What is meant by the term "time value of money"?

The term "time value of money" refers to the idea that money today is worth more than the same amount in the future due to its earning capacity. This principle is foundational in finance because it recognizes that money can earn interest, and over time, the potential growth of that money through investments leads to greater amounts in the future.

This concept is crucial for making informed financial decisions, as it emphasizes the importance of timing in cash flows. For example, receiving a dollar today allows an individual to invest it and generate returns, whereas a dollar received in the future cannot be invested until it is received, resulting in lost opportunities for growth.

Understanding the time value of money also assists in evaluating potential investments, retirement planning, and valuing cash flows from various financial instruments. As a result, it helps investors make calculations about present value and future value, reinforcing the idea that the timing of cash flows is an integral aspect of financial analysis.