Assignment Essay on Time Value of Money

Table of Contents
Time Value of Money .............................................................................................................................. 1 Time Value of Money Applications ......................................................................................................... 1 Discount and Interest Rate Components ................................................................................................ 3 Interest rate in determining future value ............................................................................................... 3 Conclusion ............................................................................................................................................... 4

Time Value of Money

One might know that time is one of the most valuable assets in our lives. In the financial world the value of money is linked to time, primarily because investors expect progressive returns on their cash over periods of time, and they always compare the return from certain investments with the going or average returns in the market. Inflation on other hand erodes the purchasing power of money causing future value of one rupee to be less than the present value of a rupee. This essay will examine time value of money and the applications that determine successes or failures. After defining the applications that generalize time value of money, an explanation will be offered regarding the components of interest rates by expanding on the concept that interest rate equates the future value of money with present value.

Time Value of Money Applications

Capital markets are markets "where people, companies, and governments with more funds than they need (because they save some of their income) transfer those funds to people, companies, or governments who have a shortage of funds (because they spend more than their income)". The two major capital markets are stock and bond markets. Capital markets promote economic efficiency by moving funds from those who do not have an immediate need for it to those who do. Individuals or companies will put money at risk if the return on the intended investment is greater than the return of holding risk-free assets. An example of this would be those that invest in real estate or purchase stocks and bonds. Those that invest want the stock, bond, or real estate to grow in value or appreciate. An example of this concept would be if an individual or company invested an amount saved over the course of a year. While investing may be riskier, these individuals hope that the investment will yield a greater return than leaving the money in a savings account drawing nominal interest. In this example the companies that issue the stocks or bonds have spending needs that exceeds their income so the company will finance their spending needs by issuing securities in the

capital markets. This is a method of direct finance because the "companies borrowed directly by issuing securities to investors in the capital markets". Opposite of direct financing is indirect financing which involves a "financial intermediary between the borrower and the investor". Banks would be an example of the intermediary because they may loan out money that an individual or company has left in a savings account. The capital marketplace could not exist without these intermediaries as they are what help create strong economies. Stocks and bonds are commonly called securities "because they both represent obligations on the part of issuers to provide purchasers with expected or stated returns on the funds invested or loaned". In the primary market firms issue securities and sell them initially to the public. When a company needs capital to expand a plant, develop products, acquire another firm, or pursue other business opportunities, it may make a stock or bond offering which gives investors the opportunity to purchase ownership shares in the firm and to take part in its future growth in exchange for providing current capital. Netscape and Yahoo! are examples of companies that have grown because of a stock offering in the primary market called initial public offering. Government agencies will also use primary markets to raise funds by issuing bonds. Treasury bonds to finance part of the budget deficit as well as state and local governments will issue municipal bonds to finance long-term capital projects in a community. A long-term capital project might be building a new school or park. Secondary markets consist of a "collection of places where previously issued shares of stock and bonds are traded among owners other than the issuing firms". A corporate security that represents the ownership or debt of a company is a stock or bond. The basic form of ownership in a business is the common stock. Purchasers of common stock expect to be paid dividends and/or capital gains that result from the increases in the value of the stock they hold. The value of the stock sold on either par value or no-par value cannot be confused with two other types of stock value, market and book value. The par value of a stock is an arbitrary value for the stock designated by the company. Since par value is arbitrary, most companies will issue no-par value stock. Market value of stock is the price the stock is currently selling at and book value is determined by subtracting the company's liabilities, including the value of any preferred stock it has issued, from its assets. The net figure is then divided by the number of shares of common stock resulting in the book value. Another form of stock issued by corporations is preferred stock. Preferred stock owners receive preference in payment of dividends. Unlike common stock holders who may lose money if a company fails, preferred stock holders will receive money if a company fails because preferred stock holders receive payment before any claim by common stockholders. Bonds are another way for a corporation to receive financing. In selling bonds, corporations obtain long-term debt capital. Bondholders have a claim on corporations assets should that corporation fail which must be satisfied prior to any claims that a preferred stockholder or common stockholder be satisfied. The three categories of securities that are used for the valuation and reporting on financial statements of corporations are trading securities, available for sale securities, and held to maturity securities. Trading securities are those securities that are "bought and held primarily for sale in the

near term to generate income on short-term price differences". Available-for-sale securities may be sold, and held-to-maturity securities are considered debt securities that the investor intends to or could hold on to until maturity. In examining other securities of a corporation one must also look at temporary investments or those securities that are held by a company that are readily marketable and intended to be converted into cash usually within a year or an operating cycle. If an investment does not meet both of the mentioned criteria, the investment is called a long-term investment. Long-term investments in available-for-sale securities are reported at fair value, and investments in common stock are accounted for under the equity method is reported at equity. Ensuring compliance and fairness in trading securities is a governmental agency known as the Securities and Exchange Board of India (SEBI). According the SEBI website (2013) the mission of the agency is "to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto" . The SEBI has oversight of those that participate in trading securities. This oversight ensures that important, relevant market-related information is shared so that securities can be traded fairly to help eliminate fraud.

Discount and Interest Rate Components

Interest rate is the cost of borrowing and is usually expressed as an annual percentage of the principal. While interest rates move the value of money forward in time, the discount rates move the value of money backward in time. Therefore, the discount rate is an interest rate used to convert the future value of money to an equivalent present value. Interest rate includes the real rate of interest and a premium for the expected rate of inflation. Real interest is the interest charged for compensating the lender for borrowing money. Real interest rate is determined by the supply and demand for loanable funds. Generally, strong demand for fund leads to higher interest rates, while increased supply leads to lower interest rates. The inflation premium of the interest rate is to compensate the investor for erosion in purchasing power of money over time due to inflationary effects. In other words, the inflation premium is necessary because the purchasing power of a rupee today is higher than it will be tomorrow, since rising prices will diminish the value of that rupee. In addition to real interest and inflation components, interest rates should be adjusted for the risk factor. Because future is uncertain and risk increases with time, a premium for risk will compensate the investor for the decrease of the value of money over time.

Interest rate in determining future value

Future value is the "value of an amount that is allowed to grow at a given interest rate over a period of time". Therefore, the future value consists of the original amount of money invested and the return in the form of interest. The general formula for computing future value is FV = PV(1 + i)n, where FV is the future value, PV is the present value, i is the interest rate, and n is the number of periods. In the formula, i represent the interest rate per period, not the annual interest rate.

Discount rate in determining present value To calculate present value, a discount rate must be determined that takes in consideration how much risk is associated with a project or an investment. High risk means high discount rate while low risk means a low discount rate. The formula for computing present value is derived from the future value formula, therefore, PV = FV / [(1+i)n].

Conclusion
Time value of money is the basic concept applied by various governmental, financial and investment institutions and companies in valuing securities and capital investments. Prices of bonds are determined by using discount rates, time to maturity and face value. Banks use the time value of money principle in calculating annuities on home loans based on interest rates, present value of principal and amortization period. Pension and other fixed income funds also determine annuities based on the time value of money. Individuals and families have to consider Time Value of Money in deciding how to invest for retirement or college expenses, whether or not to buy on credit or save up for major purchases, when to purchase a house and how much to pay for it, etc. Decisions about taking equity out of their homes to pay off debts or to purchase items should be based on opportunity cost and time value of money. Time value of money serves as the foundation of finance and the way of life. Any individual that has a goal to prosper in the future needs to always make sure on the weight of everything. Being knowledgeable of savings and investing is very important. It is a valuable tool in building a successful company as well as in building a sound financial basis for a family.