Assessment 2 - Step 6 - KCQs

Commonwealth Bank Chief Executive Officer, Matt Comyn, holding a clock and looking slightly glum.

Time Value of Money

One Australian dollar is worth one Australian dollar. If you asked to buy my dollar off me, I’d be reluctant to sell it for anything less than 100 cents. If you asked me to lend you a dollar, I’d expect you to give me a dollar back the next time I saw you. This all seems obvious. So, when is a dollar not worth a dollar? The moment time gets involved.

If you asked me to loan you a dollar for three months, I’d probably expect $1.10 in return. I can’t spend it in the meantime, and there’s always a chance you forget about it and never pay it back. I’ve also got a mortgage so large that Matt Comyn is probably losing sleep over it, and if you hadn’t borrowed my dollar, it would have been sitting in my offset, saving me interest.

That extra ten cents I demand, isn’t due to greed, it compensates me for three things. The risk I won’t get my money back, the inconvenience of not having access to it when I want it, and the opportunity cost of not using it to reduce my own debt, or invest it. Stretch that loan out to a year and the compensation increases again. I’m taking on more risk, giving up more flexibility, and missing out on more opportunities to use that money elsewhere. On top of that, inflation means a dollar in a year’s time won’t buy as much as a dollar today. So now, instead of asking for $1.10 back, I might want $1.30.

This concept is referred to as the Time Value Of Money. A dollar today is worth more than a dollar in the future, because money available now can be used, invested, or protected from risk. The further into the future you push a payment, the less it’s worth in today’s terms.