Question

The time value of money is one of those bedrock principles that supports so much of Finance (and Economics, for that matter). It is essential to understand that the value of any particular amount of money will change over time. Typically the value of a particular amount of money will erode over time in a positive interest rate economic environment.

In Chapter 4 of the text, the authors use examples of cash and financial assets (stocks, bonds, annuities, etc.) to illustrate the concepts of discounting and compounding.

• Are these concepts appropriate for analyzing investments in other types of assets (for example factory equipment or licensing rights)? Give reasons to support your answer.
• Can you think of any types of assets for which discounting or compounding are not the most appropriate valuation technique?
• Are there other types of transactions which can be efficiently analyzed using discounting and compounding techniques?

Answer 1

Conceptually the concepts of time value of money can be applied to any asset: be it fixed asset, tangible or intangible. This is because finance strongly supports the fact that value of any asset today is nothing but present value of all the future cash flows it can generate. The need to obtain present value, leads us to the concept of time value, discounting and compounding. Hence, factory equipment or licensing rights or patents - everything can be subjected to the concept of time value of money. At times, we may have problem and face challenges in estimating the correct cash flows every time period, we have in hand. We may also face issues in estimating the right opportunity cost or discount rate for discounting the cash flows from intangible assets. But otherwise, these concepts are indeed appropriate for analyzing investments in other types of assets (for example factory equipment or licensing rights).

Can you think of any types of assets for which discounting or compounding are not the most appropriate valuation technique?

• Assets that don't have the ability to generate directly realizable cash flows
• Assets that are old and need replacement
• Assets for which market value benchmarks are already available - such as gold, silver, jewelery etc
• Mutual fund units - they are already marked to market and hence don't require further discounting
• Assets where timing of the cash flows are not known or can't be stated firmly.
• Defence equipment, warships, launchers etc - they don't generate cash lows but are required for national safety and security

Are there other types of transactions which can be efficiently analyzed using discounting and compounding techniques?

• Almost every transaction in corporate finance gets analyzed on the basis of time value of money, discounting and compounding
• Options, futures, derivatives, swaps - all these instruments transactions can be analyzed using discounting or compounding
• Land purchase transactions
• House purchase transactions
• Apartment / condo purchases