Time Value of Money

Time Value of Money

We earn money so that we can spend it, and we save money with the intent to spend it in the future. However, for most people spending money in the present time is more attractive since the future is uncertain and a ways off. We can satisfy the desire to spend money today rather than in the future by knowing this fundamental law of finance: time value of money. This means that a dollar today is worth more than a dollar at some time in the future. Unfortunately, people very often want to buy things at the present time which cost more than what they earn, so they take out loans or pay on a line of credit, all of which has to be paid off at some point in the future. In this paper we will discuss the present value of money, the future value of money, compounding effect of money, and annuities. Knowledge of this basic time value of money principles and calculations is crucial for making sound financial decisions in business as well as in our personal lives.

From the borrower's viewpoint of the transaction, there are consumers and businesses that need that dollar today for various reasons and they are willing to pledge to pay back more than that dollar in the future. Businesses can invest borrowed funds in capital to hopefully create profits which are more than adequate to repay the borrowed funds plus interest. Consumers and governments borrow for various reasons but are expected to have income in the future sufficient to repay principal and interest (Understanding the Time Value of Money).

The time value of money has real, hands on functionality in many areas of Corporate Finance including stock and bond valuation and capital budgeting. Furthermore, the time value of money concepts can be grouped into two areas: Present Value and Future Value. Present value describes the process of determining what a cash flow will grow to in the future. Future value describes the process of finding what an investment today will grow to in the future.

The...