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The Time Value of Money - Essay Example
To understand time value of money, suppose that you are offered two options. You can take $ 10000 today or $10000 five years from now. Which one should you choose Many of us would accept the first option since it will provide us with the $ 10000 today and we humans, being impatient would not want to wait for 3 years for this $ 10000.
However, this is not the case with the $10000 received 3 years from now. Its value will be $10000 only since no interest will be earned as illustrated in the figure below:
In short, we can say that "a dollar today is worth more than a dollar one year from now" because the time value of money decreases over time. Why it decreases is the actual question. Interest rate, as we saw above is one apparent reason why money is related to time. Investing the money today would enable you to earn interest, causing it to grow to a larger amount over time. Let us now examine some of the other reasons and their impact on the time value of money.
Present value refers to a value that is equal to a value or values in future that have been discounted at relevant interest rate. For example, if you are expected to receive $10000 three years from now, the value of this 10000 today would be $9497 if the interest rate is 5% (PV= FV/ (1 + i )N) ) but if you were to receive $10000 five years from now, the present value would only be $7836.This $9497 at the beginning of the period is equal to $10000 at the end of the three years , showing that the value of money is related to time and therefore, causing the present value of an amount in the future to be less and less, the more you have to wait for it. ...