A thousand dollars in your hands today has more value than a thousand dollars promised one year from now. Why?
There's many reasons, but let's consider three.
First, if the cash was in your hands today, you could place it in an interest bearing facility, such as a time deposit. In one year, that cash will earn additional money for you. You could not do this with the thousand dollars promised to you 1 year from now.
Second, if you had the money with you today, any opportunity you come across between today and one year from can be acted upon. If you don't have that money, you will end up not being able seize the opportunity. Besides opportunities, you could also experience an urgent need for mpmey, as in the case of emergencies.
Third, for a long as the money is not in your hands, you are under the risk of not being paid your money. In the case of a seller who sold a thousand dollars worth of merchandise to a buyer, should the buyer end up bankrupt, or for some reason unable or unwilling to pay the money, the seller would be left with a thousand dollar loss.
So a thousand dollars today is worth more than a thousand dollars promised one year from now. But how much more?
We can answer the question in two ways. We can figure out how much a thousand dollars today will be worth one year frpm now. Conversely, we can figure out how much a thousand dollars one year from now, is worth today.
The method of calculation can be as complicated as there are factors to consider, such as the risk of not being paid, the inflation rate, the possible opportunities to be foregone, and so on. The simplest and most simplistic approach is to just consider the interest rate by which we can deposit the money if we had it in our hands today. This can be computed using the formula:
CV = PV (1 + i)^t
Where:
CV = cash value in the future
PV = cash value in the present (most commonly known as present cash value)
i = interest rate of a given time period (for example, the interest rate for 1 year)
t = the number of time periods to consider
