Time value of money
One of the fundamental principles in finance is the time value of money. The basic idea behind this concept is that USD 1 today is worth more than USD 1 in the future. That is because 1) this dollar can be invested and earn interest over time, and will therefore be worth more than USD 1 in the future; 2) money is subject to inflation, which eats away at the purchasing power of the money over time, making it worth less in the future; and 3) there is always the risk of not receiving this dollar in the future, which is not the case if the dollar is received today.
Therefore we need to measure this risk associated with time, to be able to accurately bring a future value into today’s terms. Discounting is the method used to calculate how much these future values are worth today. Values are discounted by being divided by 1 + the appropriate discount rate, or interest rate, that represents the risk associated with the payment or cash-flow.
For example, if an individual requires USD 1,000 in two years to make a certain purchase, and the current interest is 5% the present value of this loan today would be:
Present value = USD1,000 / (1.05)2 = USD907.03
In other words, the individual would need to set aside USD 907.03 today to obtain USD 1,000 in two years when he requires it.