Develop a 3 page essay (3 full pages of text) in APA format that develops your understanding of the Time Value of Money. What is it? Why is it important in Finance? How does it influence financial decision making for businesses and individuals? This essay should be in compliance with APA format guidelines, and should be double-spaced, with one-inch margins, and contain a separate cover page and References. Please cite the course textbook Brigham: Fundamentals of Financial Management, Concise ISBN: 9780357517710 and one article from The Wall Street Journal in your essay. Essays without the required citations will not be scored.
Importance in Finance
The critical importance of TVM stems from its ability to standardize and compare cash flows that occur at different points in time. Without this framework, rational financial decisions would be impossible. If a business had to choose between receiving $100,000 today or receiving $100,000 five years from now, the choice seems obvious; however, to correctly compare an initial outlay of $50,000 today with a series of expected revenues over the next decade, a common metric is necessary. This common metric is the Present Value (PV). Every major area of finance relies upon PV calculations. In bond valuation, the price of the bond is simply the present value of all its future coupon payments plus the present value of its final principal repayment. Similarly, the value of common stock, as noted by Brigham and Houston, is determined by the present value of all future expected dividends (Brigham & Houston, 2020). The required rate of return, or the discount rate (Ke), is the essential variable that links risk to value, as it reflects the riskiness of those future cash flows. A project with high risk demands a higher discount rate, which in turn reduces its calculated present value, reflecting the fundamental principle that higher risk must be compensated by a lower price or higher return.
Sample Answer
The Time Value of Money: Foundation of Financial Decision Making
The concept of the Time Value of Money (TVM) is arguably the single most important principle in the entire field of finance, serving as the bedrock for all valuation, investment, and capital budgeting decisions. At its core, TVM asserts a fundamental economic truth: a dollar received today is inherently worth more than a dollar promised at any point in the future. This premise is universally accepted because money available today can be invested, allowing it to earn a return, thereby increasing its value over time. Conversely, the value of future money must be "discounted" back to the present because of the opportunity cost of having to wait, and the inherent risk and uncertainty involved in receiving that future payment. The twin processes that define TVM are compounding, which calculates the future value of a present amount, and discounting, which calculates the present value of a future amount.