Explain the time value of money.

The time value of money is a fundamental concept in finance that asserts that a certain amount of money today has greater value than the same amount in the future. This increase in value stems from the potential earning capacity of money when invested. Essentially, money can earn interest or generate returns over time, so having money now means it can be put to work and grow, whilst a sum received in the future cannot earn anything until it is actually received and invested. Therefore, the principle recognizes that the opportunity to invest and earn a return diminishes significantly with time.

This concept is crucial for various areas such as investment decisions, loan structuring, and financial planning, as it highlights the significance of cash flow timings and the potential growth from interest or investment gains. It also underpins many financial models, including net present value and internal rate of return calculations, where the future cash flows are discounted back to their present value. Understanding the time value of money allows investors to make informed decisions that maximize their financial outcomes.