The time value of money is a concept in finance that states that money received in the future is worth less than money received in the present.
The difference in value between current and future money is due to the interest that could be earned on the present amount. In other words, the discount between future money and present money arises from the money’s opportunity cost. For example, suppose that you are promised $1,000 in one year. If you are able to earn a 5% annual return on your money in a low-risk investment, the $1,000 to be received in one year is worth $952.38 ($1,000 divided by 1.05).
The two mathematical tools involved in the time value of money concept are compounding and discounting. Compounding involves calculating the future value of a present sum, assuming reinvestment of interest. Discounting involves calculating the present value of a future amount, assuming reinvestment of interest.
For both compounding and discounting, the two key variables are the interest rate and the length of time. In this sense, the interest rate is the mechanism through which current money is equivalent to future money.
The interest rate used in time value of money calculations will depend on the estimated probability of receiving the future sum. If the investment poses a very low risk, a low interest rate is appropriate. However, if the investment poses a higher risk, the interest rate must be increased to account for the higher risk, with the higher interest rate widening the discount between the present value and future value.
