Time Value Management

Capital Allocation Decisions

Time values of money include present value and future value and are very similar in the way they work together, but there is a difference. The difference between the two depends on time. The money given today differs from money given years later because of the interest that accrues (WikiAnswers, 2008).

Present value is the value of money today, without any interest to make it grow. The actual value of a lottery prize is a great example to use to fully understand the concept of present value. If the lottery prize is $1 million, it is not worth that full amount if it is set up to pay the winner $50,000 a year for twenty years with a percentage rate of 10 percent added on to it. If the first payment is paid immediately, the present value of that prize is only $468,246 (Henderson, 2002) Future Value is the value of that investment over time, after interest has been gained and can be expressed as FV = PV (l + i) n (Block & Hirt, 2005).

An annuity is a series of equal amounts of payments or receipts that are consecutive and usually occur at the end of a period of time. The future value of an annuity is the sum of the future value of each payment. For instance, the future value of an annuity on an investment of $1,000 at the end of each year for four years, growing at 10 percent would be found out after the future value for each payment is calculated and added together. This process reversed in order to find the present value of an annuity. All discounted payments must be added after each individual payment is discounted back to the present, which gives us the present value of annuity (Block & Hirt, 2005).

According to the critics Block and Hirt (2005) "annuity is defined as a series of consecutive payments or receipts of equal amount. The annuity values are generally assumed to occur at the end of each period. Leases and rental payments are considered examples of annuities. The unknown variable was the future value or the present valueÐ'--with specific information available on the annuity value (A), the interest rate, and the number of periods or years. In certain cases our emphasis may shift to solving for one of these other values (on the assumption that future value or present value is given)".

Future value of annuity is the future value for each payment and the total of them. The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised future payments will grow to after a given number of periods at a specific compounded interest. The Future Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at the beginning of a period rather than at the end. Since each payment occurs one period earlier, we can calculate the present value of an ordinary annuity and then multiply the result by (1 + i) (Get Objects, 2002, par. 1).

"During the present value of annuity the process is reversed. In theory each individual payment is discounted back to the present and then all of the discounted payments are added up, yielding the present value of the annuity. Present value of annuity can also be thought of as the amount you must invest today at a specific interest rate so that when you withdraw an equal amount each period, the original principal and all accumulated interest will be completely exhausted at the end of the annuity. Present value of annuity is extremely useful for comparing two separate cash flows that differ in some way" (Get Objects, 2002, par. 1).

"The yield on an investment allocated to an issue is computed under the economic accrual method, using the same compounding interval and financial conventions used to compute the yield on the issue. The yield on an investment allocated to an issue is the discount rate that, when used in computing the present value as of the date the investment is first allocated to the issue of all unconditionally payable receipts from the investment, produces an amount equal to the present value of all unconditionally payable payments for the investment. Yield is another term for interest rate" (Code of Federal Regulations, 2003, p. 682). "The number of compounding periods per year will affect the total interest earned on an investment. For example, if an investment compounds daily it will earn more than the same investment with the same stated/nominal rate compounding monthly:. In considering the patterns of payment time value of money problems may evolve around a number of different payment or receipt patterns. Not every situation will involve a single amount or an annuity. For example a contract may call for the payment of a different amount each year over a three-year period. When a corporation determines present value each payment is discounted to the present and then summed. If an annuity will be paid at some time in the future, it is referred to as a deferred annuity and it requires special treatment" (Financial Calculator, 2007, par.1).

Block and Hirt 2005 states that "long-term markets are called capital markets and consist of securities having maturities greater than one year. The most common corporate securities in this category are bonds, common stock, preferred stock, and convertible securities. These securities are found on the firm's balance sheet under the designation long-term liabilities and equities. "Basically, the international capital market includes any transaction with an international dimension. It is not really a single market but a number of closely integrated markets that include some type of international component. The foreign exchange market was a very important part of the international capital market during the late 1990s. Internationally traded stocks and bonds have also been part of the international capital market" (Woepking, 2007, par. 13).

Security markets exist to aid the allocation of capital among households, corporations and government units with financial institutions acting as intermediaries. Once a security is sold for the first time, the security trades in its appropriate market among all types of investors. The structure of the security markets has changed drastically in the last several years. Some of the changes include mergers or alliances between exchanges, the transformation of member exchanges into public companies and the elimination of trading on the exchange floor. Many of the changes were driven by technology, which is creating low-cost competition for the traditional markets.

Lenders of money profit from such transactions