Time value of money (TVM) is the current value of an amount of money versus the value of that similar amount in the future. This is an essential principle in understanding the real value of money. This financial principle highlights the notion that having cash at hand is better than any future promise of earning. The opportunity cost of having funds now is much higher than the promised earning of tomorrow. In business, it means that companies have to weigh the pros and cons of receiving a cash payment immediately for goods or services rendered or passing up the opportunity to earn interest on the amount in the short term (Brigham & Daves, 2012). The financial principle is also an essential principle in understanding and comparing short term financial benefits versus long term gain. This paper will explore TVM and bond valuation.
According to TVM, money that is presently available is worth more compared to a similar sum that will be availed in the future. This difference in value is attributed to the present sum’s earning capacity ( Drake & Fabozzi , 2009 ). Time value of money is one of the core financial principles and holds that as long as money can earn interest, the sooner that any amount of money is received the better. Often, TVM is termed as the present discounted value. The concept is highly applicable in the financial management of entities, on the capital market, in banking, as well as in an individual’s day-to-day life ( Drake & Fabozzi , 2009). The notion that a given sum of money is worth more today than the same amount tomorrow is justifiable in three ways. Firstly, people prefer present consumption as opposed to future consumption. In this case, for people to give up consumption in the present, they have to be offered more in the future. Secondly, in the case of monetary inflation, the value of the currency has to decrease over time. In this case, greater inflation is accompanied by a greater difference between the value of a given sum today and the value of the same sum tomorrow. Thirdly, in case the future cash flow is associated with risk or uncertainty, the value of that cash flow is bound to decrease.
Delegate your assignment to our experts and they will do the rest.
In banking, TVM is necessary since, individuals with spare money and a desire to invest it may decide to lend the money directly to borrowers and in exchange get period payments of the principal amount and the interest ( Drake & Fabozzi , 2009). Nevertheless, this approach entails both resources and costs for both the borrower and the lender. Time value of money is particularly applicable in financial management in the selection of investment projects. The concept is also the basis of the majority of financial models used in capital budgeting, financial management, financial derivatives, and investments. In capital budgeting, TVM is applicable in the two key models notably Net Present Value (NPV) and Internal Rate of Return (IRR). The NPV is the difference between the present value of cash inflows and cash outflows over a given period. Conversely, IRR is used in capital budgeting as a means of estimating the profitability of the potential investments. In both models, TVM is used to calculate the present value of future cashflows. Moreover, TVM is used in preparing feasibility studies
A proper understanding of th e principle of time value of money can help corporate managers prepare and plan for its financial implication particularly in the context of investment. Many top - level executives are met with the dilemma of having to balance between the short term gains and long term benefits. Corporate managers need all the tools that can help them make financial decisions that benefit their companies. Financial planning is a crucial part of the decision-making process and often requires all the information necessary . This information helps in ensuring that the process is credible, objective and profitable ( Brigham et al., 2016) . Weighing the potential long term benefits versus the short term gains is a process that could be made easier through understanding the time value of money. Investments are an essential element of any company's future. The time value of money is a critical principle in understanding the potential returns of a given investment. Balancing between cash at hand, debt obligations , and investment portfolios is an important element in the management of a company’s finances ( Brigham et al., 2016) . Projecting a company's potential return after a certain period is thus essential in planning for a company’s future.
Sinking funds are funds that are established for the purchase of bonds, service of debt or large capital expenses (Brigham et al . , 2016). The se funds are set up by making contributions through an established pattern especially for the purchase of bonds at times that are deemed ideal. In this case, a sinking fund is developed by companies following the issuance of bonds. This is accomplished by setting aside some money to aid in paying back the total amount of the bonds issued.
Sinking funds possess certain advantages and disadvantages both from an investor’s and bondholder’s perspective. Concerning advantages, s inking funds help in reducing the debt and the risk associated with paying back the loan. They also allow a company to enjoy a strong reputation with creditors and potential investors. When a company or a corporation issues a bond in the open market, it needs to assure all potential investors that it will not default on its obligations. Investors prefer to put their money in entities that at the very least, guarantee their investments ( Brigham et al . , 2016 ) . A sinking fund goes a long way in inspiring confidence in the market. Sinking funds also enable a company to enjoy a stronger financial position when it comes to the repayment of bond obligations and other commitments. Further, a sinking fund solidifies a company's position and cements its ability to respond to market demand s.
One of the common disadvantages of a sinking fund is that a company may opt to make early purchases on bonds issued as a means of reducing its financial obligations . This implies that an investor often will lose out on interest payments if bonds are bought early. A sinking fund also carries another risk with investors because companies reserve the right to purchase bonds issued at a discount price ( Brigham et al . , 2016 ) . Companies are also entitled to buy back bonds at the par value of the bond issued. This can lead to lost revenue for investors who would have had a better chance of obtaining a return by selling their bonds in the open market. Overall, a financial manager’s knowledge of sinking funds and their application is beneficial to both investors and the ir compan ies. This is because the funds help to create a stable balance between assisting a company in obtaining a stronger financial footing. This is achieved by using the fund as a tool to solidify its position and prepare for future financial obligation s.
References
Brigham, E. F., Ehrhardt, M. C., Nason, R. R., & Gessaroli, J. (2016). Financial Management: Theory And Practice, Canadian Edition . Nelson Education.
Brigham, E., & Daves, P. (2012). Intermediate financial management . Nelson Education.
Drake, P. P., & Fabozzi, F. J. (2009). Foundations and applications of the time value of money (Vol. 179). John Wiley & Sons.
