FROM THE QUESTIONS Below, SELECT ONE AND PREPARE A CONCISE RESPONSE (at least 1
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Question
FROM THE QUESTIONS Below, SELECT ONE AND PREPARE A CONCISE RESPONSE (at least 1 page long), EXCLUSIVE OF CITATIONS, IF ANY
2. Why is the time value of money important in financial planning and forecasting?
3. Distinguish between a Defined Benefit and a Defined Contribution retirement plan. What are the benefits and limitations of each....which do you prefer and why?
4. In engaging in due diligence for any investment, what types of factors and issues might you focus on? Are there "levels" of due diligence?
5. What is insolvency and how does the concept differ from continuous operations despite the balance sheet data?
Explanation / Answer
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2) The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future; the dollar on hand today can be used to invest and earn interest or capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation.
Present Value
Present value = (future cash flow) / (1+ rate of return)^number of periods
Present value determines what a cash flow to be received in the future is worth in today's dollars. It discounts the future cash flow back to the present date, using the average rate of return and the number of periods. No matter what the present value is, if you invest that present value amount at the specified rate of return and number of periods, the investment would grow into the future cash flow amount.
Future Value
Future value = present value x {1 + (rate of return x number of periods)}
Future value determines what a cash flow received today is worth in the future, based on interest rates or capital gains. It calculates what a current cash flow would be worth in the future, if it was invested at a specified rate of return and number of periods.
Both present value and future value take into account compounding interest or capital gains, another important aspect for investors looking for good investments.
Simply put, the time value of money is the idea that a particular sum of money in your hand today is worth more than the same sum at some future date. For example, given the choice between receiving $1 today or $1 a year from now, you should take the money today. You could invest that $1, and even if you only earned a 2 percent annual return on your investment, you still would have $1.02 a year from now -- more than the $1 you'd have gotten if you waited. If you didn't invest that $1 at all but simply spent it, you'd still be better off; because of inflation, the $1 usually will have more buying power today than in the future.
Applications of Time Value in The Financial World
What we looked at in the previous examples was how to calculate the future value of a sum of money today, and how that relates to opportunity cost. We can also look at this in the opposite direction, and calculate the present value of a series of payments that we will receive in the future.
This is how bond values are calculated. If a bond has a coupon rate of 5%, and is going to pay me $10,000 when it expires in 3 years, I can calculate the value of all those future payments and give it a value in today’s dollars. This is called a present value calculation, and helps me decide if giving up my money today in exchange for a series of payments in the future makes sense.
This is why financial institutions charge interest. By loaning money to you, they are effectively losing the opportunity to use that money elsewhere to generate returns for themselves. In exchange for loaning the money out to you and ‘missing out’ on other opportunities, the bank requires interest payments as a form of compensation. Essentially by loaning you money, they are transferring ‘opportunity’ to you.
This is why racking up credit card debt is a bad idea. You’re squandering the opportunity of a valuable asset (money) to buy things that won’t produce returns, and generally paying interest rates as high as 20% or 30%. Ouch!
This is also where the idea of good debt comes from. If I borrow money to buy an asset that’s going to appreciate in value over time, then I’m essentially utilizing the opportunity that money has to gain in value over time.
Getting a mortgage to buy a house, or borrowing money to invest in stocks are both examples of good debt, and of using the opportunity of money to produce returns.
But that doesn’t automatically mean getting a mortgage or borrowing to invest makes sense for you, it just means that it can make sense. Everyone’s situation is different.
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