Balancing credit cards, student loans, checking and savings accounts can be quite daunting. Make sure you aren't paying more than you should -- and that you're getting all the benefits you deserve -- with these 12 tips
Unload Your Burden
Carrying a $1,000 balance at 18% blows $180 every year on interest.
That's money you could put to better use elsewhere. Get in the habit of paying off your balance in full each month.
More From Kiplinger's Personal Finance
• Save Money on Practically Everything
• The Best Credit Cards and Financial Services
• 20 Small Ways to Save Big
If you've already racked up a large balance, do what you can to pay it off.
This may sound obvious, but it is the best way to save money on those hefty interest charges.
Negotiate Your Rate
Instead of paying an APR of 18% on your credit card, call your issuer and ask for a lower rate. If you have good credit, your lender might consider it.
You'll strengthen your case if you can provide examples of offers you've gotten from other companies.
Consider a Balance Transfer
Shop for a new card with a lower interest rate.
Watch out for introductory offers, though.
You don't want to get reeled in with the promise of a 5% rate only to find that it'll shoot up to 18% after three or six months -- unless you're confident you can pay off your entire balance within the introductory time frame.
Say Goodbye to Your Monthly Fee
Your low-rate card may not be the deal you think it is if you're paying an annual fee.
For example, if you pay $40 each month toward a $1,000 balance on a card with a 12% interest rate and a $50 annual fee, that's equivalent to a no-fee card with an 18.4% interest rate.
Reap Some Rewards
You have to buy groceries and gas anyway, so why not use those purchases to get a little more green in your wallet?
Sign up for a rewards credit card and get free money, gift certificates, airline miles or other perks.
If you spend $600 a month on groceries and gas, for example, on a card paying 2% cash back, you'd save almost $150 per year.
(Of course, it's only free if you pay the balance in full each month without incurring interest charges.)
Lower Your Student Loan Rate
If you haven't yet consolidated your student loans, you can shave between one and three percentage points off your interest rate -- saving hundreds of dollars -- by going with a lender that offers a discount when you make on-time payments or automatic payments from your bank account.
You can compare deals through SimpleTuition.com.
Cut a Deal on Student Debt
If you're in over your head, ask your lender if you qualify for a graduated payment schedule (your payments start out small and increase as, presumably, your income increases). Or ask for an extended payment period, such as 15 or 20 years.
Use Free ATMs
A buck or two here and there may not seem like a big deal. But if you're frequenting ATMs outside your bank's network, the surcharges can add up quickly. Get money from an ATM that belongs to a surcharge-free network.
Allpoint has about 200 participating institutions and 32,000 ATMs. Money Pass has 600 members and 8,000 ATMs.
Give Your Credit a Checkup
Making sure your credit is in tip-top shape can save you hundreds or thousands of dollars in the long run.
You're entitled by law to one free credit report once a year from each of the three main credit bureaus. Go to www.annualcreditreport.com to see what lenders can see about your credit history.
Get Checking With Bling
No-interest checking is so old fashioned. Instead, give your money more opportunity to shine with an interest-bearing online checking account through such reputable companies as Everbank, Charles Schwab, E*Trade and ING Direct. They currently pay between 2.25% and 3.25%.
Keep Tabs on Your Balance
At $20 to $30 a pop, overdraft fees and bounced checks can put a damper on your savings efforts. So it literally pays to keep tabs on your spending.
If you use a debit card for convenience over your checkbook, jot down all your debit transactions on your checkbook register to make sure you know how much money is in your bank account at all times.
Evaluate Your Spending
Looking for help keeping tabs on your budget? Track your spending patterns through the free service at Wesabe.com. You enter your accounts to organize your spending into different categories on one convenient site.
Wesabe will also help you pinpoint areas where you could improve and lets you get feedback from other Wesabe users, all while protecting your passwords, identity and other sensitive information.
Copyrighted, Kiplinger Washington Editors, Inc.
Saturday, March 1, 2008
Friday, February 29, 2008
Bond Yield Calculation on the BAII Plus Calculator
One of the key variables in choosing any investment is the expected rate of return. We try to find assets that have the best combination of risk and return. In this section we will see how to calculate the rate of return on a bond investment. If you are comfortable using the TVM keys, then this will be a simple task. If not, then you should first work through my TI BAII Plus tutorial.
The expected rate of return on a bond can be described using any (or all) of three measures:
Current Yield
Yield to Maturity
Yield to Call
We will discuss each of these in turn below. In the bond valuation tutorial, we used an example bond that we will use again here. The bond has a face value of $1,000, a coupon rate of 8% per year paid semiannually, and three years to maturity. We found that the current value of the bond is $961.63. For the sake of simplicity, we will assume that the current market price of the bond is the same as the value. (You should be aware that intrinsic value and market price are two different, though related, concepts.)
