Question

What does the Time Value of Money account for? In other words, why are we doing the calculation?

Answer 1

Time value of the money states the importance of the money today. The $100 today will always worth more than $100 tomorrow.

The money keeps on depreciating in general. The purchasing power of $100 can buy 50Kg of wheat today but same $100 can’t buy 50Kg of wheat 5 years later because the value of money is not static and it is depreciating. We would require more than $100 to buy 50kg of rice after 5 years.

This happens due to the interest rate which is derived using economic factors like inflation, risk free rate, risk premiums etc.

Present value = Future value / (1+Interest rate)^Time

Reverse; Future Value = Present value x (1+Interest rate)^time

The future value of the money is discounted by interest rate so to get the present worth of that money which is going to come in future. It is easy to compare the value of money with present value. Because in present we can see the affordability of the money. Hence, time value of the money is important factor and hence the calculation is done with above mentioned formulas.