Question

Time value of money is an important aspect of money management. Why is it important to know what interest rates, terms of an agreement, and present value are in relationship to future value when making financial decisions?

In perspective, if you won a $25 million lottery, would you take the lump sum prize of $17 million immediately or the annual annuity of $1 million dollars for the next 25 years?
Your response should be based on what you know about present value and future value as well as include your personal opinion.

Answer 1

Present value is the value of future payments in the present and it is very important to use this when making financial decisions mainly because of inflation.

Inflation weakens money so future values are almost always less than present values so when making a decision it is the present value that needs to be factored not the future value as that is less than the present value in value.

Inflation is factored into the calculation of interest rates so they can be used to discount future values to present values. They are therefore important to know because without them we cannot make a comparison between future and present values.

For one to decide between taking a payment now vs the future, they need to discount that future value to the present to see if it is larger than the present value after which they can make their decision.

If you won a $25 million lottery and you had to choose between a lump sum of $17 million now or $1 million every 25 years, you should discount the $1 million every 25 years to the present using a relevant interest rate. If it is larger than the lump sum now, take it and if it isn't, leave it.