Benchmarking

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. Also referred to as "present discounted value".

Everyone knows that money deposited in a savings account will earn interest.

Because of this universal fact, we would prefer to receive money today rather than the

same amount in the future. For example, assuming a 5% interest rate, $100 invested

today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100

received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming

a 5% interest rate.

Relationship determined by the mathematics of Compound Interest between the

value of a sum of money at one point in time and its value at another point in time. Time

value of money can be illustrated by the fact that a dollar received today is worth more

than a dollar received a year from now because today's dollar can be invested and earn

interest as the year elapses. Implicit in any consideration of time value of money are the

rate of interest and the period of compounding. For example, the present value of $1

million received 10 years from now is only $386,000 today, assuming a 10% rate of

interest and annual compounding. Insurance companies make use of time value of money

by earning investment income on premiums between the time of receipt and the time of

payment of claims or benefits.

Expenditures for an investment most often precede the receipts produced by that

investment. Cash received later has less value than cash received sooner. The difference

in timing affects whether making an investment will earn a profit. Amounts of cash

received at different times have different values. We use interest calculations to make

valid comparisons among amounts of cash paid or received at different times.

Businesses typically state interest cost as a percentage of the amount borrowed per unit of

time. Examples are 12 percent per year and 1 percent per month. When the statement of

interest cost includes no time period, then the rate applies to a year; thus "interest at the

rate of 12 percent" means 12 percent per year. (WEIL, 2000)

The amount borrowed or loaned is the principal. Compound interest means that

the amount of interest earned during a period increases the principal, which is then larger

for the next interest period. If you deposit $1,000 in a savings account that pays

compound interest at the rate of 6 percent per year, you will earn $60 by the end of one

year. If you do not withdraw the $60, then $1,060 will earn interest during the second

year. During the second year your principal of $1,060 will earn $63.60 interest; $60 on

the initial deposit of $1,000 and $3.60 on the $60 earned the first year. By the end of the

second year, you will have $1,123.60. Compounded annually at 8 percent, cash doubles

itself in nine years. If a twenty-five-year old invests $2,000 each year which earns 8

percent a year, the retirement fund will grow to more than $425,000 by the time that

person reaches age sixty-five.

When only the original principal earns interest during the entire life of the loan,

the interest due at the time the borrower repays the loan is simple interest. Simple interest

calculations ignore interest on previously earned interest. Nearly all economic

calculations, however, involve compound interest.

The time value of money is the premise that an investor prefers to receive a payment of a

fixed amount of money today, rather than an equal amount in the future, all else being

equal. In other words, the present value of a certain amount of money is greater than the

present value of the right to receive the same amount of money time in the future. This is

because the amount a could be deposited in an interest-bearing bank account (or

otherwise invested) from now to time t and yield interest. Consequently, lenders acting at

arm's length demand interest payments for use of their financial capital.

Additional motivations for demanding interest are to compensate for the risk of borrower

default and the risk of inflation (as well as some other more technical factors).

All of the standard calculations are based on the most basic formula, the present value of

a future sum, "discounted"