Question

Explain the concept of the time value of money and the principle of compound growth, and discuss the characteristics of common stock.

Answer 1

The concept of the time value of money is that money received today is worth more than money received in the future. This is because there is an opportunity cost of money. If money is received today rather than later, it could be invested to earn a return. By receiving money in the future, this return is foregone, and is the opportunity cost of receiving money in the future. This is the reason that money received today is worth more than money received in the future.

If a sum of money is invested, it earns a return. When these returns are reinvested and added to the original investment, it is called compounding. Thus, the original investment keeps growing in value due to the reinvested returns. This is called compound growth.

The characteristics of common stock are :

• They represent ownership in the company
• They pay dividends out of earnings, which may be at the discretion of the management. This is unlike bonds, where the interest has to be paid mandatorily, and irrespective of whether there are earnings available for paying the interest
• They give the holders voting rights in the company
• In case of liquidation, they are paid after the claims of creditors and preferred stockholders are settled