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Time Value of Money

Concept

Time Value of Money (TVM) is an essential concept in finance that draws on the core principle that a dollar today is worth more than a dollar tomorrow. This fundamental notion underpins many areas of finance, including investing, capital budgeting, retirement planning, and risk management.

At its heart, TVM is a concept that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. The rationale behind this principle is that the money you have now can be invested to earn returns, making it more valuable than the same sum received in the future.

There are several key components associated with the Time Value of Money:

  • Present Value (PV): The current value of a future sum of money or stream of cash flows, discounted at a specific rate.
  • Future Value (FV): The value of an asset or cash at a specified date in the future, based on an assumed rate of return.
  • Net Present Value (NPV): The difference between the present value of cash inflows and outflows over a specific period.
  • Internal Rate of Return (IRR): The discount rate that makes the net present value of an investment zero.

Understanding these components is crucial in making sound financial decisions, whether it's deciding on an investment, evaluating a project's profitability, or planning for retirement.