The "Time Value of Money" Concept

A free video tutorial from Svetoslav Deltchev
Real estate Investor
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The "Time Value of Money" Concept

Learn more from the full course

How to Use the Top 11 Real Estate Fin Ratios in the Best Way

Learn these 11 easily used financial ratios before you invest in rental property

01:45:31 of on-demand video • Updated February 2020

Basic principles of the real estate deal analysis
Get familiar with the 11 most used ratios in the real estate deal financial analysis
The 3 types of financial ratios that are used for analysing of all kinds of assets and how they are applied for the real estate deals
The advantages and disadvantages of each financial ratio that is presented
When do you need to apply one or another ratio calculation in order to get the relevant comparison with the market
Some basic concepts used in the financial analysis as the "Time value of money" concept
Which of the financial parameters is the KING among them all and is most reliable
Which parameters could mislead you
Which ratios have "pitfalls" and how to avoid them
English [Auto]
While we are entering the deep waters already in this chapter I will present you the issues that are used by the professionals and the large corporations. This is the most precise measurement of the performance of an investment in this respect. If you don't understand everything from the first time you should know you are not alone. This is normal. Repeat the lecture once again or sent me a short email and I'll answer you within 40 48 hours at latest. My email address is at the beginning at the end of each lecture so let us start with the general concept. As mentioned at the beginning of the course one of the main postulates in finance is a door to day is more valuable than a door tomorrow. That basically means that if you compare money amounts from different periods you are comparing apples with oranges the comparison is simply ridiculous and it will not give you an accurate basis for a final decision. To avoid this we must ask ourselves how we could transform door amounts from one period into door amounts of another period. There must be a mathematical method so that we can make accurate calculations of the cash flow. And indeed there is a formula for the calculation and transformation of the future doors to today's dollars and vice versa. Let us start with one example in order to illustrate the concept as a whole. Imagine that somebody is offering you 200 dollars today or take a hundred dollars in two weeks period. If you trust the person probably you go for the three hundred dollars in two weeks but what would you decide if you have to wait one year for this money. And if you have to wait two years let's see which are your options. First ask yourself this question What are you going to do with the two hundred dollars if you get them immediately. Let us assume you could invest them in treasury bonds and collect 7 percent per annum interest only invested amount. In this case each 100 door today will be worth one hundred and seven door in one year period right. The calculation is as follows the initial amount of one hundred plus one hundred multiplied by 7 percent per annum equals one hundred and seven dollars. At the end of the period in order to write it as a general far more. Let us indicate the future value with the letters f v the present value SPV and the return or the interest in our case as are the small index next to them is indicating the respective period for which this value is valid. For instance if the one means the future value at the end of the first period if the two means the future value at the end of the second period and TV zero indicates the present value in the current period and here we go. Written as formula F V 1 equals P V zero plus previous zero times are or rearranged in a slightly different way. F V one equals P G zero times open bracket one plus are close bracket it became two scientific indeed. So let us bring some animation at this point. So this is the one that we saw already. We have some initial money that we invest we will add some small amount to it based on the interest or dividends earned. And at the end we will receive our initial money plus a small amount of interest extra. This is the future value of our 100 dollars. Today if you invest your money not for one but for two years you have to repeat this calculation once again. Then the money you have at the end of the first year must be reinvested for another year at 7 percent per annum interest rate then the calculation will be as follows. One hundred and seven dollars at the beginning of the period plus one hundred and seven dollars multiplied by seven percent annual interest equals one hundred and fourteen point forty nine. At the end of the second period the general formula for the A V at the end of the second period is as follows. If the two equals f the one plus if you one times are or slightly rearranged. If the two equals if new one times open bracket one plus are close bracket please note that as a starting point for this calculation we are using the end of the first period and not the current period. It is a one step movement forward. So far to bring the value back to the initial period that means to the current period we will need to replace the value of f the one in above for more using the value of the present value from the first formal more. If we illustrate it as a timeline it should look like that if we calculate only with one p it will start of course at the end of the previous period. We will jump metaphorically said only one period at the time to bring the amount to the current period. However we must take into consideration how many periods away is this amount from the current moment one two. Or in general t periods as it is indicated in the general far more. It means we must leap from the end of each period to the very beginning of the timeline where it is the current period. In our example we had two periods so it means that f v 2 is calculated as follows. F g two equals P v 0 times open bracket one plus are close bracket times open bracket one plus