Given the choice between receiving £100 today or £100 next year, almost everybody would choose to have the money now.
In other words, money today is more valuable than the same amount of money tomorrow. This principle is called the time value of money.
The difference in value is not only due to inflation - even if inflation were zero, people would virtually always prefer to receive money now than in a year's time. The main reasons for this are:
· money received now can be 'put to work' to earn a return so that, in a year's time it will have accumulated in value
· the benefit of money received now is certain whereas, because there is no guarantee that you will be alive next year, the benefit of money received next year is uncertain
· most people have an expectation that their wealth will be greater in the future, so the relative value to them of a particular sum of money will be correspondingly less in the future
Taken together, these factors mean that people usually require some compensation for delaying receiving a sum of money; this compensation is called interest. When a person invests money, they are delaying the time when they can spend the money and they expect to receive interest in compensation for this delay.
When a person borrows money, they can benefit from the money immediately rather than having to wait, and are willing to pay interest in return for this privilege.
The stronger the preference for money today over money tomorrow, the higher the interest rate which lenders wish to charge and borrowers are willing to pay.
The time value of money is important in appraising projects because, generally, the costs and benefits of a typical project are spread out in time.
Typically, most of the costs are incurred near the beginning, whereas the benefits do not arise until later. The further into the future the benefits occur, the less valuable they are. Also, the stronger the preference for money today over money tomorrow, the less valuable future components of the cash flow become.
The process of taking into account the time value of money when appraising a project is called discounting. It involves reducing the calculated value of future elements of the cash flow according to a discount rate.
Choosing the appropriate discount rate to use is not straightforward, and depends on a wide range of factors (see Choice of discount rate for more information).
The arithmetic of discounting is similar to, but the reverse of that used to calculate compound interest, and the discount rate is closely linked with the interest rate. Evaluating a project cash flow using the technique of discounting is called discounted cash flow (DCF) analysis. The result of discounting each future component of a cash flow is that we calculate its present value.