Money today is more valuable than the same money to be received later only for the sole reason of time value in the money. But if there is an interest rate then that same money will be more valuable in the future. This nature is due to the compounding effect of time and interest. In an economy presence of inflation decreases the purchasing power and value of the dollar in the future. So, the interest rate that should be provided should incorporate three basic rates namely:

Inflation: compensation for loss of purchasing power

Real return: compensation for deferred consumption

Risk premium: compensation for taking the risk.

Taking the concept of the time value of money into the decision-making process is essential as it also accounts for opportunity costs. While valuing bonds, pricing of futures or forwards or even loan pricing time value of money should be accounted for. The time value of money has two concepts namely the compounding effect and discounting effect.

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