"A dollar today is worth more than a dollar a year from now"
One of the most important tools in personal finance and investing is the time value of money. Evaluating financial transactions requires valuing uncertain future cash flows; that is, determining what uncertain cash flows are worth at different points in time.
Discounted cash flow is based upon the time value of money concept. What this means is that not only do we value how much cash flow is generated, but we are also very concerned with when it is received. Sooner is better. The faster the cash flow is received, the sooner it can be reinvested.
The time value of money serves as the foundation for all other notions in finance. It impacts business finance, consumer finance, and government finance. Time value of money results from the concept of interest.
Calculations involving the time value of money allow people to find and compare the value of future payments. To do this, five figures come into play: interest rate, number of periods or number of times interest or dividend payments are made, payments, present value and future value. Formula involving these figures answer questions such as how much would you have to deposit now to have $10,000 in six years if the interest rate is 7 percent.
Present value (PV) is the current value of future cash flow.
Future value (FV) is the value of cash flow after a specified period.
The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.
Compounding is the process by which interest earned on an investment is reinvested so that in future periods, interest is earned on the interest previously earned as well as the principal. In other words, with compounding, you are able to earn compound interest, which consists of both simple interest and interest on interest.
If company A has the opportunity to realize $10,000 from an asset today, or two years in the future, TVM allows the company to calculate exactly how much more that $10,000 is worth if it’s received today, as opposed to in the future. It is important to know how to calculate the time value of money because it means you can distinguish between the value of investment opportunities that offer returns at different times.
In an inflationary economy, the money received today, has more purchasing power than the money to be received in future.
Individuals generally prefer current consumption to future consumption.
The fixed income from government bonds is normally used to calculate the present value of a future payment. The income from government bonds is assumed to be a risk-free rate of return.