FIN 6301 Unit III CS

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Course Learning Outcomes for Unit II At the end of this unit, you should be able to:

2. Summarize the concept of the time value of money. 2.1 Identify the key factors, such as inflation and interest rates that influence the dynamic nature of

money’s value over time.

4. Apply financial principles of leading an organization. 4.1 Distinguish between different financial strategies and tools used in leading an organization,

including the issuance and valuation of bonds. 4.2 Explain the importance of bond market dynamics, such as the relationship between interest

rates and bond prices, in shaping organizational financial strategies.

Required Unit Resources Chapter 4: Time Value of Money (ULO 2.1) You are not required to read the Summary, Questions, or Web Extension at the end of the chapter. The purpose of this chapter is to discuss the time value of money. First, we name the elements of a timeline so we can explain the four methods to calculate future values from present values and calculate present value from future values. We further identify the number of years required to reach a financial goal. Next, we define annuity and annuity due and calculate future value of an ordinary annuity. We compare present values of ordinary annuities and annuities due, find interest payments, periods, and interest rates. Chapter 5: Bonds, Bond Valuation, and Interest Rates (ULOs 4.1 and 4.2) You are not required to read the Summary, Questions, or Web Extension at the end of the chapter. The purpose of this chapter is to understand bonds, bond valuation, and interest rates. First, we name the four main types of bond issuers, list the seven key characteristics of bonds, and apply three procedures to calculating a bond’s value. Next, we show the time path of a bond’s maturity, determine the price of a bond with semiannual payments, and find a bond’s yield to maturity. We identify determinants of market interest rates and contrast the nominal and real risk-free interest rates. We further explain inflation premium and bond ratings.

Unit Lesson Lesson: Time Value of Money (TVM) and Bonds (ULOs 2.1, 4.1, and 4.2)

Introduction In the ever-evolving world of finance, understanding the impact of time on the value of money is paramount. Consider receiving a sum of $1,000 now versus 10 years from now. Given the choice, most of us would prefer to have the money today. This simple preference underscores the essence of the time value of money (TVM). In the same vein, bonds—a staple in the financial markets—offer a bridge to understand future payments today. As we dive deeper, we will unearth the real-world implications of these concepts.

UNIT II STUDY GUIDE

Fixed Income Securities

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Time Value of Money (TVM): The Pulse of Financial Decisions Money, by its very nature, is dynamic. Its worth is susceptible to various forces. At the heart of these forces lie three primary factors: inflation, interest rates, and the allure of alternative investment opportunities (Lusk, 2022). Inflation: Eroding Purchasing Power Inflation signifies the increasing prices of goods and services over time (Montevirgen, 2023). As a result, a dollar today will not buy you the same basket of goods a year from now. Think about it—remember when a candy bar used to cost much less a decade ago? That is inflation in action. Anna, our young entrepreneur, was acutely aware of this issue. When she started her journey with $10,000, she knew that if she merely held onto that money, its purchasing power would decline over time. Instead of a laptop she could buy today, she might only be able to afford a tablet 5 years down the line with the same amount of money, given the rising costs. Interest Rates: The Cost or Return of Money Interest rates play a dual role. On the one hand, they represent the cost of borrowing money. On the other, they signify the return one can expect from saving or investing money (McBride, 2022). For instance, if Anna kept her $10,000 in a bank account that offers a 5% interest rate annually, she would have $10,500 at the end of the year. This interest serves as an incentive for people to save or invest rather than spend. Missed Opportunities: The Road Not Taken Every choice Anna makes comes with an opportunity cost. By choosing to invest in a particular venture, she is potentially foregoing other investment opportunities that might have yielded better returns. It is this constant evaluation of potential returns that makes the decision-making process in the financial world incredibly intricate. The Journey of Money Through Time Visualizing money’s journey is pivotal in grasping the nuances of financial decision-making. A dollar today has a different trajectory than a dollar a year from now, and this journey is defined by the interplay of the factors discussed above. Anna’s decision to invest her $10,000 was not what that sum could become in the future. By projecting her money’s potential growth rate in various avenues, she was trying to navigate the complex roadmap of financial forecasting. Present Value Versus Future Value Two pivotal concepts emerge here:

• Present value (PV): This is today’s worth of a sum of money that is expected to be received in the future, discounted at a certain interest rate. Anna, considering an investment, would wonder: ”How much is the potential money I might get in 5 years’ worth today?”

