 The time value of money simply means that the value of money, i.e. purchasing power, changes over time. It is based on two fundamental ideas. The first is that invested money earns income over time. We call this interest usually. The second is that cash received sooner is preferred over cash received later. Let's dive into both of these concepts starting with interest. Generally, there are two ways to calculate interest. Simple interest is when interest is only calculated on the principal amount. Compound interest is when interest is calculated on the principal amount and on the interest earned to date. Here's an example of simple interest. As you can see that $10,000 earning 5% annually results in $500 of interest per year. Over five years, that's $2,500 of interest earned. Here is an example of compound interest. The same $10,000 earning 5% annual compound interest results in $2,763 of interest over that same time period. My good friend and yours Albert Einstein is credited with the following quote. Compound interest is the eighth wonder of the world. He who understands it earns it. And he who doesn't pays it. The other basic concept of the time value of money is we would prefer to receive cash sooner rather than later. This is because a dollar received today is worth more than a dollar received tomorrow. Or perhaps a better example is $1,000 received today is worth more than $1,000 received next year. You all know this to be inherently true even if you don't know why. Ask yourself if your grandpa offered you $1,000 today or $1,000 when you graduate college, which would you choose? Of course you would choose today. The reason is because today's dollar can be invested so that you would have more than $1 tomorrow or more than $1,000 when you graduated college. Let's wrap up this video by learning some terms that will be used when we apply time value of money to capital budgeting. The principal amount or the initial investment or a single amount are one-time cash flows. They can occur anytime over the life of the project. They can be an inflow or an outflow. However, the initial investment occurs at the beginning and it is a cash outflow. An annuity is a reoccurring cash inflow or outflow of equal amounts made at equal time intervals. So they are regular cash flows occurring year after year rather than a one-time amount. There are two classifications of annuities. Ordinary annuity is when the cash flow occurs at the end of the period and an annuity due is when the cash flow occurs at the beginning of the period. For capital budgeting purposes, annuities are ordinary annuities. In accounting, the only example that I can think of where we use an annuity due is when we price capital leases. Future value is the value an asset will be worth in the future in terms of future dollars. For example, an investment will be worth $1 million when I retire. The problem with future value is we aren't sure about the purchasing power of $1 million 20 years from now. Present value is the value of an asset in today's dollars. So let's assume that my investment will be worth $1 million when I retire, but it has a present value of $350,000. Now the problem is resolved because I understand the purchasing power of $350,000 today. So in accounting, we only use present value for our calculations. Finance uses future value, but accounting does not. The interest rate is the annual percentage earned on the investment or the cost of funds used to finance the investment. It has some other names that are shown on the slide. And finally, the number of periods is the length of time from the beginning of the investment until the end. It could be divided into interest payment periods or annual cash flows. So you will be seeing these terms in action in the next several videos.