time value of money
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Ask anyone: would you rather have 1,000 today or 1,000 a year from now? Almost everyone picks today — and they are right. Money in hand now can be spent, invested, or earn interest before next year arrives, and there is always the risk that the future payment never comes. That simple, deep intuition that a dollar today is worth more than a dollar tomorrow is the time value of money.
The time value of money is the principle that a sum of money has greater value the sooner it is received, because money can earn a return over time. It works in two directions. Going forward, present money grows to a larger future value: 1,000 invested at 5 percent becomes 1,050 in a year. Going backward, a future amount is worth less today — its present value: 1,050 due in a year, at 5 percent, is worth only 1,000 now. The interest rate used to translate between today and the future is called the discount rate, and the further away a payment is, the more its present value shrinks.
This principle is the foundation under almost every accounting and finance decision that spans time: valuing bonds, pricing loans and leases, deciding whether an investment is worth it, and measuring long-term liabilities. Accountants use it to record many obligations at present value rather than the larger sum eventually paid. Ignoring the time value of money — treating 1,000 next decade as equal to 1,000 today — leads to badly wrong valuations.
At a 10 percent annual rate, 100 today grows to 110 in one year and 121 in two years. Reversed, a promise to receive 121 two years from now is worth exactly 100 today. The same numbers, read in either direction, are two faces of the time value of money.
Future value grows forward; present value discounts backward — the same idea seen from each end.
Time value of money is about the earning power of money over time, not about inflation — even with zero inflation, a sooner dollar is still worth more because it can be put to work earlier.