What is the Time Value of Money? The Core Principle of Finance

The Time Value of Money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential.

The Time Value of Money (TVM) is the fundamental principle that $1 today is worth more than $1 tomorrow. This is due to three factors: inflation, risk, and opportunity cost. Because money can be invested to earn interest, any delay in receiving capital results in a loss of potential growth. TVM is the basis for all asset pricing, from simple bank loans to complex multi-period infrastructure projects.

The relationship between Present Value ($PV$) and Future Value ($FV$) is defined by the formula: $FV = PV \times (1 + i)^n$. Here, $i$ represents the interest rate per period and $n$ is the number of periods. If you invest $10,000 in a 2-year Treasury note with a 5% annual yield, the future value in 2025 will be $10,000 \times (1.05)^2 = $11,025.

Compounding is the process of earning interest on interest, which leads to exponential growth of capital over long horizons. Conversely, Discounting is the process of determining the present value of a payment to be received in the future. In finance, we discount future cash flows using a required rate of return to see if an investment is 'worth it' today. If the $PV$ of future cash flows is higher than the initial cost, the investment has a positive Net Present Value (NPV).