Time 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 Money

Overview

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

Corporate Valuation

There are some specific measures that corporations must take in order to ensure that their entities have value over time. In order to effectively manage a company, it is important to know how much it is worth. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is potential to make fatal mistakes that may be detrimental to the organization's well-being. There are different ways one can determine the value of an organization, and some of those methods are discussed below.

Asset-Based Methods

Asset-based methods began with the "book value" of an organization's equity. An organization's equity is defined as the organization's assets minus its debt. Corporations are charged with two major responsibilities, that they: Acquire financial and productive resources, and; combine the resources in order to create new resources. Acquired resources are called assets, and the different types of assets are called equities. Therefore, the foundation for the basic accounting equation is "Assets = Equities." However, since equities can be divided into two groups, the basic accounting equation can be revised to read as "Assets = Liabilities + Owners' Equity."

• Assets. Although assets consist of financial and productive resources, not all resources are considered to be assets. In order to determine if a resource is considered to be an asset, it must satisfy all three of the following criteria:
• The resource must possess future value for the business. The future value must take the form of exchange ability (i.e. cash) or usability (i.e. equipment).
• The resource must be under the effective control of the business. However, legal ownership is not mandatory. As long as the resource can be freely used in business activities, the resource will met the asset criteria. An example would be a leased computer. Although the organization may use the computer, legal rights still belongs to the leasing company.
• The resource must have a dollar value resulting from an identifiable event or events in the life of the organization. The value assigned to the asset must be tracked to an exchange between the organization and others (Page & Hooper, 1985).

If the resource does not meet all of the criteria, it cannot be reported as an asset.

• Liabilities. When someone other than the owner provides an organization with an asset, the claims against the business take the form of a debt. Sources of assets from someone other than the owner are referred to as liabilities. Liabilities are the debts and legal obligations that a business incurs as the result of acquiring the assets from non-owners.
• Owners' Equity. Some businesses may obtain assets via owner investment or sale of stock. When the owner supplies the organization with assets, the claim against those assets is called owners' equity (or stockholders' equity) in a financial report.

Another way to measure an organization's value is to determine its current working capital and its relationship to market capitalization. Working capital can be defined as the amount left once one has subtracted the organization's current liabilities from its current assets. Working capital is the amount of funds that an organization has ready access to for use in conducting its everyday business.

Shareholder equity helps one to determine the value of an organization when there is a need to calculate the book value. The book value of an organization is the value of an organization that can be found on the accounting ledger. To calculate book value per share, one has to take the organization's shareholder's equity and divide it by the current number of shares outstanding. The next step is to take the stock's current price and divide it by the current book value in order to get the price-to-book ratio.

Comparables

The most common way to value a company is to use its earnings. Earnings, also referred to as the net income or net profit, are the amount of cash that is available after the organization has paid its bills. In order to make a valid comparison, one has looked at earnings and measures them according to its earnings per share (EPS). An accountant may calculate the earnings per share by dividing the dollar amount of the earnings that is reported for an organization by the number of shares it currently has outstanding. However, it should be noted that earnings per share alone does not mean anything. In order to evaluate an organization's earnings relative to its price, most financial professionals will use the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings.

Free Cash Flow Methods

Cash flow is seen as the most common measurement for valuing public and private companies used by investment bankers. Cash flow is defined as the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Cash flow tends to be the only method that makes logical sense in most situations.

The argument for the discounted free cash flow method is that an organization's value can be estimated by forecasting future performance of the business and measuring the surplus cash flow generated by the organization. The surplus cash flows and cash flow shortfalls are discounted back to a present value and added together to arrive at a valuation. The discount factor used is adjusted for the financial risk of investing in the company. The mechanics of the method focus investors on the internal operations of the company and its future.

The discounted cash flow method can be defined in six steps. Given the fact that this method is based on forecasts, it is crucial that the financial professionals of an organization have a good understanding of the business, its market and its past operations. The steps in the discounted cash flow method are as follows:

• Develop debt free projections of the company's future operations. This is clearly the critical element in the valuation. The more closely the projections reflect a good understanding of the business and its realistic prospects, the more confident investors will be with the valuation it supports.
• Quantify positive and negative cash flow in each year of the projections. The cash flow being measured is the surplus cash generated by the business each year. In years when the company does not generate surplus cash, the cash shortfall is measured. So that borrowings will not distort the valuation, cash flow is calculated as if the company had no debt. In other words, interest charges are backed out of the projections before cash flows are measured.
• Estimate a terminal value for the last year of the projections. Since it is impractical to project company operations out beyond three to five years in most cases, some assumptions must be made to estimate how much value will be contributed to the company by the cash flows generated after the last year in the projections. Without making such assumptions, the value generated by the discounted cash flow method would approximate the value of the company as if it ceased operations at the end of the projection period. One common and conservative assumption is the perpetuity assumption. This assumption assumes that the cash flow of the last projected year will continue forever and then discounts that cash flow back to the last year of the projections.
• Determine the discount factor to be applied to the cash flows. One of the key elements affecting the valuation generated by this method is the discount factor chosen. The larger the factor, the lower the valuation it will generate. This discount factor should reflect the business and investment risk involved. The less likely the company is to meet its projections, the higher the factor should be. Discount factors used most often are a compromise between the cost of borrowing and the cost of equity investment. If the cost of borrowed money is 10% and equity investors want 30% for their funds, the discount factor would be somewhere in between — in fact, the weighted-average cost of capital.
• Apply the discount factor to the cash flow surplus and shortfall of each year to the terminal value. The amount generated by each of these calculations will estimate the present value contribution of each year's future cash flow. Adding these values together estimates the company's present value assuming it is debt free.
• Subtract present long term and short term borrowings from the present value of future cash flows to estimate the company's present value (Giddy, n.d., p. 2).

