The concept is very simple that the worth of money changes with time. Therefore the future cash flow are discounted to get present value of future cash flows. it means that if 5000 is expected to inflow after 5 years is discounted to find the current value of 5000.
There are mainly three reasons for introducing the concept of time value of money.
- Inflation
- Risk factor
- Interest Factor
The simple example is that if Mr. A give 1000 USD to Mr. B and Mr. B is required to pay back 1000 in 20 years so after 20 years the worth of 10,000 would not be same and therefore the interest element is added.
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