Calculating the Time Value of Money
Part of the Managerial Economics For Dummies Cheat Sheet
Calculating the time value of money is important. Basically, as long as you can earn interest, you’d rather have a dollar today instead of a dollar one year from now. If you receive that dollar today and the interest rate is 5 percent, one year from now you’ll have $1.05, and that’s certainly better than a dollar. This idea becomes even more important for businesses when thousands or millions of dollars are involved.
Many business decisions involve investing money today in order to get some amount of future profit. Because you’re receiving the money/profit in the future, you need to discount it because you can’t use it today to earn interest. This discounting is accomplished by calculating the present value of the money you receive in the future.
Present value (PV) is determined through the following formula:
Because profit equals revenue minus cost, the numerator of this calculation represents profit for some future year (t) — year t’s revenue (Rt,) minus year t’s cost (Ct). The denominator is 1 plus the interest rate (R) expressed in decimal form: 5 percent interest is 0.05. The power used in the denominator is how many year’s into the future you receive the money — three years into the future means t equals 3. And, because you’re likely to receive this profit for more than one year, you determine this value for each year and then add or sum up all the values.