The Current Yield
The current yield is a measure of the income provided by the bond as a percentage of the current price:
There is no built-in function to calculate the current yield, so you must use this formula. For the example bond, the current yield is 8.32%:
Note that the current yield only takes into account the expected interest payments. It completely ignores expected price changes (capital gains or losses). Therefore, it is a useful return measure primarily for those who are most concerned with earning income from their portfolio. It is not a good measure of return for those looking for capital gains. Furthermore, the current yield is a useless statistic for zero-coupon bonds.
The Yield to Maturity
Unlike the current yield, the yield to maturity (YTM) measures both current income and expected capital gains or losses. The YTM is the internal rate of return of the bond, so it measures the expected compound average annual rate of return if the bond is purchased at the current market price and is held to maturity.
In the case of our example bond, the current yield understates the total expected return for the bond. As we saw in the bond valuation tutorial, bonds selling at a discount to their face value must increase in price as the maturity date approaches. The YTM takes into account both the interest income and this capital gain over the life of the bond.
There is no formula that can be used to calculate the exact yield to maturity for a bond (except for trivial cases). Instead, the calculation must be done on a trial-and-error basis. This can be tedious to do by hand. Fortunately, the BAII Plus has the time value of money keys, which can do the calculation quite easily. Technically, you could also use the IRR function, but there is no need to do that when the TVM keys are easier and will give the same answer.
To calculate the YTM, just enter the bond data into the TVM keys. We can find the YTM by solving for I/Y. Enter 6 into N, -961.63 into PV, 40 into PMT, and 1,000 into FV. Now, press CPT I/Y and you should find that the YTM is 4.75%.
But wait a minute! That just doesn't make any sense. We know that the bond carries a coupon rate of 8% per year, and the bond is selling for less than its face value. Therefore, we know that the YTM must be greater than 8% per year. You need to remember that the bond pays interest semiannually, and we entered N as the number of semiannual periods (6) and PMT as the semiannual payment amount (40). So, when you solve for I/Y the answer is a semiannual yield. Since the YTM is always stated as an annual rate, we need to double this answer. In this case, then, the YTM is 9.50% per year.
So, always remember to adjust the answer you get for I/Y back to an annual YTM by multiplying by the number of payment periods per year.
The Yield to Call
Many bonds (but certainly not all), whether Treasury bonds, corporate bonds, or municipal bonds are callable. That is, the issuer has the right to force the redemption of the bonds before they mature. This is similar to the way that a homeowner might choose to refinance (call) a mortgage when interest rates decline.
Given a choice of callable or otherwise equivalent non-callable bonds, investors would choose the non-callable bonds because they offer more certainty and potentially higher returns if interest rates decline. Therefore, bond issuers usually offer a sweetener, in the form of a call premium, to make callable bonds more attractive to investors. A call premium is an extra amount in excess of the face value that must be paid in the event that the bond is called.
The picture below is a screen shot (from the NASD TRACE Web site on 8/17/2007) of the detailed information on a bond issued by Union Electric Company. Notice that the call schedule shows that the bond is callable once per year, and that the call premium declines as each call date passes without a call. If the bond is called after 12/15/2015 then it will be called at its face value (no call premium).
It should be obvious that if the bond is called then the investor's rate of return will be different than the promised YTM. That is why we calculate the yield to call (YTC) for callable bonds.
The yield to call is identical, in concept, to the yield to maturity, except that we assume that the bond will be called at the next call date, and we add the call premium to the face value. Let's return to our example:
Assume that the bond may be called in one year with a call premium of 3% of the face value. What is the YTC for the bond?
In this case, the bond has 2 periods before the next call date, so enter 2 into N. The current price is the same as before, so enter -961.63 into PV. The payment hasn't changed, so enter 40 into PMT. We need to add the call premium to the face value, so enter 1,030 into FV. Solve for I/Y and you will find that the YTC is 7.58% per semiannual period. Remember that we must double this result, so the yield to call on this bond is 15.17% per year.
Now, ask yourself which is more advantageous to the issuer: 1) Continuing to pay interest at a yield of 9.50% per year; or 2) Call the bond and pay an annual rate of 15.17%. Obviously, it doesn't make sense to expect that the bond will be called as of now since it is cheaper for the company to pay the current interest rate.
I hope that you have found this tutorial to be helpful.
