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Time Value Of Money

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Time value of money is the financial concept that deals with equating the future value of money or an investment with its present value. Time value of money explains how interest rates and time affect the value of money. The general time value of money equation is:

PV = FV/(1+r)^t
where
FV = future value
PV = present value
r = interest rate per period
t = period (e.g. years)

To illustrate the time value of money, suppose an investor expects to receive $100 three years from now and that the investor can invest at a constant 5% annual investment rate. Based on the time value of money equation, the $100 to be received three years from now has a present value of $100/(1+.05)^3 = $86.38. Time value of money then suggests that at a 5% annual rate, $100 three years from now is equivalent to $86.38 today. Thus, time value of money concludes that, if there is an investment vehicle with a positive real rate of return, owning a dollar today is worth more than owning a dollar in the future. The time value of money concept has numerous applications in finance including but not limited to the valuation of annuities, bonds, and equities. Time value of money is also applied to solve calculations such as net present value and internal rate of return.



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