A dollar does not always equal a dollar. To put this another way, a dollar today does not equal a dollar tomorrow and does not equal a dollar 30 years from now. All of those dollars, while they are the same size, are all valued differently because of the time value of money. The time value of money simply means that the dollar today is more valuable than the future dollar because of the interest that can be earned on the dollar today. The problem that we have with this concept is that it is very difficult to quantify the difference in value between a dollar today and a dollar in the future. The most recent Calculator Challenge, involving a loan between Bea & Monica, gives insight on how to solve this dilemma.
Monica is creating a business and needs money to get started. Bea is looking to lend money. If Bea lends Monica money today, Monica will agree to pay Bea $50,000 in 5 years. Bea agrees to lend Monica the money so long as her money earns 12% interest, and Monica agrees to give Bea collateral to secure her loan. How much is Bea willing to lend today if her money is to work at 12% and she will get $50,000 in 5 years?
Answer: these are the numbers to enter into your HP 10bii financial calculator
N (number of months) = 60 (the loan will be for five years or 60 months)
I/YR (interest rate/year) = 12 (this is the interest rate that Bea wants to earn)
PV (present value) = ??? (this is what we are solving, we are working to figure out how much Bea will lend today.)
PMT (payments/month) = 0 (there will be no monthly payments made during this loan)
FV (future value) = $50,000 (this is how much Monica agreed to pay Bea in 5 years)
After entering all of this information into the calculators, the answer is $27,522.48. In other words, if Bea is going to lend money to Monica at 12% for the next 5 years and she will receive $50,000 at the end of that time, the amount that Bea can lend today is $27,522.48.
After seeing this, how much would you pay for $50,000?