Time value of money

The time value of money is one of the fundamental concepts of financial theory. It is a very simple idea: a given amount of money now is worth more than the certainty of receiving the same amount of money at some time in the future. Furthermore, a given amount of money to be received at a given future date is worth more than the same amount of money to be received at a date further in the future. This is fairly self evident: receiving £1,000 right now is better than a reliable promise £1,000 at the end of next year, which in turn is better than £1,000 the following year.

This leave the question of how much more a given amount of money on a future date is worth than cash now. There is a market rate that can be used to determine this. When investors buy government bonds they are exchanging cash now for a certain amount of money on a future date. Therefore the risk free rate of return can be used to calculate the present value of a certain future payment.

If a future payment is not certain its value needs to be adjusted for risk as well as time value. Its present value needs to be calculated using a discount rate that reflects both time value and risk, such as those calculated using CAPM.

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