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Investment in its most simple form means “using an asset you own to generate future profits” and assets don’t always mean money; sometimes it could be time, effort, or a property you own.
With this perspective, we can consider two school kids pledging portions of their lunches to each other as a crude form of investment.
As for profits, it is up to you to define what is acceptable to you, based on the alternatives that surround you. For skilled investors, this is where using the time value of money comes in.
Choosing the investment with the highest interest rate (returns rate) is viable but this doesn’t work in all cases, because it might be difficult to estimate the return rates on all available options.
The length of time it takes for each investment to pay their respective returns should also be considered, among other factors like cost of investments, industry differences, the possibility of other cash inflows or compounding interest and any non-quantitative factors.
The time value of money rule is:
"Money received today is worth more than that same amount received in future."
The time value of money is used to guide investment decisions. Before you invest, you want to know which of the options before you promises the highest profits in today’s value. To do this you would grade your investments using either of these time value factors depending on your exact situation.
PV= FV / (1+i)n
n=Number of years.
Interest rates used in the present value or future value formula can also be called discount rate. When considering an investment, it is appropriate to use the opportunity cost of putting your money elsewhere as your interest rate.
This is calculated as:
Opportunity Cost = FO−CO
FO= Forgone option
CO= Chosen option
Calculating the present value of money answers the question;
If an investment promises to pay me a certain amount in future, how much is that sum worth today?
This answers the questions:
I have a certain amount in hand today, how much is it worth in future?
Writer, artist, Accountant and a forever learner. Learning, loving, Hoping.
These ideas explain the importance of time value considerations in making investment decisions.
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