In order to make sound financial decisions as a manager, investor, or customer it is critical to comprehend time value of money. Since businesses and individuals finance a large portion of their main resources knowing how the system works helps to make informed choices regarding financing options. To best evaluate financing or investment opportunities one must understand time value of money concepts such as interest rates, compounding, present and future values, opportunity cost, annuities, and the Rule of '72. These concepts help one interpret the value of money today versus the value of money in the future as well as borrowing costs.
Interest rates and compounding
Interest is defined as the "rent" paid to borrow money ("Interest," 2007, para. 1). Compound interest refers to interest that is applied to the original loan amount and later interest added on to the original borrowed total plus the added interest ("Compound interest," 2007).
Therefore if one was to borrow X amount of money for payback over a two year period, the repayment amount would be calculated by adding the original borrowed figure to the interest rate plus compound interest where applicable. Obviously, increasing interest and allowing for longer repayment terms is highly beneficial to the lender.
Present value or discounting refers to the time money value of the dollar less the anticipated potential earning income. Present value is occasionally referred to as the opportunity cost of money. The reason for this is that money is more valuable when you have the actual cash in hand to invest. Upon investing the money it has now generated interest earning capability. However, if payments on a loan are missed, then interest earnings are reduced. For example, if a loan is paid off early before finishing out the contracted length, less finance charges are applied...