Discussion Assignment 2.1

TIME VALUE OF MONEY Part 1: The Big Picture

Female Speaker Why does the lottery offer two ways to claim your winnings? Is it better to take it in a lump sum, or over 30 years? Is paying for your computer on a monthly basis a good deal? How much money should you put aside now to buy a car in four years? You want to retire a millionaire, how much do you need to save each month in order to have a million dollars at age 65? These are all examples of something called the “Time Value of Money.” This idea underlies many of your daily decisions and it is a key to understanding the basic concept of finance.

The Time Value of Money refers to the fact that a dollar in your pocket today is worth more than a dollar promised to you in the future. That is because this dollar can be put to work so that it can grow into something bigger. Whether you know it or not, you already have experience with the time value of money. By choosing to go to college, you have made a decision based on the time value of money. You have chosen to invest money in school instead of going to work. In essence, you are investing in your future.

You are betting that by deferring the salary from a low paying job now in order to get an education, you are increasing your chances of getting a high paying job in the future. You are making an investment in yourself that you expect will pay off at some future time. This is a perfect example of the time value of money. What if your parents offered to buy you a car when you graduate? That makes the deal even sweeter. You still do not make any money while you are in school, but now in addition to the possibility of higher earnings, there is a financial reward when you graduate.

Let us say the car you want costs $30,000 and your parents are going to pay cash for it. How much money will they have to put aside each year you are in school? The first answer that springs to minds is $7500 per year, because that is one quarter of $30,000. But your parents could actually raise $30,000 in four years with only a $24,000 investment. By putting away $500 a month at 10% interest, they can achieve their goal. That is only $6000 per year. The money grows this fast because it is earning interest on both the original investment and on the interest it earns.

Collecting interest on interest is called compounding and it is one of the basic forms of the time value of money. This is an example of something finance people call “Future Value.” This idea reflects the fact that investment grows over time at a certain rate of interest. Five hundred dollars a month today has a future value of nearly $30,000 four years down the line. How fast your money grows depends on two main factors, the rate of interest and the length of time the money is invested.

The car can wait four years, but you think you need a new laptop computer today. Dell is offering a beauty for $1300. You have seen a similar system on eBay for only $900. The choice may seem obvious but there are several factors you need to consider. The laptop on eBay is cheaper but that “Buy it now” link means that you need the money immediately, you do not have $900.

Page 1 of 2BUS3062 Time Value of Money Part 1 Transcript

7/14/2018http://media.capella.edu/CourseMedia/BUS3062/TimeValue1/TimeValue1_ts.html

Dell is offering a deal with includes no payment for 30 days followed by 48 payments of only $45 per month and all college students qualify. You could swing that. The laptop from Dell cost $400 more and the financing means you will pay even more than that with interest, but it is more affordable on a monthly basis. You choose to go with the more expensive option. In this case, it may be the only possible way to get the laptop. But how much are you actually paying for the computer? Forty-five dollars a month for four years amounts to an effective interest rate of about 28%, which means, you are actually paying $2160 for a $1300 laptop. Maybe the walk to the computer lab is not that bad. Of course, you could win the lottery then all your problems would be over or would they?

Most lotteries offer you the choice of taking the money as a lump sum or taking payments over a period of time, generally about 30 years. By now, you should recognize that $30 million over 30 years is not the same as $1 million every year. The Powerball price in August of 2001 was $295 million. One of the largest prices ever. The winner could take the price in 30 equal payments of approximately $10 million or as a lump sum of $165 million. Why does the lump sum payment seem to be so much less?

The lottery authority does not have $295 million on hand. They are counting on compounding interest to allow them to payout $10 million each year for the next 30 years. If they payout a lump sum, they lose that interest. Therefore, the present value of $10 million a year to the lottery authority is $165 million.

The calculation of present value is the reverse of future value. Present value is what some amount of money down the line is worth today. Discovering present value involves discounting which is similar to compounding. But instead of compounding money into the future, present value discounts a future value back to the present. As it turns out, the lottery authority discounted the $10 million a year payout by 4.25% in order to arrive at the lump sum payment of $165 million. This 4.25% is called the discount rate.

You could recover the interest the lottery authority discounted by investing the lump sum payout or you could just tighten your belt and live on $10 million a year. Still, you do not need to win a million dollars in order to have a million dollars. Start saving when you graduate and you can retire a millionaire. If a 25- year old can save as little as $158 a month and earn an average rate of 10% a year, at the end of 40 years, they will have a million bucks all due to compound interest.

Winning the lottery, financing a computer and retiring a millionaire may seem like radically different scenarios but each involve the time value of money. Each one looks at the value of a dollar today compared to what that dollar could be worth in the future. To a financial planner, all three cases are simply different shades of the same color.

L i c e n s e d u n d e r a C r e a t i v e C o m m o n s A t t r i b u t i o n 3 . 0 L i c e n s e .

Page 2 of 2BUS3062 Time Value of Money Part 1 Transcript

7/14/2018http://media.capella.edu/CourseMedia/BUS3062/TimeValue1/TimeValue1_ts.html