Option-Based Valuation

Many financial professionals still have issues with the amount of risk and uncertainty in evaluating investments and acquisitions. Despite the use of net present value (NPV) and other valuation techniques, these individuals are often forced to rely on instinct when finalizing risky investment decisions. Given the shortcomings of NPV, real options analysis has been suggested as an alternative approach. This approach considers the risks associated with an investment while recognizing the ability of corporations to defer an investment until a later period or to make a partial investment instead. Basically, investment decisions are often made in a way that leaves some options open. The simple NPV rule does not provide accurate conclusions as to whether or not uncertainty can be managed. In acquisitions and other business decisions, flexibility is crucial, and the value of flexibility can be taken into account explicitly, by using the real-options approach.

Financial options tend to be used for risk management in banks and firms. Real or embedded options are analogs of these financial options and can be used for evaluating investment decisions made under significant uncertainty. Real options can be identified in the form of opportunity to invest in a currently available innovative project with an additional consideration of the strategic value associated with the possibility of future and follow-up investments due to emergence of another related innovation in the future, or the possibility of abandoning the project.

The option is worth something because the future value of the asset is uncertain. Uncertainty increases the value of the option. If the uncertainty is interpreted as the variance, there are possibilities for an organization to earn higher profits. The loss on the option is equal to the cost of acquiring it. If the project turns out to be non-profitable, one may have the choice of not exercising the option. The real options approach is finding its place in corporate valuation.

Conclusion

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.

It has been suggested that most Americans do not know how to save or prepare for their future. 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.

In order to effectively manage a company, it is important to know how much it is worth. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is a potential to make fatal mistakes that may be detrimental to the organization's well-being.

Terms & Concepts

Assets: Any item of economic value owned by an individual or corporation, especially that which could be converted to cash.

Discounted Cash Flow Analysis: A valuation method used to estimate the attractiveness of an investment opportunity.

Future Value: Future value is 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.

Interest: A charge for borrowed 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.

Liabilities: Total assets minus total owners' equity.

Modern Portfolio Theory: A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Number of Periods: Evenly-spaced intervals of time; each interval will correspond to a compounding period for a single amount or a payment period for an annuity.

Owners' Equity: Total assets minus total liabilities.

Payments: A series of equal, evenly-spaced cash flows. In TVM calculations, payments must represent outflows (negative amounts) or inflows (positive amounts).

Portfolio Management: The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk vs. performance.

Present Value: Present value is 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.

Bibliography

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American Association of Individual Investors (n.d.). From theory to practice: How to apply MPT concepts to your 401(k) plan. Retrieved September 27, 2007, from http://www.aaii.com/includes/DisplayArticle.cfm?Article%5fId=2974&ro=2245

American Association of Individual Investors (n.d.). Investing basics: Investing questions that every successful investor should know how to answer. Retrieved September 27, 2007, from http://www.aaii.com/faqs/investingbasics.cfm

American Association of Individual Investors (n.d.). The ten myths of retirement planning. Retrieved September 27, 2007, from http://www.aaii.com/includes/DisplayArticle.cfm?Article%5fId=2977&digit=256

Dunn, B. (2006, August). Modern portfolio theory — with a twist: The new efficient frontier. Retrieved on September 27, 2007, from www.aquillian.com/docs/AquillianEfficientFrontier.pdf

Ennis, H.M. (2012). Some theoretical considerations regarding net asset values for money market funds. Economic Quarterly (10697225), 98(4), 231-254. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90037644&site=ehost-live

Gallager, T., & Andrew, Jr., J. (1996). Financial management: Principals and practices. Upper Saddle River, NJ: Prentice Hall.

Giddy, I. (n.d.). Methods of corporate valuations. Retrieved December 14, 2007, from http://pages.stern.nyu.edu/~igiddy/valuationmethods.htm

Markowitz, H. (1959). Portfolio selection: Efficient diversification of investments. New York, NY: John Wiley.

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Page, J., & Hooper, P. (1985). Microcomputer accounting and business applications. Reston: Reston Publishing Company, Inc.

Rosca, V. (2013). A model for measuring value for money in professional sports. Theoretical & Applied Economics, 20(7), 77-86. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89750400&site=ehost-live

Suggested Reading

Bland, L. (2005). A modern take on an old portfolio theory. Money Management, 19(16), 26-26. Retrieved September 27, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17176205&site=bsi-live

Darwish, M. (2006, March). Imperfect production systems with imperfect preventive maintenance, inflation, and time value of money. Asia-Pacific Journal of Operational Research, 23(1), 89-105. Retrieved January 2, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20577939&site=bsi-live

Gill, J. (2007). Your rates: Are they value for money? Chartered Accountants Journal, 86(10), 16-17. Retrieved January 9, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27464654&site=bsi-live

Grundy, P. (2007). Value for money? Circuits Assembly, 18(11), 30-31. Retrieved January 9, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27452365&site=bsi-live