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First a deep breath. Many of you have heard horror stories about
the time value of money. Fortunately, these horror stories are not
true. In fact this is arguably the EASIEST section as this is where
you can check your answers and the problems tend to be "cook-book."
(i.e. step by step--ok so maybe not the easiest but not that bad either.)
The first thing that needs to be explained in the concept of simple vs. compound interest. When we are dealing with the time value of money we are interested in compound interest. Briefly, compound interest is when your interest earns additional interest; simple interest is when only the original principle earns interest. For a more detailed description of this important tiopic try the note pages devoted to simple vs. compound interest .
Now that you have Simple vs.Compound interest down, we can get into the Time Value of Money. The basic idea of time value of money is that a dollar today is worth more than a dollar tomorrow. That is you would rather have a dollar now than later, BUT would rather pay later if possible.
This can be shown in many ways, many people find it easiest to understand if they think in terms of something they already know: food. For example having the money today allows you to buy some food immediately. Alternatively you may be willing to forgo current consumption and wait until later to purchase your food. Thus you could lend your "food money" to another with the promise of being paid back at some future time. Since you are passing up food today you would demand a return sufficient to allow you to buy at least as much food in the future that you are giving up now.
As we do not know the future, any future deal involves risks. For example the borrower may decided to not pay you back. This is called default risk. Or the borrower may pay you back but due to rising prices you can no longer purchase the same amount of food as you had expected to be able to buy (this is called inflation risk).
As a result of these risks, you as a lender require a higher interest rate to compensate for accepting the risks. However if you ask for too high of interest rates you will not find any takers for your loan.
There are two basic concepts that you will need to know. Present Value and Future value. These can be confusing, but once you get them you will find them exceedingly useful throughout your finance career.
The two ideas are closely related:
- Present Value calculations deal with how much something is worth today given a set of assumprions about the future.
- Future Value calculations deal with how much money you will have in the future given a set of assumptions.
Notes on Present Values
Notes on Future Values
Other sources:
http://www.soho.org/Finance_Articles/compound_interest.htm