The Time Value of Money
*Explain the concept of time value of money. How would you use this in personal financial planning such as borrowing or saving for the future?
*Compare the process of compounding to determine future values and the process of discounting to determine present values.
*Compare characteristics of corporate bonds and stocks. List three to five characteristics. What is the difference between common stock and preferred stock?
*How does a company utilize stocks and bonds in financing growth? Identify the major sources of external financing for companies.
Sample Answer
The Time Value for Money
Time value of money concept is that the worth of certain amount of money is more now than in the future. This is because you can use that money to make an investment that will generate returns in the future. It is better to earn a certain amount now than wait to earn it in the future. The concept of the time value of money is valuable in financial planning as it will aid in deciding whether to borrow now for investment or save for the future (Joshi, 2019). The time value money argues that having money now is more important than money earned in the future. I will choose to borrow money and make investments and take advantage of opportunities that are available now, and reap the benefits. When one has a dollar on the hand today, they can invest and earn capital gains and interest (Rama-Poccia, 2018). A dollar that has been promised in the future will be worth less than a dollar that one has today because of inflation. When one knows how to calculate the time value for money through determining the present and the future value, one can differentiate between the investments worth that will provide returns in dissimilar times.
References
- Joshi, V. (2019). An Overview of Mathematics of Finance with Reference to ‘Time Value of Money. Available at SSRN 3351683. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3351683
- Rama-Poccia, M. (2018). What is the time value of money and why does it matter? TheStreet. https://www.thestreet.com/personal-finance/education/time-value-of-money-14796679
Compounding
Compounding involves calculating the current value of the future investment. It is issued to determine the current value of future returns if a certain investment decision is made. It can also be described as the time value of money in several periods into the future where the original amount is added interest. When the compounding periods are numerous in one year, the future investment value will be higher. Therefore, two periods of compounding every year are better compared to one while four compounding periods are better than two. To determine the future value, interest is credited to a principle amount that already exists as well as to the interest that has already been paid (Walther, 2021). It is interest on interest where banks and financial institutions credit compound interest in annual, monthly or daily periods.
Discounting involves calculating the present value of current cashflows. It is the present-day value of the future expected cash flows is a certain investment decision is made. Discounting helps in calculating the present value of a payment or payment streams that will be received in the future. A discount rate is applied to determine the present value. The rate is referred to as the foregone rate of return when an investor chooses to accept a sum in the future versus the same amount today (Fernando, 2022). The present value discount rate is very subjective since it is the anticipated rate of return one would get had they had invested a dollar today for a period of time.
References
- Fernando, J. (2022). How to calculate present value, and why investors need to know it. https://www.inv.com/terms/p/presentvalue.asa
- Walther, L. M. (2021). Compound interest and present value. principlesofaccounting.com. https://www.principlesofaccounting.com/chapter-24/compound-interest/
