TIME VALUE OF MONEY

Time Value of Money

Time Value of Money

Introduction

It is often said "time is money" to mean that we should not waste it. But in finance, they say literally, that is to say that time really is money. What is the time value of money? How can we explain that a dollar today is worth more than a dollar in a year or more?

Discussion

The time value of money becomes a reality obvious to everyone, simply by recalling what we could buy a dollar several years ago? Probably much more than what one can buy today.

The easiest way to explain the influence of time on the value of money is that it can produce its own money, which probably influences its value. Indeed, putting 100 dollar a year to 10%, we will give 110 dollar at the end of the year without selling or buying anything!

The interest rate reflects the time value of money and it really covers several elements, namely:

Inflation

The purchasing power of one dollar is not the same from one year to another. A lender of a dollar today should give it a rebate that covers the inflation rate in one year so as to maintain the same purchasing power.

•Assume that there is no inflation and that you can buy a dollar today is the same as a year. The lender's preference to consume today than a year which would explain some of the interest rate that is sort of the price of renouncing consumption today in future consumption.

•The risk associated with the uncertainty of what the borrower will make the money he lends also includes a price in interest rates.

In financial mathematics is expressed this time value of money by "capitalization" and "discount."



Discount and capitalization

Capitalization and updating are crucial in all financial calculations ...