Question

What is the concept of the time value of money and how is this concept used in an everyday context. Please provide an example to enhance the discussion.

Answer 1

Concept: Money becomes more worthy today than it is in future. It happens because of opportunity cost of waiting. A certain sum of money will earn interest in future if it is received today; if such money is not received today, the loss of interest is the opportunity cost. Therefore, such preference of holding of money in today’s date instead of future date is the concept of TVM.

Every day: TVM is used in everyday life; suppliers want payment from manufacturer in today’s date, some retail shops don’t give credit to customers, because they want cash transaction only, lenders charge interest on their loan amount, as the money will be repaid in future, etc.

Example: Suppose there is an option of receiving $10,000 today or 1 year after. Suppose the bank interest rate is 10% per year. The receiver prefers receiving of such today, because after receiving he can keep the money in the bank and can receive interest; interest amount is ($10,000 × 10% =) $1,000. If he doesn’t receive today, such interest income (known as opportunity cost) is gone.