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Money at hand is always more valuable than the same amount of money expected at some future time, even if there is absolute certainty you will receive that payment. This simple idea is referred to as the time value of money and lies at the heart of finance. Thoroughly understanding this fundamental concept will make you a better investor.
A cash inflow today is better than a future cash flow, because you can always earn interest by getting the cash right now and investing it. No matter how low the interest rate offered by banks, you will always make money simply by keeping your money in a bank account. For this reason alone, money has a time value. If banks are offering 5 percent annual interest on deposits, the one-year time value of $100 equals $5, since you can earn this much from $100 in one year without having to take any risk in the process.
Future cash flows are almost always uncertain, as there is usually a risk that the expected cash flow may not materialize. While bank deposits are government guaranteed and the probability of not getting back the money you placed in a bank, plus interest, is practically zero, most investments carry a real rate of risk. When you lend money to a corporation by purchasing its bonds or invest money in a stock, a real possibility exists that you will not get it back. It is better to have that money at hand sooner and sleep better than to worry about repayment.
RIsk Free Discount Rate
If money now is better than the potential for money in the future, you have to decide how much more preferable it is. This is where the discount rate comes in. To determine what a future cash flow is worth, divide the number by one plus the proper discount rate. For example, the $105 you expect from the bank in one year is worth $105 / 1 + 5 percent or $105 / 1.05, which equals $100. The discount rate in this example is 5 percent, which is the rate at which the money will grow annually when placed in a risk-free instrument, such as a bank deposit. This makes perfect sense, because the $105 you expect in one year is the result of investing $100 today.
Risky Discount Rate
When the return of the money is uncertain, the discount rate -- the rate at which money must grow each year to make the risk and wait time worthwhile -- is higher. How much higher is a subjective question. If you expect a stock to be worth $11 in one year, how much you should pay for it depends on the discount rate. If the discount rate is 10 percent, the stock is worth $11 /1+10 percent, or $10. If such a stock is presently trading at $9.5, it is a good buy. If it is trading at $10.5, it is not an attractive investment.
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