The paper looks at the concept of the time value of money by examining the price an investor may pay for a Starbucks bond worth $2,000 in a years rime. The factors that may be considered in assessing a present value are assessed and a calculation is demonstrated. The bond is then compared to two other companies where the investor may be prepared to pay a higher or a lower level for a similar bond, with the reasons behind a different valuation explained.
Finance
Time Value of Money; Assessing the Value of a Starbucks Bond
The concept of the future value of money and the present value of money are useful when assessing potential investments. The future value of an investment is the value that the investor will expect to receive at some point in the future. If an investor is considering purchasing a Starbucks bond which will pay one $2,000 in a year's time, this is the future value of the bond. As investment takes place with the aim of making money and creating value for the investor they would be unwilling to pay $2,000 today for that bond, as this would not result in a profit. Instead, the investor will need to consider the price they are will to pay today in order to receive the $2,000 from Starbucks after a year, allowing for the passage of time. This is an assessment of the present value, which is discounting the future value to allow for time value of money (Howells and Bain, 2007).
When assessing how much the investment that will mature at $2,000 in a year is worth there are several considerations. The first consideration may be the rate of inflation. Inflation erodes the real value of money; therefore any investment should at least be able to keep pace with inflation (Howells and Bain, 2007). While one cannot be certain what the future rate of inflation will be, it is possible to look at forecasts. One current forecast for the U.S. is a projected rate of 3.2%
(Forecast-chart.com, 2012). Therefore, if an investor wants to make sure that an investment retains its real value; which means that it will buy the same value of goods in 12 months time as it will today, the investment will need to give a return of at last 3.2%. This is the level needed fore the investment to keep pace with inflation. However, this will not create value.
If the investment is to create value, as well as keeping pace with inflation there will need to be additional growth. This means an investor may look at alterative investments to assess the value they may gain elsewhere. For example, the investor may look at the rate of return that is currently paid on savings accounts, or the rate that is expected on the stock market.
To assess the potential return that may be earned on the stick market one may look at the recent performance. While future performance is not dependant on the past, this can be chosen as a guide. It has been noted that the growth of investments on the stock market generally show a positive movement, and that over a long -period of time this tends to be in the region of 7.5% (Howells and Bain, 2007). This can vary widely, but it is a useful measure. If this is used as a guideline, and the investor believes they can gain this elsewhere, then the Sat bucks bond will need to be discounted by at least this much.
If the market as a whole is expected to grow by 7.5% this also reflects a spread of risk. If the investor buys only a single bond they have not been able to diversify that risk. There is always a risk that the face value of a bond may not be paid at the maturity date. Therefore, there may also be the consideration of risk. The higher the perceived level of risk the greater the return the investor will want to compensate for that risk, this is known as the risk premium (Nellis and Parker, 2006). The higher the risk the greater the risk premium; this means that the higher the risk the higher the required rate of return. The perception of risk can be personal, and those with a conservative or low risk profile may not be willing to invest in higher risk bonds, so may not be prepared to pay anything if it is seen as too risky. When assessing the risk associated with Starbucks the beta may be used, this is a measure of the share price volatility, and may be used as an indicator of the underlying risk. If the value is 1, it means that the volatility of the share price is the same as the stock market as a whole, as the Starbucks beta is 1.28, this means it is 1.28 times more volatile than the stock market (Yahoo Finance, 2012). Therefore, assuming that an investor can accept this risk, the expected rate of return may need to be adjusted and increased to allow for this increased risk. This may be undertaken mathematically, using models such as CAPM, or one may simply state that as the risk higher than the stock market as a whole a higher rate, such as 8.5% is required. The logical behind this is that this level of return may be gained elsewhere for e a similar perceived level of risk.
Assessing the actual value becomes a simple calculation following the decision on the discount rate. The equitation is FV/(1+r) n = PV, where FV is the future value, r is the interest rate, n is the number of years PV is the present value. This gives a calculation of $2,000/(1 +0.085)1
This gives us the result of $1,843.
Therefore the price that the investor may choose to pay is $1,843.
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