1.
8 • Concepts of Time and Value 29
the future. Economists, investment advisers, your friends, and mine love to discuss the trade-off of
consumption now or later—even if not in those words. We have all heard conversations that go something like
this: “Let’s go grab a beer—you can study for tomorrow’s exam in the morning.” Or “My father’s investment
adviser told me that if I invest $500 per month for the next 30 years and earn an annual rate of 10% on my
investments, I will have invested $180,000 over time but accumulated an investment portfolio worth over $1.13
million!”
An important aspect of the trade-off between saving and spending involves your short-, intermediate-, and
long-term goals. Delaying consumption until later comes with risks. Will your consumption choices still be
available? Will the prices be attainable? Will you still be able to consume and enjoy your future purchases?
When saving for short-term objectives, the safety of the principal invested is important, and the value of
compounding returns is minimal compared to longer-term investments. Most short-term investors have a low
tolerance for risk and hope to beat the rate of inflation with a little extra besides. An example could be to start
a holiday savings account at your local bank as a way to save, earn a small rate of return, and assure that you
have funds set aside for consumption at the end of the year.
An intermediate investment may be to save for a new car or for the down payment on a house or vacation
home. Again, maintaining the principal is important, but you have some time to recover from poor investment
returns. Intermediate-term investments tend to earn higher average annual rates of return than short-term
investments, but they also have greater uncertainty and risk.
Long-term investments have the advantage of enough time to recover from temporary poor performance and
the luxury of compounded returns over a long period. Further, long-term investments tend to have greater
risk and higher expected average annual rates of return. Even though this is a business finance text,
sometimes a personal finance example is easier to relate to. To illustrate, Table 1.2 demonstrates four different
investment scenarios. In scenario 1, you invest $5,000 annually from ages 26 through 60 into an account
earning an average annual rate of return of 10% per year. Over your lifetime, you invest a total of $175,000,
and at age 60, you have an estimated portfolio value of $1,490,634. This is a healthy amount that has almost
certainly beaten the average annual rate of inflation. In scenario 1, by investing regularly, you accumulate
roughly 8.5 times the value of what you invested. Congratulations, you can expect to become a millionaire!
Compare your results in scenario 1 with your college roommate in scenario 2, who is able to invest $5,000 per
year from ages 19 through 25 and leave her investments until age 60 in an account that continues to earn an
annual rate of 10%. She makes her investments earlier than yours, but they total only $35,000. However,
despite a much smaller investment, her head start advantage and the high average annual compounded rate
of return leave her with an expected portfolio value of $1,466,369. Her total is almost as great as the amount
you would accumulate, but with a much smaller total investment.
Scenarios 3 and 4 are even more dramatic, as can be seen from a review of Table 1.2. In both scenarios, only
five $5,000 investments are made, but they are made earlier in the investor’s life. Parents or grandparents
could make these investments on behalf of the recipients. In both scenarios, the portfolios grow to amounts
greater than those of you or your roommate with smaller total investments. The common factor is that greater
time leads to additional compounding of the investments and thus greater future values.
Average Annual Rate of Return = 10%
Assumptions Scenario 1 Scenario 2 Scenario 3 Scenario 4
Starting investment age 26 19 14 9
Ending investment age 60 25 18 13
Total investments 35 7 5 5
Table 1.2 Four Investment Scenarios: Assumptions and Expected Outcomes
30 1 • Introduction to Finance
Average Annual Rate of Return = 10%
Assumptions Scenario 1 Scenario 2 Scenario 3 Scenario 4
Annual investment $5,000 $5,000 $5,000 $5,000
Total investment amount $175,000 $35,000 $25,000 $25,000
Value at age 60 $1,490,634 $1,466,369 $1,838,858 $2,961,500
Table 1.2 Four Investment Scenarios: Assumptions and Expected Outcomes
Definition of Economic Value
Value is a term used frequently in business and especially in economics, accounting, and finance. Accountants
track, record, and display value in the form of financial statements and footnotes. The numbers they present
are “book values” and represent what has occurred. Financial people like to speak in terms of “market values.”
Market values are calculated using expected future cash flows discounted to today. Market values are the
prices that consumers pay for a product. Economic value is what we believe consumers are actually willing to
pay for a product, service, or experience. For example, the price of a movie ticket may be $10, but there are
individuals who are willing to pay far more for the experience of watching a movie on the big screen.
Generally, the economic value is at least as great as the market value or current price of an asset. When Bacon
Signs planned for the future, the firm attempted to determine the economic value of its products when
creating an optimal mix of price and quantity sold. Firms that produce unique products for clients may have
multiple prices based on the estimated economic value of their good or service to the client. One way to think
about the difference between market value and economic value is that market value is what you have to pay,
while economic value is what you are willing to pay.
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1 • Summary 31
Summary
1.1 What Is Finance?
Finance is the study of the trade-off between risk and expected return. There are three broad areas of finance:
business finance, investments, and financial markets and institutions.
1.2 The Role of Finance in an Organization
The accounting department creates financial statements, and the finance department implements the firm’s
policy objectives, monitors results, and responds to necessary strategic and tactical changes. Finance is
responsible for budgeting and forecasting. Finance aids in establishing firm objectives and is responsible for
meeting with creditors, lenders, owners, regulators, and other stakeholders that provide capital to the firm or
have a claim against firm assets.
1.3 Importance of Data and Technology
Much of the data used in business today has been available for many years. However, data today is more
attainable than ever due to technological advancements facilitating a user’s ability to gather, evaluate, and
store information faster and more cost effectively than ever. Information is continually available, so the
quicker and less expensively firms can adjust to the arrival of new information, the more valuable they become
for their stakeholders.
1.4 Careers in Finance
Careers in finance are plentiful, fulfilling, and well compensated. Introductory positions are available in areas
such as data collection and data entry. More skill and experience is required for roles such as data analysis and
forecasting. Eventually, executive-level positions such as CFO present themselves to the most qualified.
Finance careers are not limited to financial firms, as understanding finance is an important skill in government
regulatory positions, nonprofit management, and all types of commercial business—from real estate, to retail,
to manufacturing, to education.
1.5 Markets and Participants
Financial markets are where buyers and sellers of financial securities come together to trade. The trading of
securities allows markets to value assets and signal value as new information arrives. Brokers operate to bring
buyers and sellers together and receive commissions. Dealers trade from their own portfolios and are often
willing to make markets for specific securities by agreeing to buy or sell at the current bid and ask prices.
Financial intermediaries actually change or create new financial products.
1.6 Microeconomic and Macroeconomic Matters
Economics is the study of the allocation of scarce resources. Economists attempt to understand the how and
why of human, physical, and financial capital allocation. Microeconomics is the study of factors affecting an
individual’s consumption, and macroeconomics is the study of all the aggregate factors affecting an economy.
Economics is important in finance due to the number of economic variables critical to good financial
forecasting.
1.7 Financial Instruments
Maturity is one method to differentiate among financial instruments. Using this methodology, we have money
markets and capital markets. Money markets consist of short-term marketable securities, and capital markets
focus on longer-term securities such as bonds and stocks.
1.8 Concepts of Time and Value
The concepts of time and value involve the resolution of conflict between consumption now versus
consumption later. Time and value represent the trade-off between risk and expected return. Many financial
