Question

Why is understanding the concept of time value of money important?

Answer 1

Time value of money also referred to as present value discounted. Time value of money concept states that an amount of money is worth more today than the same amount tomorrow or some time in future.This is due to the potential earning capacity that the amount of money has.That is the money that the individual has today can be invested to earn more in the future.

Time value of money concept is applied in Present Value ,Future Value and Net Present Value

Present Value is used to determine the value of money to be received in the future.The formula used is PV=1/(1+r)^N,r is the interest rate n is the number of years

Future value is used to compute the value of the money in the future so that it can be compared to the present value.

The formula is FV=PV*(1/1+r)^N where r is the interest rate n is the number of years and PV is the principal amount

NPV (net present value) is the sum of present value of inflows deducted from the initial out lay.It is used to evaluate projects and rank them.The projects that have a positive NPV are deemed viable and accepted.

So in conclusion understanding the concept of time value of money is important for decision making.