A dollar today is not worth the same thing as a dollar a year from now.
If you promise to give me a dollar in a year, I can’t do anything for a year. But if you give me a dollar today, my options are open: I can put that dollar in the bank and collect interest, I can use it to buy raw materials so I can make something and sell it at a profit, I can invest it in the stock market…or I can just spend it. The point is, I have the option to make that dollar increase in value over the course of the next year.
If I invest that dollar at 5% annual interest, it’ll be worth $1.05 in a year. What that means is that, if you gave me the option of a dollar today or a dollar in a year, I would say that you’d have to give me at least $1.05 in a year for it to be worth my while to wait, because I believe that I can get 5% if I have that dollar today. This is called the “internal rate of return,” or IRR, and the value of my dollar today is called the “net present value,” or NPV.
Thought about it another way, I’d gladly take 96 cents today instead of a dollar year from now, because I ought to be able to earn that extra 4 cents over the course of a year…and maybe more. That’s one reason people who win the lottery aren’t crazy for taking the lump sum: with proper investing, they may be able to earn more money than if they just divided the payments up over time (the amount of that lump sum is actually based on the lottery’s calculation of NPV).
In business terms, you would use this to decide whether or not to make a particular investment, or go forward with a particular project. If you plan to spend $1000 launching a new business, and you determine that you can probably just turn that $1000 into $1050 in a year if you put it in the bank, then your new business would need to be worth at least $1050 in a year for it to be worthwhile. If it wasn’t, you’d just skip all the risk and settle for earning interest.
That’s simplifying it a bit. Figuring out what is a realistic IRR is a big part of the process. But it does illustrate a really important point: the power of compound interest over time. Earning a nickel on a dollar over the course of a year isn’t much of a thing, but imagine earning $50,000 a year on a million-dollar investment.
It takes money to make money.
Mark. Your last comment is certainly I feel the most important one. It does take money to make money. This is true of all business, well except the worlds oldest business. That takes something else entirely. Good read man
I would take the annuity.