The time value of money principle (TVM) states that a dollar in hand
today is worth more than a dollar to be received tomorrow. Why? Because
an amount to be received in the future has opportunity costs.
If you have a dollar today, you have use of that dollar today. You
could invest it and have the dollar plus one day's interest tomorrow.
The time value of money is the concept that cash flows that occur at
different points in time are not equal. You would not give up $1,000 of
your money today only to get back $1,000 in five years. The issue then
is: How much would you need to receive in five years to replace $1,000
This additional amount reflects the cost of money (or interest) or,
in this case, the compensation for deferring the opportunity to use the
funds. When you defer collection of cash flows now in exchange for
collection later, you incur a cost: You cannot use your monies today,
and thus you demand compensation for the delay. Likewise, if you borrow
today, expecting to repay later, you must compensate the lenders who
cannot use the funds now but must wait.
Before you can compare cash flows, you must adjust for the fact that
the cash flows occur at different points in time. The adjustment
process uses a percentage growth rate to equate two quantities that
occur at different points in time.
Using the principles of TVM, you should be able to
- construct time lines to illustrate cash flows over time
- determine how much you must repay in the future to borrow a specific amount today (the future value of present consumption)
- determine how much you must invest today to obtain a specific amount in the future (the present value of future consumption)
Digital Imagery © copyright 2000 PhotoDisc, Inc.