“A dollar now is worth more than a dollar tomorrow.” The time value of that dollar is how much more it’s worth now rather than later.
In finance, there is one recurring theme. A concept that underlies the whole field of study; a concept that, in fact, also underlies our very own decision-making process: the concept of risk and uncertainty. Why is a basket of apple costs more to buy than a basket of apple seeds? The answer: We know that just a handful of seeds can produce a lot more than just one basket of apples. What we don’t know is whether or not that will happen.
The English language has an appropriate word for that: potential.
“We can potentially harvest a truckload of apples from these handful of seeds.” Or not, if insects and pests get to them before they bear fruit.
“This stock’s price can potentially quintuple in a year, making it a good investment.” Or it can plummet all the way down, making a heavy loss.
Risk is inherent in every potentiality.
So that’s risk. What does it have to do with the time value of money?
You see, finance people are generally a cautious bunch (I’m a classically-trained financialist myself, I should know). We are trained to see all the bad things that could happen to our money and investments. Unexpected natural disaster, breakthrough product by a competitor, political unrest, unfavorable shifts in interest rates, random shark attacks causing decline in customer count causing a crash in the company’s stock. Cautious? Perhaps. Or perhaps we’re just paranoid.
It’s this aversion to risk that makes one value the same thing higher now than later. If I can get it now, why should I wait until later? so goes the thinking.
It is not that hard to see why people prefer a dollar now than a dollar tomorrow. Therein lies the concept of present and future value. It goes something like this: I would still consider a dollar tomorrow, but I see its value as less than a dollar today. This concept is made clearer when we lengthen the time frame and insert inflation into the equation.
This is why banks charge interests on the loans we make. It can be said that the interest is merely the cost of borrowing money. But what exactly is that “cost”, why do they differ from place to place? Notice that the riskier the environment the banks operate in (due to sociopolitical conditions and other factors), the higher its interest rates. The bank is charging more for each dollar it lends. That is risk and uncertainty in play.
The takeaway: a dollar now is worth more than a dollar tomorrow.