Why Future Money is Worth Less Today?

Imagine someone offered you a choice: would you rather receive one hundred dollars today, or one hundred dollars ten years from now? Most people would choose to receive the money today, and this simple preference lies at the heart of why future cash flows have a lower present value the further into the future they are expected.

This concept is all about the time value of money. Think of it like this: money today has more potential than the same amount of money in the future. Why is that? Well, if you have one hundred dollars today, you have options. You could spend it on something you need or want right now. Maybe you’d buy groceries, pay for a fun outing, or even put it towards a bill. Alternatively, and perhaps more importantly for our discussion, you could invest it.

If you invest that one hundred dollars, even in a very safe, low-interest savings account, it will grow over time. Let’s say you earn a modest interest rate. After a year, your one hundred dollars might become one hundred and five dollars, or maybe even a bit more. Over ten years, that initial one hundred dollars will have grown significantly, thanks to the power of compounding interest. This growth potential is a key reason why money today is more valuable.

Now, consider the one hundred dollars offered to you in ten years. You can’t use it today to meet your current needs or take advantage of immediate opportunities. You also lose out on the potential to invest it and watch it grow over those ten years. This lost opportunity to earn a return on your money is a major factor in the decreasing present value of future cash flows. Economists call this lost opportunity the ‘opportunity cost’. By waiting to receive the money, you are essentially giving up the chance to use it productively in the meantime.

Another important factor is inflation. Inflation is the general increase in prices of goods and services over time. Think about the price of gasoline or groceries ten years ago compared to today. They are likely more expensive now. This means that the purchasing power of money decreases over time. One hundred dollars today can buy more goods and services than one hundred dollars will likely be able to buy ten years from now. So, the future one hundred dollars is not just delayed; it’s also likely to be worth less in terms of what you can actually purchase with it.

Furthermore, the future is inherently uncertain. There’s always a degree of risk associated with receiving money in the future. Things can change. The company promising the future cash flow might face financial difficulties, or unforeseen economic events could occur that impact the value of that future payment. The further into the future we look, the greater the uncertainty and the higher the risk. To compensate for this increased risk, we naturally value future cash flows less in the present.

In essence, the further away a cash flow is in the future, the more we ‘discount’ its value in today’s terms. This ‘discounting’ reflects the combined impact of opportunity cost, inflation, and risk. It’s a way of acknowledging that time itself has value, and that receiving money sooner rather than later is always preferable, all else being equal. Therefore, the present value of a future cash flow decreases as the time until it is received increases because of these fundamental economic principles.