Wait! $20 today isn’t worth as much tomorrow????

For anyone who read my post on “Valuing an ordinary Annuity using Javascript” and wondered why everything was discounted by the interest rate, there’s a concept in finance called time value of money. Of course, there’s also inflation but we’ll get to it sometime later.

Basically, the interest is the amount of money you’d want in the future plus the principle if you were to loan the principle it out today. I ran into a funny example when I was still an undergrad and was sneaking into the graduate finance class.

Imagine two college students, one name Peter and the other one named Dave. Peter is very thrifty and always has the cash to spare. Dave isn’t. So one day Dave does up to Peter, “Pete! I need $100 to pay for my hot date tonight! I know you have the money.”

Peter, has $100 but he wanted to put his money into a bond fund that pays 5% annually. So in order for Peter to give up the $100, wants Dave to pay at least 5% interest if not more. How much more depends on how reliable Dave is to repay the loan. (in this case – it’s probably a very high interest)

So if they agree on a deal that one year in the future Dave will pay Peter back $105, that $105 to Peter would be worth to him then just as much as $100 dollars does now. At the same time if Dave overpays, let’s say $110, then that is worth $104.76 dollars to Peter today. If Dave underpays, let’s say $100, then it will only be worth $95.24 to Peter today.

Hence the idea behind present value and discount rates.

If you like my post feel free to like and share if you have any questions feel free to leave them in the comments – as I may use them for a future post.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s