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The Time Value of Money

The time value of money follows the idea that the value of money at the present time has a greater amount of value than the same amount it would have in the future because of inflation and interest rates. If money can earn interest, it is then worth more the sooner it can start earning interest. The time value of money quantifies the value of a dollar over a period of time and is affected by interest rate or rate of return. The basic idea of the time value of money is that the earlier the better.

The time value of money is separated into future value and present value. Future value is what the investment will amount to in the future and present value is what a sum in the future is worth in the present. The present value of a cash flow stream is equal to the sum of the individual cash flow’s present value. The future value of a cash flow stream is equal to the sum of the future values of individual cash flows.

An important part of the time value of money is simple interest and compound interest. Simple interest is just interest on the initial amount and stays the same over a period of time. Compound interest is interest that accumulates over time and dramatically grows over time.

The basic calculations for time value of money are taken from the algebraic expression of present value of a future sum that is discounted to the present with the amount being equal to the time value of money¹. Calculations based on the time value of money are present value, present value of annuity, present value of a perpetuity, and future value.

 

References:

1. Baseline Education. Oct 11, 2012. Annuities and Perpetuities with continuous compounding. Retrieved from www.baselineeducation.blogspot.co.uk/2012/10/annuities-and-perpetuities-with.html

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