Time value of money

Even if inflation and interest rates are zero, money has a time value. If you are owed £10, you would rather it was paid back now than in, say, one year’s time. That’s because the borrower is less likely to pay you back if you wait.

Now throw in interest rates. Lend someone £100 now with interest rates at 5% and if they return £100 in one year you’ve actually lost out. That’s because you could have earned £5 of interest in the meantime. So they should be paying you £105 – and that assumes you were happy to accept zero default risk when you made the loan. Equally, if you lend the £100 over two years you should expect £100 x 1.05 x 1.05 back, or £110.25.

In reverse, the “present time value” of £110.25 due in two years time but received today instead is £100 (if interest rates are a constant 5%).

• Watch Tim Bennett’s video tutorial: What is the time value of money?

MoneyWeek magazine

Latest issue:

Magazine cover
Profit from the agriculture boom

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 3 FREE Issues
Shale gas 'fracking' promises to transform Britain's energy market. Find out what it is, what it means, and how to invest.

More from MoneyWeek

The problem with the Bank of England

Fracking: Nine reasons not to get carried away

Five small-cap stocks worth a flutter

This Dutch company could help us tame floods

ScreenHunter_01 Mar. 25 09.51

Get the latest tips and investment opportunities from MoneyWeek magazine: Claim 3 FREE issues HERE