The Role of Time Value in Finance - Essay Example

Financial Management-Reflection Paper April 28, 2011 The following evaluation will explain three of the most important financial concepts that I, believe to be very important professionally and personally. The role of Time Value in Finance Many financial managers and investors will confront opportunities to earn positive rates of return on firm funds. This may occur through investments toward attractive projects or in interest-bearing securities or deposits. The timing of cash outflows and inflows has valuable economic consequences. This concept, simply known as time value of money; is the concept that says a dollar today is worth more than a dollar that the firm receives at some future date. Time value in finance is considering two views. That time value has future value and present value. A time line that compounds to find future value and discounting to find present value shows compounding and discounting. Most financial managers will make decisions at time zero. That means that they rely primarily on present value techniques. The time value of money can show a personal finance example too. John Doe places $100 in a savings account paying 8% interest compounded annually at the end of 1 year he will have $108 in the account. The initial principal of $100 plus 8% or $8 in interest will appear in the account at the end of the year. The future value at the end of the first year, therefore, calculated by using the following formula. Future value at end of year 1=$100 x 1 + 0.08 = $108 PV=initial principal, or present value ί = annual rate of interest paid. FV n=PV X (1 +i) n The personal finance example would show that Jane Doe places $800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of 5 years. Substituting PV=$800, I=0.06, and n=5 gives the following equation. FV5=$800 times (1+0.06)5 = $800 times (1.338= $1,070.40. Time value of money is a critical financial tool to use as a financial manager or to figure one's own individual finances. The second most important concept is that a financial manager must learn to assess two key determinants: risk and return. Risk is the chance of financial loss. Assets having greater chances of loss, viewed as more risky than those with lesser chances of loss are. In financial management, risk is a term that is interchangeable with uncertainty to refer to the variability of returns associated with an asset. We need to understand what return is and how to measure it. The return is the total gain or loss experienced on an investment over a given period. We measure this by cash distributions during the period plus the change in value. We express this as a percentage at the beginning of the period investment value. To calculate the rate of return earned on an asset over period t, rƫ. The return equation would look like this rţ= actual, expected or required rate of return during period t Ct= cash (flow) received from the asset investment in the time period Pt=price (value) of asset at time t Pt-1 = price (value) of asset at time t-1 The combined impact of cash flow and changes in value as measured by rate of return is important. When dealing with Risk and Return the CAPM or capital asset pricing model. This is the theory that links risk and return together. We use CAPM, to understand the basic risk-return tradeoffs involved in all types of financial decisions. The equation that we use in CAPM is rj = return on asset j. Rf = risk free rate of return, commonly measured by the return on a U.S. Treasury bill. bj = beta coefficient or index of non-diversifiable risk for asset j. rm = market return; return on the market portfolio of assets. The personal example of the use of this tool is as follows. If our firm was looking into a growing computer software firm and wished to see how much it was really worth. We will first determine the required return of asset Z that has a beta of 1.5. The risk free rate of return is 7%; the return on the market portfolio of assets is 11%. Substituting bZ =1.5, rf = 7%, and rm=11% into the capitol asset pricing model given in Equation 5.8 yields a required return of 13%. The market risk is therefore good. The third concept that I believe important is Stock Valuation. At some point, it is likely we will personally hold stock as an asset for retirement programs. If someone wants to estimate the value of a stock and if the stock is selling below normal value, this may be the time to start investing. When its market price is above its value, it may be time to sell the stock. Some people rely on financial advisors to make buy and sell recommendations. It is important for individuals to understand how stocks are valued. When learning about stock valuation the important concepts were to know the difference between debt and equity capital. The rights, characteristics, and features of both common and preferred stock have value for future use. Therefore, knowing the process that we use to issue common stock, including venture capital, going public, and the investment banker, how to interpret stock quotes are all valuable future resources. Stock valuation is important when trying to understand the efficiency and basic common stock valuation using zero-growth, variable growth models. There are differences in the free cash flow valuation model and the book value of a stock, liquidation value, and price/earnings or (P/E) approaches. There are many relationships among financial decisions return, risk and the firm's value. Through this course the three most important concepts learning in Financial Management is the role of time value of money, determinates, of risk and return, and finally stock valuation. There continue to be linkages among financial decisions, where time value of money, return and risk and stock valuation being the three most important. Reference: Gitman, L., Principals of Managerial Finance. 2009. Pearson/Prentice Hall. Read More