Value for Money
This article focuses on the concept of time value of money. Although the concept has a major influence on individual, business and government finances, this article highlights the concept's effects on individual and corporate finance. There is an introduction of corporate valuation and how corporations determine their worth. Understanding and calculating the worth of an organization allows the stakeholders to anticipate the present and future worth of the business. One can use this information in positioning the organization for growth, diversification or merger. In addition, there is a discussion of how individuals can utilize modern portfolio theory to develop an investment strategy that makes money over time.
Keywords Assets; Discounted Cash Flow Analysis; Future Value; Interest; Liabilities; Modern Portfolio Theory; Number of Periods; Owners' Equity; Payments; Portfolio Management; Present Value; Time Value of Money (TVM)
Finance: Value for MoneyOverview
The time value of money has an impact on every sector of society, which includes individual, business and government finance. Time value of money (TVM) is a basic priniciple in budgeting and investing. The time value of money tends to vary based on the situation. For example, the foundation of the concept relies on the premise that a dollar that one has today is worth more than the expectation that one will receive a dollar in the future. In essence, the money that one has today is worth more because the person can invest it and earn interest. Many would agree that the global economic system determines a basic time value of money according to the level of interest rates.
The foundation of the concept rests on the belief that one can determine the value that a single sum will grow to at some time in the future. This calculation is based on five elements. If one is given any four of the factors, the fifth factor can be calculated. According to Gallager and Andrew (1996), the five elements are: Interest rates; number of periods; payments; present value, and; future value.
- Interest: Charged for borrowing money; usually set as a percentage. There are two types of interest — simple and compound. Simple interest is computed on the original amount borrowed, and is the return on the principal for one time period. Compound interest is calculated each period on the original amount borrowed and all unpaid interest accumulated to date.
- Number of Periods: Evenly-spaced intervals of time. Each interval corresponds to a compounding period for a single amount or a payment period for an annuity.
- Payments: A series of equal, evenly-spaced cash flows. In TVM calculations, payments must represent outflows (negative amounts) or inflows (positive amounts).
- Present Value: An amount today that is equivalent to a future payment or series of payments that has been discounted by an appropriate interest rate. Since money has time value, the present value of a promised future amount is worth less the longer a person has to wait to receive it.
- Future Value: The amount of money that an investment with a fixed, compounded interest rate will grow to by some future date. The investment can be a single sum deposited at the beginning of the first period, a series of equally-spaced payments or both.
TVM is considered to be an important aspect of financial management. The concept can be used to compare investment alternatives as well as solve a variety of financial calculations such as loans, mortgages, and leases. One of the most popular ways to measure time value of money is through the rate of return that one can earn on an investment without losing any money.TVM & Investments
It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. Some of the tips that have been provided by organizations, such as the American Association of Individual Investors, include:
- Build and maintain a cash reserve to meet short-term emergencies and other liquidity needs.
- Develop an overall investment strategy even if it cannot be implemented immediately.
- Select mutual funds that fit into the overall investment strategy, then consider what the minimum initial investments are.
- Select a balanced fund for less aggressive investors or a broad base index fund for more aggressive investors. Build the portfolio after this initial investment has been completed.
- Review the percentage commitment to each stock market segment in order to determine when to add funds to the initial investment.
- Do not agonize over small deviations from the original allocation plan. Stay the course! (p. 1-2).
Financial counselors may inquire about whether or not an organization has some type of retirement plan (i.e. 401 (k) plan) in place for their employees or they may go directly to the employee for supplemental retirement opportunities. One popular approach that has emerged is the modern portfolio theory. Modern Portfolio Theory sounds like an academic and analytical concept; however, "it is the accepted approach to investment and portfolio management today" (American Association of Individual Investors, n.d.). The relationship between risk and return tend to form the foundation for investment theory. However, a third dimension, modern portfolio theory, can be added to the equation in order to create a framework that can assess investment opportunities that exist for the sole purpose of making money (Dunn, 2006).Application Modern Portfolio Theory
Modern Portfolio Theory (MPT) provides an opportunity for investors to utilize diversification in order to maximize the potential of their portfolio, and assumes that the investor is adverse to risk. Therefore, the investor will only take a risk if he/she has determined that the risk will provide them with a higher expected return. In essence, the investor has to be willing to take on more risk in order to be compensated with higher returns.
The concept can be used by both individuals and corporations, and can be used to determine how one can optimize his/her portfolio as well as what the price should be for a risky asset. According to the Association of Individual Investors, there are two parts of this approach and they are:
- First, focus on the concept that the best combination of assets should be developed by focusing on how the various components perform relative to each other.
- Second, focus on the belief that the natural outcome of many people searching for under priced securities in the markets should be an "efficient market" in which it is difficult to add value by finding under priced securities, especially since it is expensive to do so (par. 4 and 5).
MPT was introduced by Harry Markowitz, an economist and college professor, when he wrote an article entitled "Portfolio Selection" in 1952. He eventually became a Nobel Prize recipient for his work in the field. Prior to his work, most investors only focused on the best way to assess risks and receive rewards on individual securities when determining what to include in the portfolio. Investors were advised to develop a portfolio based on the selection of those securities that would offer them the best opportunity to gain. Markowitz took this practice and formulized it by creating a mathematical formula of diversification. "The process for establishing an optimal (or efficient) portfolio generally uses historical measures for returns, risk (standard deviation) and correlation coefficients" ("Modern portfolio theory," n.d., para. 6). He suggested that investors focus on selecting portfolios that fit their risk-reward characteristics (Markowitz, 1959).Viewpoint...
(The entire section is 3542 words.)