Time Value of Money

Concepts and applications

The concept of compound interest or interest on interest is deeply embedded in time value of money. When a money is subjected to compound interest, the growth in the value of the money from period to period reflects not only the interest earned on the original principal amount but also on the interest earned on the previous period’s interest earnings – the interest on interest.

TVM applications frequently call for determining the Future Value (FV) of a money as a result of the effects of compound interest. computing FV involves projecting the cash flows forward, on the basis of an appropriate compound interest rate, to the end of the money’s life. The computation of the Present Value (PV) works in the opposite direction – it brings the cash flows back to the beginning of the money’s life based on the appropriate compound rate of return.

Being able to measure PV and/or FV of the money becomes useful when comparing investment alternatives because the value of the investment’s cash flows must be measured at some common point in time, typically at the end of the investment horizon (FV) or at the beginning of the investment horizon (PV).

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For instance, today it can buy 40 gram of gold. but after 10 years, the same amount can buy less than 40 gram of gold.

Why and how?

Is it meant that we should buy the gold for today as many others do?



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