Question

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

1.) What does the above statement mean to you (why is money worth more the sooner you receive it)?

2.) Why is it important?

Answer 1

1) The given statement means that $1 received today is more valuable than $1 received an year later. This is because in the case where we receive the money today, we can invest the same in the bank ,say @10% pa, and have $1.1 at the end of the year. This is more valuable than the other case where we receive $1 at the end of the year.

2) The concept implied in the above statement is called Time value of money. This concepts holds immense importance in the world of finance. Any investment that is under consideration is also tested on the fronts of Time of value of money. For example an investment that earns $100,000 an year later must be more valuable another investment of same value that yields $100,100 2 years later given normal market interest rates.

The concept of time value of money, i.e money received today is more valuable than the same money received an year later, exists due to the various risks associated with money. For example, Credit Risk, i.e. the risk that the person responsible for payment might default on the payment. Another Risk to be considered is the risk of Inflation.