A dollar received or paid at one point in time is not worth the same as a dollar received or paid at another point in time.
This concept is called the time value of money. It is based on the simple idea that through the power of interest, money at one point in time grows to more money at another point in time. Just as a bank pays interest on CDs and savings accounts, any amount of money at a particular date is worth less than the same amount of money at a later date because the money at the earlier date would earn interest and be worth more at the later date.
The accumulation of interest over time is called compounding or compound interest. Money at one point in time is converted to its value at a later point in time by a term called the compound interest factor.
The opposite of compounding is discounting, which is a far more important concept in finance. From the above statements about compounding, money at a future date is worth less today. This future sum of money is converted to its current value, called the present value, by a term called the present value factor. Since valuation of stocks, bonds, and assets is such an important concept in finance, we often find ourselves determining the present value of something.
When making time value of money calculations, we always look for short-cuts. Sometimes we must find the future value or present value of a series of equal payments, which is called an annuity. There are short-cut terms that enable us to quickly obtain the future value or present value of an annuity.
An annuity in which the first payment occurs one period after the current time is called an ordinary annuity. An annuity in which the first payment starts immediately is called an annuity due. The compound and discount factors differ for annuities due than for ordinary annuities.
An ordinary annuity that lasts forever is called a perpetuity. It is the easiest type of annuity to find its present value. The future value is also simple and rarely must be calculated, because the future value of a perpetuity is infinite.
One of the most important points to remember about time value of money is that it means that you cannot add money that exists at one point in time with money that exists at another point in time. Either the earlier figure must be compounded to the date of the later figure or the later figure must be discounted to the date of the earlier figure before you can add the two figures.
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Last updated: January 9, 2011