Question

What is time value of money? Briefly explain how it is related to interest rate.

Answer 1

Suppose you want to sell your mobile, and your friend - A offered to give $ 100 and another friend - B also offered to give $ 100. Now to whom do you sell the mobile?

Now see the additional information, Friend - B will give $ 100 on the spot, but Friend - A can pay you after one year from now. Now to whom do you sell the mobile? The answer this time is very eassy. Our choice is B, since we get 4 100 right now as against postponed payment of A.

This is what we call time value of money. The delay in the receipt of dollar value, decreases its value relative to time. If interest rate = 10%, $ 1 will produce $ 1.10 after one year. In otherwords, value of a dollar to day is $0.909 for $ 1 receivable after one year.

how it is related to interest rate.

Imagine a world with no interest rates or reinvestment oppourtunities. Then what will be the difference between receiving $ 100 today or it is received after 1 Year or 2 Years? It implies that interest rate is the main reason for giving the money, so called time value. In absence of interest rates value of dollar remains same irrespective of the date of its receipt or payment.

Present value = Future value / ( 1 + r )ⁿ

r = interest rate and n = period of delay from today.