A:

The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future; the dollar on hand today can be used to invest and earn interest or capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation.

The time value of money can be broken up into two areas: present value and future value.

Present Value

Present value = (future cash flow) / (1+ rate of return)^number of periods

Present value determines what a cash flow to be received in the future is worth in today's dollars. It discounts the future cash flow back to the present date, using the average rate of return and the number of periods. No matter what the present value is, if you invest that present value amount at the specified rate of return and number of periods, the investment would grow into the future cash flow amount.

Future Value

Future value = present value x {1 + (rate of return x number of periods)}

Future value determines what a cash flow received today is worth in the future, based on interest rates or capital gains. It calculates what a current cash flow would be worth in the future, if it was invested at a specified rate of return and number of periods.

Both present value and future value take into account compounding interest or capital gains, another important aspect for investors looking for good investments.

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