Time value of money. Stocks and bods market

Time Value of Money

Time value of money is a key concept in finance. In essence, time value of money is the recognition that a dollar today and a dollar at some time in the future do not have the same worth at this moment in time. In short, time is money.

Most of us want more of things now rather than later. You have heard the expression “time is money.” What is the meaning of this? Economists call this concept a positive time preference—we prefer things now as opposed to later. This preference gives rise to the concept of time value of money (TVM).

A positive time preference influences the value of money today versus the value of money tomorrow. Because we prefer money now, we want to be compensated for waiting until tomorrow.

We tend to value things less that are in the future, relative to things that might happen in a short time period. In other words, we discount the future. Furthermore, the time value of money also represents the cost of using money and the money itself. Will Rodgers, a famous entertainer in the 1930s during the Great Depression, said he wasn’t worried about the return on his money, so much as the return of his money.

The main elements of time value of money are money (cash), interest, and time. The formula or equation for present value and future value for either a lump sum or an annuity contains mathematical operations: addition, multiplication, and exponents.

Basic Elements of TVM

Money can be received or given in two main ways. The first is as a one-time amount—either an inflow or outflow, today or tomorrow. This is a lump sum. If we are determining the value today, it is a present value. If we are talking about a value to be received or paid in the future, it is a future value.

Second, the money might be received in a series of cash flows over time, such as an annuity or a payment. This is a series of cash flows. The flow or stream may be an even amount each period, or uneven.

Finally, money may come in as a combination of a series of cash flows and/or a lump sum. For example, a bond, debt issued by corporations or governments, has periodic cash flows, interest payments, and a lump sum—the principal or par value of the bond.

Interest is the way we recognize that compensation is needed for waiting until the future to use money. We have to pay for getting the money sooner, or be compensated for waiting until later.

An interest rate is the interest payment divided by the principle or balance of a loan. The interest payment may be received annually, semiannually, monthly, and so on. You may earn interest on interest and principal. This is compounding, or the inverse of discounting. When you deposit money in the bank and earn interest over time you are receiving compound interest.

The interest element represents the opportunity cost of using money. John Maynard Keynes, an economist, suggested we hold money for three motives: transactions, precautionary, and speculative. That is, we hold money because we need it for making purchases in the short term, to have in case of emergencies, or to have in case we find a “good deal.”

Here is an example of using a financial calculator for a car loan.

You want to buy a car with a $1,000 down payment. The loan amount is $9,000. The annual interest rate is 6% and the loan is for 60 months. What are your payments?

First, set your calculator to monthly payments.

Be sure to set your calculator to the appropriate payments per year. Most problems are annual—one payment per year.

Securities Market

The value of a financial asset is the present value of the cash flow received from owning, selling, or both. Two common financial assets are bonds and stock. Key equity funding sources are preferred stock, common stock, and retained earnings.

Equity is a means of funding long-term investments by using owners' capital. When raising new equity capital in the primary markets, firms sell shares of stock to investors. In this case, firms are raising funds by extending ownership in the company.

Stocks (or shares) are certificates that represent ownership in an entity. Investors purchase stock with the goal of maximizing rates of return. Investors attain rates of return through dividends and capital gains. Dividends are the portion of earnings paid to owners as rewards for their investments.

Capital gains represent the percentage of increase in stock price from one period to the next. Capital gains are “realized” if investors “cash in” on the gains. Investors cash in by selling shares to other investors in the secondary markets. These gains also can be realized if shares are sold back to firms in a stock repurchase transaction. If investors do not cash in, the gains are said to be “unrealized.” Whether realized or not, management must make gains available by maximizing the firm's value.

For stocks, the balance sheet presents the number of shares authorized, the number of shares issued, and the number of shares outstanding. The statement also presents total par value and total additional paid in capital.

 Number of shares authorized:

• Maximum number of shares that can be outstanding at any point in time

• Set by the firm's board of directors as an attempt to control the degree of ownership in the firm and minimize dilution effects on earnings per share (EPS)

• This “authorized” figure is not used in any calculations

Number of shares issued:

• Number of shares sold to investors over time

• Figure affects the capital contribution made by investors

Number of shares outstanding:

• Number of shares in the possession of investors at a given time

• Dividend payments are made on shares outstanding

• Equity figures on balance sheet are based upon shares outstanding