In accounting, time value of money indicates the relationship between time and money. Basically a dollar received today is worth more than a dollar owed at some time in the future. A dollar is worth more today because of the opportunity to invest the dollar and receive interest on the investment.
What is interest? Interest is payment for the use of money. It is the excess cash received or repaid over and above the amount of money lent or borrowed. For example, if you lend a friend $100 at the rate of 10 percent per year. After a year, your friend would owe you $110 ($100 borrowed plus $10 in interest).
There are two methods of computing interest on money, simple interest and compound interest.
1. Simple interest is the return on the principal for one time period. The previous example is an example of simple interest. Every year, interest is calculated based on the original amount lent or borrowed.
2. Compound interest is the excess cash received over and above the amount of money lent or borrowed for two or more time periods. Compound interest uses the accumulated balance (original amount plus interest to date) at each year-end to compute interest in the next year.
Take the previous example, and change it from simple interest to compound interest. During the first year, you would earn $10 in interest, $110 total. After the second year, you would earn $11 in interest, for a total balance of $121. The extra dollar comes from the extra interest earned on the original balance plus interest earned in year 1 ($110 X 10%).
The extra money earned by compounding interest makes it the obvious preferred method. Compound interest is the typical method applied in business situations.