Now versus Later Concepts
By the end of this section, you will be able to:
- Explain why time has an impact on the value of money.
- Explain the concepts of future value and present value.
- Explain why lump sum cash flow is the basis for all other cash flows.
How and Why the Passage of Time Affects the Value of Money
The concept of the time value of money (TVM) is predicated on the fact that it is possible to earn interest income on cash that you decide to deposit in an investment or interest-bearing account. As times goes by, interest is earned on amounts you have invested (present value), which effectively means that time will add value (future value) to your savings. The longer the period of time you have your money invested, the more interest income will accrue. Also, the higher the rate of interest your account or investment is earning, again, the more your money will grow.
Understanding how to calculate values of money in the present and at different points in the future is a key component of understanding the material presented in this chapter—and of making important personal financial decisions in your future (see Figure 7.2).
Figure 7.2 The Time Value of Money It is better to be paid today, or you will lose out on the money you would have earned in interest.
The Lump Sum Payment or Receipt
The most basic type of financial transaction involves a simple, one-time amount of cash, which can be either a receipt (inflow) or a payment (outflow). Such a one-time transaction is typically referred to as a lump sum. A lump sum consists of a one-off cash flow that occurs at any single point in time, present or future. Because it is always possible to dissect more complex transactions into smaller parts, the lump sum cash flow is the basis on which all other types of cash flow are treated. According to the general principle of adding value, every type of cash flow stream can be divided into a series of lump sums. For this reason, it is critical to understand the math associated with lump sums if you wish to have a greater appreciation, and a complete understanding, of more complicated forms of cash flow that may be associated with an investment or a capital purchase by a company.