The time value of money theory states that a dollar that you have in the bank today is worth more than a reliable promise or expectation of receiving a dollar at some future date. You can invest the dollar today and earn a return on that investment, such as interest or dividend payments.
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.
the basic terms used in time value of money calculations are:
- Present Value
When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value.
- Future Value
Future value is the amount that is obtained by enhancing the value of a present payment or a series of payments at the given rate of interest to reflect the time value of money.