A dollar today is worth more than a dollar tomorrow
One of the most important concepts in finance is time value of money that means that money has its value. This means that a dollar in hand today will be worth more than a dollar a person will have in the near future. For example, that a dollar that is invested today in saving account or in some bond will have an interest added in it on an annual basis that will eventually result in the rise of dollar value in the future. (Business Finance Online, 2013) This occurs because of:
- Risk and Uncertainty is always present because no one can pre-determine the future well, but we can always control the expense because it is in our control whereas there is no conformity of cash flows in future.
- When the inflation is rising in an economy, money loses its value day by day. So the money we receive today has more value than the one that we will tomorrow because it effects the purchasing power of individuals too.
- Current or future investment opportunities are present. A dollar that is invested today in saving account or in some bond will have an interest added in it on an annual basis that will eventually result in the rise of dollar value in the future.
How would you apply time value of money concept to the scenario
This concept can be utilized using the time value of money. For this, we will discuss Net Present Value (NPV). This calculates the money that will be received in the future as compared to what an individual has today. This will clearly state how time effects value of money. If you want to save up for next two years with money you have in hand today, it is important to realize the earning potential of that dollar today. When we invest our current earnings in purchasing national saving bonds or in saving accounts, etc. we earn a certain amount of interest based on rate of return. When we calculate this profit with our capital invested amount, we can find out the total that will be accumulated at the end of two years to go on spring break trip. (Foreman,2012)
Why is stock valuation difficult then bond valuation?
We know that the value of stock is dependent on the performance of the stock. The better the performance is, the more reliable the stock becomes for the investor to invest in and the value of stock increases and the same happens when the stock is not performing well, the investor confidence reduces on stock and the value is reduced. So from this is clear, that at different time the confidence of investor is different at stock. For example, at one time the company might be performing better but at another time the performance is not up to the mark. Hence, the value of stock fluctuates accordingly and due to this fluctuation the investor tries to invest or sell stock. This makes stock valuation more difficult than bond valuation because in case of bond payments, there is certain fixed amount of payments that we know are due but in stock valuation this is not the case hence the dividends are not expected. Secondly, the investment that is done in stock has no maturity point, and thirdly due to the stock price fluctuation the rate of return of investment cannot be figured out easily. (Hans Peter Hesse, 2010)
Business Finance Online (2013) “The Time Value of Money”
Gary Foreman (2012) “ Understanding the time value of Money- Its about time
Hans-Peter Hesse (2010) “The Value of Common Stocks” http://university.akelius.de/library/pdf/value_of_c_hesse_hans1010.pdf