The Core Principle
The reason a dollar today is worth more than a dollar tomorrow is because today's dollar can be invested and earn interest. This principle underpins many financial concepts, from retirement planning to corporate finance decisions. Understanding TVM is essential for making sound financial choices.
Future Value (FV) and Present Value (PV)
TVM calculations revolve around two key concepts:
- Present Value (PV): The current worth of a future sum of money or stream of cash flows given a specified rate of return.
- Future Value (FV): The value of a current asset at a specified date in the future based on an assumed rate of growth.
The formula for Future Value is: FV = PV * (1 + r)^n, where 'r' is the interest rate and 'n' is the number of periods.
Application in Corporate Finance
In corporate finance, TVM is used extensively in capital budgeting. When a company is considering whether to invest in a new project, it must estimate the future cash flows that project will generate. It then uses TVM principles to discount those future cash flows back to their present value. If the present value of the future cash flows is greater than the initial cost of the project, the investment is considered worthwhile.
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