I’ll Gladly Pay You Tuesday for a Hamburger Today: Time Value of Money

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The time value of money is a fundamental principle of investment analysis. The guiding economic principle behind the time value of money is that a dollar today has a greater value than a dollar to be received in the future. This is true for the following 3 reasons:

  1. No risk – There is no risk associated with getting your dollar back.
  2. Higher purchasing power – I remember when gas cost $0.98/gallon! Due to inflation prices for goods and services tend to increase over time and, as a result, the dollar you have today can buy more than at some point in the future.
  3. Opportunity cost – Today’s dollar can be invested and earn interest; tomorrow’s dollar cannot (until it is received). The amount of that lost interest is the opportunity cost associated with the time value of money. Therefore, the opportunity cost of capital is the rate of return that is foregone when choosing one investment over another.

Based on these factors, investors will require a rate of return on their investment that accounts for the risk associated with the investment, the devaluation of their capital over the holding period due to inflation, and the opportunity cost of not deploying their capital elsewhere.

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