What does the time value of money illustrate?

The time value of money is a fundamental financial concept that emphasizes that a dollar today is worth more than a dollar in the future. This principle is based on the potential earning capacity of money; if you have a dollar today, you can invest it and earn interest or returns over time. In contrast, a dollar received in the future does not have the same potential to earn returns during that interim period.

Additionally, the concept accounts for inflation, which generally diminishes the purchasing power of money over time. Therefore, receiving money today allows one to capitalize on investment opportunities and/or avoid the erosion of value due to inflation.

This foundational principle underpins many financial decisions and calculations, including net present value, internal rate of return, and various annuity and loan evaluations. Understanding that money's value changes over time is crucial for making informed investment choices.