UNIT IV STUDY GUIDE Time Value of Money and Bonds Course Learning Outcomes for Unit IV Upon completion of this unit, students should be able to: 3. Apply time value of money techniques to various valuation and budgeting problems. 3.1 Calculate the annual payment on a loan using the present value of an annuity. 3.2 Use discounting to determine the present value of an annuity. 3.3 Calculate the future value of an annuity and periodic annuity payments. 6. Evaluate stock and bond valuation. 6.1 Determine the present value of a bond. Course/Unit Learning Outcomes 3.1 3.2 3.3 6.1 Learning Activity Unit Lesson Chapter 9 Unit IV Assessment Unit Lesson Chapter 9 Unit IV Assessment Unit Lesson Chapter 9 Unit IV Assessment Unit Lesson Chapter 10 Unit IV Assessment Required Unit Resources Chapter 9: Time Value of Money Chapter 10: Bonds and Stocks: Characteristics and Valuations Unit Lesson In this unit, we will study two important areas of finance: the time value of money which was introduced in Unit I and bonds. We will examine the time value of money formulas for present value and future value calculations. Further, we will learn how the discount rate and time periods factor into the calculations. By the end of this unit, you will no longer wonder how much to save each year for retirement. You will learn practical ways of handling money and planning for the future. Money is an important part of functioning in society as it provides citizens with the means to purchase goods and services such as housing, food, and clothing. Money, however, does not retain the same value over the course of time, fluctuating with inflation and other factors in the economy. Moreover, bonds are also commonly used in the American economic system, often with a goal of earning interest in the future. Bonds are also subject to fluctuations in value, with time playing a large role in the fluctuations experienced. It is therefore crucial that individuals understand the time value of money and bonds, in addition to bond valuation, dividends and stock repurchases, compounding and discounting, and how time value applies to everyday life. BBA 3301, Financial Management 1 Time Value of Money and Bonds The time value of money is the concept that money today is worth more than an identical amount in the future (Martinez, 2013). In turn, calculating time value of money is important in ensuring the individual receives the greatest amount of value for his or her money or bonds (Martinez, 2013). For instance, $100 currently has the value of $100. However, in one year, that same amount of currency might only be worth $90.91 if you calculate for a 10% rate of interest over the course of a year (Chen, 2011). Therefore, it is more beneficial to take the $100 now rather than a year from now when the time has created a devaluation of almost $10 (Chen, 2011). Alternatively, if a person is offered $100 today or $200 in two years, they would be better off taking the $200 in two years as the present value would be around $165 with 10% interest calculated (Chen, 2011). It is important that people understand how to calculate the time value of money before making fiscal decisions regarding accepting money at certain intervals (Martinez, 2013). UNIT x STUDY GUIDE Title Time matters when it comes to money. (Iam, 2017) Bonds Bonds are essentially a promissory note purchased from a company or the government that are guaranteed to be paid back in full along with receiving regular interest payments (McGowan & Joyner, 2015). However, a bond differs from a stock purchase in a company, which provides ownership, while also differing from a typical loan (McGowan & Joyner, 2015). There are around seven different categories of bonds including treasury bonds, government bonds, investment/corporate bonds, high-yield bonds, mortgage-backed bonds, municipal bonds, and foreign bonds (McGowan & Joyner, 2015). Bond Valuation Bond valuation is an important part of the bond consideration process. Since the market value of bonds can fluctuate, bond valuation provides a technique for determining the value of a bond currently and in the future when it matures (Johnson, 1995). Investors will therefore examine the present value, or face value, of the bond, the coupon payment, the required rate of return, or interest, and the length of time until the bond reaches maturity, in order to obtain the unknown price, or value, of the loan over time (McGowan & Joyner, 2015). Dividends and Stock Repurchases Dividends, or a sum of money regularly paid by a company out of its profits, can become challenging when dealing with bond valuation as lowered company profits may result in an inability to pay the bond payments on time (Johnson, 1995). Similarly, stock repurchasing may have additional transactional costs in which gains to shareholders are obtained at the expense of bondholders who made an agreement for payments with different shareholders (Maxwell & Stephens, 2003). It is, therefore, important to pay close attention to bonds that are provided to corporations who are at a higher likelihood to engage in share repurchasing than their governmental counterparts (Maxwell & Stephens, 2003). Compounding and Discounting In order to ensure that a bond will be lucrative in the future, the investor will want to use compounding and discounting in order to calculate the potential earnings or losses that may be incurred when purchasing a bond (McGowan & Joyner, 2015). For instance, compound interest is a method used to calculate the application of time to money or bonds and will provide the investor with the amount he or she will earn at the maturity of the bond or after a certain length of time left in a savings account accruing interest (McGowan & Joyner, 2015). Discounting, however, provides the investor the means to calculate the present value of the BBA 3301, Financial Management 2 money he or she would receive