• Future value (FV): Conversely, this is the worth of a present sum at a future date, based on a certain rate of return or interest (Moadel, 2022). For Anna, this would translate to: ”Given my current investment, how much can I expect it to be worth in 5 years?:

These calculations serve as the bedrock for myriad financial decisions. Whether evaluating the viability of a startup’s future earnings or determining the end value of a savings account, the oscillation between present and future values is constantly at play.

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Applications: From Savings to Investments As Anna dives deeper into her entrepreneurial journey, she grapples with the practical applications of TVM daily. Investing in Startups Anna’s decision to fund a startup is fraught with variables. Beyond the initial capital, she would need to consider the expected rate of return, potential dividends, and the startup’s growth trajectory. By employing TVM, she can estimate her potential earnings in the future and juxtapose them with today’s investment to determine its viability. For instance, if the startup projects a 10% annual growth, Anna’s $10,000 investment today could turn into approximately $16,105 in 5 years. This potential growth can significantly influence her investment decisions. Dividends and Returns Suppose the startup Anna invested in plans to offer dividends. These periodic payouts become another layer in her financial calculations. Dividends expected in the future have a present value based on her required rate of return. So, if the startup promises a $500 dividend next year and Anna seeks an 8% return, that dividend is worth about $463 to her today.

Annuities: Regularity in the Financial World Amidst the intricacies of finance, annuities offer a semblance of predictability. An annuity is a series of equal payments made at regular intervals. Ordinary Annuities Versus Annuities Due There are two main types of annuities:

• Ordinary annuities: Payments occur at the end of each period. Most loans and investments follow this pattern. If Anna receives dividends at the end of each year, they form an ordinary annuity.

• Annuities due: Payments occur at the beginning of each period. Lease payments are a typical example.

The distinction may seem subtle, but from a TVM perspective, it is crucial. Annuities due are worth more in present value terms than ordinary annuities because they are received sooner. Real-Life Application: Loans and Repayments When Anna took out a loan to amplify her business operations, she committed to an ordinary annuity. Her monthly repayments, a fixed sum she would dispatch at the end of each month, encapsulated the principle of annuities. By understanding the time value implications of these repayments, Anna could better strategize her financial management, ensuring her business thrived and her debts were methodically managed. In summary, the time value of money is not merely a theoretical concept but a guiding principle in real-world financial decisions. Whether you are an entrepreneur like Anna, an investor, or simply someone planning for the future, understanding how money morphs over time is essential. With this foundation, you are better equipped to navigate the intricate web of corporate finance, making informed decisions that bolster financial growth and stability.

Bonds: A Deep Dive into IOUs and Future Payments At their core, bonds are a form of a loan in which you are the lender, and the borrower can be a corporation, municipality, or government (Ashburn, n.d.).

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Understanding Bond Basics Imagine lending money to a friend, and in return, they give you a written promise to repay the amount by a specific date, plus a little extra as gratitude. That little extra is akin to the interest, and the written promise: well, that is fundamentally what a bond is. When Anna’s corporation or even a government entity lacks the necessary capital for a project, they do not call a bank; they turn to the public. By issuing bonds, they borrow funds from willing investors. These bonds are a promise to repay the amount called the principal or face value at a specified maturity date, along with periodic interest payments, known as coupon payments. Bonds Versus Stocks While both are investment vehicles, there is a clear distinction. When you buy a stock, you purchase a piece of the company, becoming a shareholder. However, with bonds, you become a creditor. This difference implies that if a company were to go bankrupt, bondholders, who are creditors, get paid before stockholders (Guberti & Schultz, 2023). Bond Valuation: Deciphering the True Worth For Anna, as for any bond issuer, the challenge lies in setting the right price and interest rate for the bonds. Bond valuation is a technique to determine the fair price of a bond. Several elements determine the worth of a bond:

• Coupon rate: This is the interest rate promised by the bond issuer. If Anna's bond offers a 5% annual coupon, on a $1,000 bond, she would pay $50 annually.

• Prevailing market interest rates: If new bonds in the market offer higher interest than Anna’s bond, her bond’s price might decrease to remain attractive to investors.

