In our accounting, finance and economic courses we are taught that a dollar available to spend today is worth more than that same dollar if it were available to spend sometime in the future. Present dollars are said to be worth more than future dollars. There are three basic reasons usually given to support this assertion.
A first reason is that immediate gratification is usually more preferable to delayed gratification. I could with that present dollar buy something that gives me pleasure today. If I have to wait to get that dollar sometime in the future, I will have to delay purchasing that thing and so defer the gratification that the desired thing provides me.
A second reason is that most currencies suffer inflation over time. This means the amount of goods and services I can acquire with today’s dollar is usually greater than the amount of goods and services I can acquire with that same dollar any time in the future.
The third reason offered is that if I have a dollar in my pocket today, I can take it out of my pocket and invest it in some financial instrument and create more dollars in the future. If I have to wait to invest that dollar until sometime in the future, I have lost some of those extra dollars I could have accumulated had I begun investing today.
Whatever the rationale for translating present dollars into future dollars and vice versa, we are taught to quantify just how much greater the value of today’s dollar is compared to the future dollar. We use formulas to convert present dollars into future dollars and vice versa.
The key parameter in all these formulas is a percentage rate usually denoted “i” that goes by different names. The “i” usually stands for interest rate. But the same rate is also called a discount rate. Ordinarily when we convert a present sum into a future sum the “i” term is called interest. Usually when we are converting a future sum to a present sum we call “i” a discount rate. Sometimes we refer to the “i” as a rate of return. In this course I use these terms interchangeably. But no matter what name we give it, “i” represents the fundamental conversion variable in all the time value formulas I will discuss in this course.
I recommend reviewing the compound interest page first but there is no need to follow the suggested ordering below after reading that page.