The expected rate of return on a bond can be described using any (or all) of three measures:
Current Yield
Yield to Maturity
Yield to Call
We will discuss each of these in turn below. In the bond valuation tutorial, we used an example bond that we will use again here. The bond has a face value of $1,000, a coupon rate of 8% per year paid semiannually, and three years to maturity. We found that the current value of the bond is $961.63. For the sake of simplicity, we will assume that the current market price of the bond is the same as the value. (You should be aware that intrinsic value and market price are two different, though related, concepts.)
The Current Yield
The current yield is a measure of the income provided by the bond as a percentage of the current price:
There is no built-in function to calculate the current yield, so you must use this formula. For the example bond, the current yield is 8.32%:
Note that the current yield only takes into account the expected interest payments. It completely ignores expected price changes (capital gains or losses). Therefore, it is a useful return measure primarily for those who are most concerned with earning income from their portfolio. It is not a good measure of return for those looking for capital gains. Furthermore, the current yield is a useless statistic for zero-coupon bonds.
The Yield to Maturity
Unlike the current yield, the yield to maturity (YTM) measures both current income and expected capital gains or losses. The YTM is the internal rate of return of the bond, so it measures the expected compound average annual rate of return if the bond is purchased at the current market price and is held to maturity.
In the case of our example bond, the current yield understates the total expected return for the bond. As we saw in the bond valuation tutorial, bonds selling at a discount to their face value must increase in price as the maturity date approaches. The YTM takes into account both the interest income and this capital gain over the life of the bond.
There is no formula that can be used to calculate the exact yield to maturity for a bond (except for trivial cases). Instead, the calculation must be done on a trial-and-error basis. This can be tedious to do by hand. Fortunately, the BAII Plus has the time value of money keys, which can do the calculation quite easily. Technically, you could also use the IRR function, but there is no need to do that when the TVM keys are easier and will give the same answer.
To calculate the YTM, just enter the bond data into the TVM keys. We can find the YTM by solving for I/Y. Enter 6 into N, -961.63 into PV, 40 into PMT, and 1,000 into FV. Now, press CPT I/Y and you should find that the YTM is 4.75%.
But wait a minute! That just doesn't make any sense. We know that the bond carries a coupon rate of 8% per year, and the bond is selling for less than its face value. Therefore, we know that the YTM must be greater than 8% per year. You need to remember that the bond pays interest semiannually, and we entered N as the number of semiannual periods (6) and PMT as the semiannual payment amount (40). So, when you solve for I/Y the answer is a semiannual yield. Since the YTM is always stated as an annual rate, we need to double this answer. In this case, then, the YTM is 9.50% per year.
So, always remember to adjust the answer you get for I/Y back to an annual YTM by multiplying by the number of payment periods per year.
The Yield to Call
Many bonds (but certainly not all), whether Treasury bonds, corporate bonds, or municipal bonds are callable. That is, the issuer has the right to force the redemption of the bonds before they mature. This is similar to the way that a homeowner might choose to refinance (call) a mortgage when interest rates decline.
Given a choice of callable or otherwise equivalent non-callable bonds, investors would choose the non-callable bonds because they offer more certainty and potentially higher returns if interest rates decline. Therefore, bond issuers usually offer a sweetener, in the form of a call premium, to make callable bonds more attractive to investors. A call premium is an extra amount in excess of the face value that must be paid in the event that the bond is called.
The picture below is a screen shot (from the NASD TRACE Web site on 8/17/2007) of the detailed information on a bond issued by Union Electric Company. Notice that the call schedule shows that the bond is callable once per year, and that the call premium declines as each call date passes without a call. If the bond is called after 12/15/2015 then it will be called at its face value (no call premium).
It should be obvious that if the bond is called then the investor's rate of return will be different than the promised YTM. That is why we calculate the yield to call (YTC) for callable bonds.
The yield to call is identical, in concept, to the yield to maturity, except that we assume that the bond will be called at the next call date, and we add the call premium to the face value. Let's return to our example:
Assume that the bond may be called in one year with a call premium of 3% of the face value. What is the YTC for the bond?
In this case, the bond has 2 periods before the next call date, so enter 2 into N. The current price is the same as before, so enter -961.63 into PV. The payment hasn't changed, so enter 40 into PMT. We need to add the call premium to the face value, so enter 1,030 into FV. Solve for I/Y and you will find that the YTC is 7.58% per semiannual period. Remember that we must double this result, so the yield to call on this bond is 15.17% per year.
Now, ask yourself which is more advantageous to the issuer: 1) Continuing to pay interest at a yield of 9.50% per year; or 2) Call the bond and pay an annual rate of 15.17%. Obviously, it doesn't make sense to expect that the bond will be called as of now since it is cheaper for the company to pay the current interest rate.
I hope that you have found this tutorial to be helpful.
Wednesday, February 27, 2008
Time Value of Money (Short Definition)
The time value of money is based on the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal.
