your money, you give up the chance to invest it somewhere else. And that loss of “the road not taken” (in this case possible income) is called opportunity cost.
The same can be said of all kinds of life choices (see article right below), where you may have done much better otherwise. But for now, let’s focus on just the investment side of things.
In essence, we want to find a way to compare relative values / benefits to us of alternative investment choices. So when we think about present value (of money today), we’re also talking about something with opportunity costs.
==> MORE: Examples of Opportunity Cost (LINK COMING SOON)
Now back to the present value of money today
I took that detour into opportunity cost because it’s the heart of understanding present value. An investment choice you make today comes with the potential cost of other opportunities to earn in the future. And so the present value of money brings with it an inferred interest opportunity loss, as with Wimpy’s burger deal.
Present value calculations have to factor in what’s being promised in the future — a lump sum of money or stream of payments — and their timing. And the longer it takes to see any of your money again, the less the present value to you of those future payments.
“A dollar today is worth more than a dollar tomorrow.”
I learned that helpful saying in grad school and have seen it many times since. Future money comes with lost earnings opportunities and also more uncertainty. Therefore the present value of money today is less valuable to you than a handful of for-sure cash right now.
The added factor of timing in present value
When it comes to most things, the average person doesn’t like waiting. So having the money in our hands today feels a lot better than knowing it will arrive some time in the future. That feeling offers us a present value of sorts in and of itself.
So when thinking about an investment decision or loan you might make to someone, it’s not just the initial dollars. Remember to factor in the amount of time and how much you’ll be getting from the deal. Also the certainty of ever seeing your money again.
How to calculate the present value of money today
The truth is that I use my handy-dandy HP12C calculator. It has present value and future value functions built in. I enter what I know for sure, like the price of a house. Then I choose a best-guess interest rate and period of time.
In this case, I would use present value to figure out what the payments will be. You can do this for any kind of loan, personal, car, home equity, etc. You can also use present value calculations when thinking about buying bonds.
I try to keep to the basics on this site, so I found another site to help. I think this can lead you through the calculations, if you really want to go there. (There are also online present value calculators, if your calculator doesn’t have the ability to do that.)
==> MathIsFun.com: Simple guide to calculating present value
More on present value theory
For a much more in depth understanding of the present value of money today and some great examples, I think this paper is excellent:
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