• Time to maturity: Generally, longer the bond’s maturity, the riskier it is, affecting its price.

• Creditworthiness of the issuer: A bond’s value hinges on the issuer’s ability to make promised payments. Anna’s company’s financial health and credit rating would play a pivotal role here.

Yield to Maturity (YTM) YTM is the total return anticipated on a bond if it is held until maturity. It is vital for Anna to understand this as it provides investors a way to compare bonds of different durations and credit qualities. Interest Rates: The Heartbeat of Bond Pricing Interest rates and bond prices share an inverse relationship. When market interest rates climb, newly issued bonds come with higher coupon rates, making existing bonds with lower rates less attractive. Hence, the prices of these existing bonds fall to align with the new market conditions (U.S. Wealth Management, ,2023). Anna would need to tread carefully. If she issued bonds at a 5% rate and market rates then rose to 6%, her already-issued bonds would lose some appeal, leading to a potential decrease in their market value. The Interplay of Central Banks Central banks, like the Federal Reserve in the United States, play a crucial role in determining interest rates (Papandrea, 2023). Policy decisions can influence bond markets considerably. As an astute entrepreneur, Anna would keep an eye on the broader economic landscape and central bank policies. Bond Types: From Investment-Grade to Junk Bonds come in various flavors, and their risk-return profile varies accordingly.

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Investment-Grade Bonds These are high-quality bonds, issued by reputable entities. They have a lower risk of default, meaning there is a slim chance the issuer will not fulfill its payment promises. Consequently, they offer lower yields. If Anna’s company has a stellar financial record and positive credit rating, it would be in a position to issue investment-grade bonds, drawing investors seeking stability. Junk Bonds (High-Yield Bonds) These are riskier propositions. They offer higher yields because there is a greater risk of default (Chandler, 2020). New companies, or those with questionable financial histories, typically issue these. Should Anna’s enterprise be a newer player or face financial challenges, she might opt for junk bonds, offering higher interest rates to lure investors willing to shoulder more risk. The intricate world of bonds offers both challenges and opportunities. As Anna’s journey showcased, understanding the nuances of bonds—from their basic nature to the complexities of valuation—is paramount for any entrepreneur or investor. Both the time value of money and bonds serve as pillars in financial decision-making. With these foundational concepts, one is set to dive deeper into the multifaceted realm of corporate finance, weaving through more intricate financial strategies, tools, and analyses, all aimed at achieving sustainable financial success.

References Ashburn, D. (n.d.). Bond market basics: Here’s what to know. Britannica money.

https://www.britannica.com/money/bond-market-basics Chandler, S.2020, October 1). What are junk bonds? A risky yet high-yield investment that can bring rewards

if you’re willing to take the chance. Business Insider India. https://www.businessinsider.in/finance/news/what-are-junk-bonds-a-risky-yet-high-yield-investment- that-can-bring-rewards-if-youre-willing-to-take-the-chance/articleshow/78417151.cms

Guberti, M., & Schultz, J. (2023, July 12). Bonds vs. stocks: Differences in risk and reward. US News & World

Report. https://money.usnews.com/investing/articles/bonds-vs-stocks-differences-in-risk-and-reward Lusk, V. (2022). Time value of money: The guiding principle for virtually every financial and investing decision.

Business Insider. https://www.businessinsider.com/personal-finance/time-value-of-money McBride, G. (2022). What are interest rates and how do they work? Bankrate.

https://www.bankrate.com/personal-finance/what-are-interest-rates-and-how-do-they-work/ Moadel, D. (2023, December 11). Time value of money (TVM) definition. US News & World Report.

https://money.usnews.com/investing/term/time-value-of-money Montevirgen, K. (20232024, January 5). Inflation. Britannica.

https://www.britannica.com/money/topic/inflation-economics Papandrea, D. (2023, December 14). How federal interest rates work. US News & World Report.

https://money.usnews.com/loans/articles/how-federal-interest-rates-work U.S. Wealth Management. (2023, How changing interest rates impact the bond market. (2023, December 18).

U.S. Bancorp Investments/U.S. Bank. https://www.usbank.com/investing/financial- perspectives/market-news/interest-rates-affect-bonds.html