Understanding the Time Value of Money
Congratulations!!! You have won a cash prize! You have two payment options:
A. Receive $10,000 now
OR
B. Receive $10,000 in three years.
Okay, the above offer is hypothetical, but play along with me here ... Which option would you choose?
What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now: over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:
If you are choosing option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for option B, on the other hand, would only be $10,000. But stay tuned to find out how to calculate exactly how much more option A is worth, compared to option B.
Future Value Basics
If you choose option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:
Original equation: ($10,000 x 0.045) + $10,000 = $10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have?
To calculate this, you would take the $10,450 and multiply it again by 1.045. At the end of two years, you would have $10,920:
Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)
Think back to math class in junior high, where you learned the rule of exponents, which says that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:
We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:
This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:
Present Value Basics
If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:
Let's walk backwards from the $10,000 offered in option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of year two:
Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:
Present value of $10,000 in one year:
Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of option B.
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Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:
In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:
Present Value
From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years!
Conclusion
These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.
A. Receive $10,000 now
OR
B. Receive $10,000 in three years.
Okay, the above offer is hypothetical, but play along with me here ... Which option would you choose?
What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now: over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:
If you are choosing option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for option B, on the other hand, would only be $10,000. But stay tuned to find out how to calculate exactly how much more option A is worth, compared to option B.
Future Value Basics
If you choose option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:
Original equation: ($10,000 x 0.045) + $10,000 = $10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have?
To calculate this, you would take the $10,450 and multiply it again by 1.045. At the end of two years, you would have $10,920:
Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)
Think back to math class in junior high, where you learned the rule of exponents, which says that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:
We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:
This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:
Present Value Basics
If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:
Let's walk backwards from the $10,000 offered in option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of year two:
Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:
Present value of $10,000 in one year:
Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of option B.
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Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:
In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:
Present Value
From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years!
Conclusion
These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.
What is Financial Management?
Financial management is concerned with all aspects of how the business deals with its financial resources in order to maximize profit over the long term.
COMPONENTS OF FINANCIAL MANAGEMENT
Financial Management involves the following activities:
Financial planning: which predicts the performance of the business in financial terms to give an overall measure of how it is performing and to provide a basis for financial decision-making and for raising finance.
Financial accounting: which clarifies, records and interprets in monetary terms transactions and events of a financial nature. Financial accounting will involve maintaining records of transactions (book-keeping), preparing balance sheets and profit and loss accounts, preparing value added statements, managing cash, handling depreciation and inflation accounting. The accounts prepared by the firm will be audited to ensure that they present a 'true and fair view' of its financial performance and position. But there is scope within the law and accounting rules for company accountants to indulge in 'creative accounting' to improve the picture the accounts present to the outside world (the City and investors).
Financial analysis: which analyzes the performance of the business in terms of variance analysis, cost-volume-profit analysis, sales mix analysis, risk analysis, cost-benefit analysis and cost-effectiveness analysis.
Management accounting: which accounts for and analyzes costs, provides the basis for allocation costs to products or processes, prepares and controls financial budgets and deals specifically with overhead and responsibility accounting. Management accounting provides the data for financial analysis and for capital appraisal and budgeting.
Capital appraisal and budgeting: which selects and plans capital investments based on the returns likely to be obtained from those investments. The capital appraisal techniques comprise accounting rate of return, payback and discounted cash flow.
COMPONENTS OF FINANCIAL MANAGEMENT
Financial Management involves the following activities:
Financial planning: which predicts the performance of the business in financial terms to give an overall measure of how it is performing and to provide a basis for financial decision-making and for raising finance.
Financial accounting: which clarifies, records and interprets in monetary terms transactions and events of a financial nature. Financial accounting will involve maintaining records of transactions (book-keeping), preparing balance sheets and profit and loss accounts, preparing value added statements, managing cash, handling depreciation and inflation accounting. The accounts prepared by the firm will be audited to ensure that they present a 'true and fair view' of its financial performance and position. But there is scope within the law and accounting rules for company accountants to indulge in 'creative accounting' to improve the picture the accounts present to the outside world (the City and investors).
Financial analysis: which analyzes the performance of the business in terms of variance analysis, cost-volume-profit analysis, sales mix analysis, risk analysis, cost-benefit analysis and cost-effectiveness analysis.
Management accounting: which accounts for and analyzes costs, provides the basis for allocation costs to products or processes, prepares and controls financial budgets and deals specifically with overhead and responsibility accounting. Management accounting provides the data for financial analysis and for capital appraisal and budgeting.
Capital appraisal and budgeting: which selects and plans capital investments based on the returns likely to be obtained from those investments. The capital appraisal techniques comprise accounting rate of return, payback and discounted cash flow.
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