are close bracket or slightly rearranged if the two equals P v 0 times open bracket one plus are close bracket to the power of 2. Please note that for each bit into the future we at once the expression in the brackets one plus are in this respect. If you have 4 periods you know that the future value at the end of the 4th period will be f v for equals P v 0 times 1 plus are in parentheses times 1 plus are in parentheses times 1 plus R in parentheses times one plus R in parentheses. Or this is equal to F G 4 equals B the 0 times 1 plus are in parentheses to the power of Thor or the general way to write. This looks like this f V.T. equals b v 0 times 1 plus R to the power of D where the index t is indicating the number of periods we must consider if we do is the value of today's money after two periods f the one is the value of today's money after 1 period Peavy 0 is the present value of the money R is the return you believe you could achieve and D as mentioned is the number of the periods we can see the provided we could calculate how much our today's money would be worth at some certain future period we definitely could calculate how much is worth today a certain amount of money that we receive at some future point of time we simply reversed the above equation but it is the same equation f the one equals b 0 times one plus R in parentheses in our example one hundred and seven equals TV zero times open bracket one plus zero point zero seven close bracket or one hundred and seven divided to one point zero seven equals to the present value or the present value is one hundred dollars let come back to our example we were offered three hundred dollars after two years to make the right choice we need to compare them with the two hundred dollars today to compare apples with apples we must either compare the present values of these two amounts or the future value of these two amounts. In any case the village must be in one in the same period of time so we will calculate how much is worth the three hundred dollars in today's N B zero equals f the two divided to one plus R in parentheses to the power of two or B zero equals in our example three hundred dollars divided to one plus zero point zero seven in parentheses to the power of two or B zero equals three hundred dollars divided to one point one four five this is our present value is two hundred sixty two dollars. It means that today's value of three hundred doors after two years at seven percent discount rate is two hundred sixty two. In comparison with the offer it's two hundred dollars. Today they are the bigger amount and 3 percent obviously the better term alternative. As mentioned this calculation was necessary in order to compare comparable amounts. Remember that it is wrong to compare future dollars with today dollars. You must always calculate their values at 1 in the same period of time respectively. Whether it is today or some future period. Now it's time to ask us another question. When they promise us three hundred dollars in two years. Will the pair be able to fulfill its obligation in two years time from this point of view. It might not be too bad idea to accept a two hundred dollar today. This is the second fundamental role in the finance. The risk free dollar is more valuable than the risky door in decline of thoughts. Do you think we could somehow calculate also the risk of these 300 doors in the future. Of course we must have the appropriate comparison in our case. We shouldn't compare the future cash flow with income under his creed treasury bills but with the profitability the investors expect from risky investments. If we assume that the risk is compatible with the risk of any other stock investment then we could take the profitability of the stock exchange investments as comparison. It is about 12 percent in the long term. In this respect having in mind also the risk of the future cash flow. We could adopt our four more as follows Peavy 0 equals 300 dollars divided to one plus zero point one two in parentheses to the power of two or our present value would decline to two hundred thirty nine point sixteen. Now we see that the value of our three hundred dollars after two years declined significantly when we calculated also the risk. It is still worth it to accept the discounted those after two years because two hundred thirty nine is a bigger number than two hundred. We will elaborate this in a much bigger detail in the next lectures where we will speak about the biggies the net present value and the internal rate of return of our investment. Some people could argue now that in today's economic environment you can't achieve 7 percent profitability from your treasury bills and the average profitability on the stock exchange is not 12 percent but rather 10 percent or even less. The exact numbers don't really matter because the main idea here is to demonstrate the importance to compare comparable numbers and the future dollars are not equal to today's dollars. This is important concept that is not realized by many people but you should use it as basis for your investment decisions. I can assure you that all see a force of the large corporations are doing it and calculate not. The difference between today's dollars and future those I am including this topic in the course because I believe that your money is so important for you as it is important for the large corporations to protect and multiply the money of their shareholders. For those of you who hate to use calculators and calculations I have a surprise I have included an additional resource to this lecture with a table with the present values for various future periods. It is actually very convenient if you are not in front of your computer assignment. Calculate the present value of 500 dollars. After 40 years and compare it with the alternative to get three hundred and fifty dollars right now recap door today is more valuable than door tomorrow. This corridor is more valuable than risky door. Always compare apples with apples. Break all cash flow respectively. Whether it is income or expense from the various periods to the same period in order to make the right conclusion.