Q:

What is the importance of the time value of money?

A:

The time value of money is an important concept because it is one of the fundamental concepts used in making investment and other financial decisions. It is the foundation of the concept of present value.

The fundamental premise of the time value of money is that money received earlier is worth more than money received at a later time. Over time, the value of money changes due to outside factors such as inflation and interest. Inflation is an increase in the general level of prices, and, over time, it decreases the value of money. As a result, a given amount of money will purchase a smaller basket of goods in the future. Interest is money paid for the use of money, as in an auto or home loan.

Receiving cash sooner rather than later is preferred for a couple of other reasons. First, individuals generally prefer present consumption to future consumption. To entice a consumer to forgo present consumption in favor of future consumption, he must be offered more future consumption in exchange. The cost of future goods in today's money is known as their present value. Also, money now is worth more than money later because of the risk that future payment might never be received. The reasons for this risk include default and death.


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