The fact that a safe dollar is worth more than a risky dollar. The recent debt crisis projects that the instruments that are about to be in default now were AAA+ rated some time back, that means they had almost no chance of default.
Hence, the Time Value Of Money formula is important to compare the riskiness adjusted value of different cash flows. For instance, if you had an option to lend out money to A at 5% per annum interest or B at 7% per annum interest, you can compare the relative riskiness of the cash-flows using the TVM formula.
The riskiness is compared using the discount factor, which includes the risk of default, alternative opportunity costs, inflation premium and many more components. However, one must understand that the Time Value of Money formula is not a formula in the mathematical sense of the world. It does not give you direct answers.
In reality, it is a framework. You still have to guess what numbers to put in the formula. Moreover, a slight variation in the inputs creates drastic variation in the output, which makes entering the correct input all the more vital.
The framework suggests that you use the respective discount factors on all streams of cash flows. This will bring them down to their risk adjusted present value. Now, these numbers are comparable with each other and you can choose the number with the highest net present value today. This approach is the best known so far and has always been recommended.…