in the future, which will display whether it is worth for the money or if UNITwaiting x STUDY GUIDE the investor will be at a loss in the long run based on present money value (McGowan Title & Joyner, 2015). The power of compounding—it can have a huge impact on your savings! (Siraanamwong, n.d.) Why is compounding and discounting so important? It affects your planning and longterm decision-making! For instance, assume you are 25 and just finished your MBA. You are fresh out of college with a new job, so you decide to invest in the stock market for your retirement. Your ultimate goal is to have $1 million when you retire. Let’s assume you will earn 10% annually on your stock investments. How much will you need to invest at the end of each year to reach that goal by the age of 65? The answer is $2,259.41 based on calculating the present value (PV) of each payment for each year, which is $40. The easiest method for computing PV and future value (FV) totals is Excel since you can use the insert function command to input rates, time periods, etc. In our example above, what would happen to the payments if the rate dropped from 10% to 8%? The amount per year would increase to $3,860.16. What happens if you wait until you are 40 before you start to put away money for retirement? How would that impact your annual contribution? Based on a 25-year time period with a 10% rate, you would need to invest $10,168 each year in order to meet the $1 million retirement goal. That is a significant amount more than the $2,259 we calculated earlier based on 40 years. This example illustrates why one should never put off saving for retirement. The longer you wait, the more you will need to save each year to meet the goal. The moral of the story is to celebrate your graduation from school, but once you get that new job, start saving! Time Value of Money in Everyday Life Time value of money and bonds is important in everyday life as individuals are often facing future fiscal and investment decisions that can affect their future financial success. As a general rule, currently having money is more valuable than having money later (Chen, 2011). For instance, the present value of $100 is currently $100. If an interest rate of 5% is added, in one year that $100 would be worth $105. However, when the discounted interest rate of 5% is applied, the $100 a year from the present will only be worth $95.24, making the $100 more valuable today (Chen, 2011). The same can be compared over longer lengths of time, with differing interest rates, both compounded and discounted, in order to gauge whether the investment will be lucrative. Moreover, the same process may be used when addressing home loans to ensure that the value of the home will be retained with the cost and the interest rates. Finally, everyday credit card purchases have a time value because of the interest that is tacked on. In turn, the purchase of a cup of coffee for $3 may end up costing the consumer $15 if the balance is not paid immediately. These costs can add up and, therefore, make time value an important concept for all consumers to understand before making current and future financial decisions. In summary, we looked at the time value of money concept and its many uses. We examined the different applications and how the concept is useful for planning. We highlighted key areas of bonds and the different types. Finally, we studied interest rates and their direct impact on bonds. All of these concepts combined give a great overview of a very important topic in financial management. BBA 3301, Financial Management 3 References UNIT x STUDY GUIDE Title Chen, J. (2011). Time value of money and its applications in corporate finance: A technical note on linking relationships between formulas. American Journal of Business Education (AJBE), 2(6), 77–88. doi:10.19030/ajbe.v2i6.4090 Iam, S. L. (2017). ID 92759653 [Image]. Retrieved from https://www.dreamstime.com/stock-photo-close-uptime-stack-money-coins-time-value-money-concept-business-finance-theme-saving-money-futureimage92759653 Johnson, S. A. (1995). Dividend payout and the valuation effects of bond announcements. The Journal of Financial and Quantitative Analysis, 30(3), 407. doi:10.2307/2331348 Martinez, V. (2013). Time value of money made simple: A graphic teaching method. Journal of Financial Education, 39(1), 96–117. Retrieved from https://www.jstor.org/stable/41948701 Maxwell, W. F., & Stephens, C. P. (2003). The wealth effects of repurchases on bondholders. The Journal of Finance, 58(2), 895-919. doi:10.1111/1540-6261.00550 McGowan, C. B., & Joyner, D. T. (2015). Computing bond values to teach time value of money principles. Applied Finance and Accounting, 1(2), 64. doi:10.11114/afa.v1i2.862 Siraanamwong. (n.d.) ID 87329169 [Image]. Retrieved from https://www.dreamstime.com/stock-illustrationpower-compounding-vector-illustration-image87329169 Suggested Unit Resources In order to access the following resources, click the links below. The video below gives more information on the time value of money, which is the focus of this unit. You are encouraged to view it to learn more. Khan Academy. (2011). Time value of money [Video file]. Retrieved from https://www.youtube.com/watch?v=733mgqrzNKs If you are interested in learning more about the difference between stocks and bonds, watch this short video by the Khan Academy that explores this topic. Khan Academy (2009). Bonds vs. stocks [Video file]. Retrieved from https://www.youtube.com/watch?v=rs1md3e4aYU Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. The Unit IV Activity will give you practice using the math skills that you have learned in this unit. It will be very helpful practice for the assessment in this unit, and you are encouraged to complete this prior to taking the assessment. BBA 3301, Financial Management 4 
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