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Time Value of Money

See Also:
Valuation Methods
Adjusted Present Value (AVP)
Net Present Value Method
Internal Rate of Return Method
Required Rate of Return

Time Value of Money (TVM)

Time value of money is the difference between an amount of money in the present and that same amount of money in the future. Having money now is more valuable than having money later.

The present amount is called the present value, the future amount is called the future value, and the appropriate rate that relates the two amounts is called the discount rate.

Present Value = Future Value / (1 + Discount Rate)

Future Value = Present Value x (1 + Discount Rate)

Time Value of Money Examples

Now, let’s look at time value of money examples. If you invest $100 (the present value) for 1 year at a 5% interest rate (the discount rate), then at the end of the year, you would have $105 (the future value). So, according to this example, $100 today is worth $105 a year from today.

$105 = $100 x 1.05

$100 = $105 / 1.05

Likewise, $100 a year from today, discounted back at 5%, is worth only $95.24 today.

$95.24 = $100 / 1.05

To calculate the time value of money for a period longer than one year, you simply raise the discount factor by the appropriate number of time periods. For example, to calculate the future value of $100 at 5% for 5 years:

$127.63 = $100 x (1.05)5

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Retainage

Retainage Definition

What is retainage? What is a retainage fee? In the contracting business, vendors define this term as a portion of the payment that is withheld until the completion of a project. The client doesn’t pay the contractor remaining payment until all work on the project is complete. It is defined the risk clients take when paying contractors. Its result is a protection for their money, time, and other resources.

Negotiate retainage upfront and represent it as a percentage of the overall cost of the project. A common withheld payment amount is 10%. This incentivizes the contractor to provide quality work up until the very end of the project. As a deal-sweetener, or for small scale projects and rushed jobs, a client may offer to forego this percentage to a familiar and reputable contractor. This definition can vary somewhat depending on industry and company focus.

Retainage Collection

Similar to accounts receivable and other forms of trade credit, an uncollected retainage receivable is essentially an interest-free loan with a cost equal to the cost of financing current assets and the time value of money.

Therefore, from the contractor’s perspective, a shorter collection period is optimal. Typical collection periods for retainage accounts receivable can be as long as 6 months or as short as 45 days. If you want to be very efficient, then consistently collect the withheld amount from clients within 90 days of project completion. A reduction is surely needed if collection occurs beyond the marker of 6 months.

Collection Hurdles

Typically there are three steps to complete before the contractor can collect retainage. These three steps are: completing the punch list, putting together the close-out package, and submitting this invoice.

Define a punch list as a list of minor details and leftover items related to the project. The bulk of the project may be complete, but small tasks may remain unfinished. For instance, a punch list may include an unpainted portion of a ceiling, faulty wiring for a light bulb, or a problem with plumbing. The client will not pay the retainage until these minor items have been taken care of, so this is an important step to complete in speeding up collections.

The close-out package is a collection of documents related to the project. Some clients, especially in the medical field, expect a close-out package prior to paying retainage. The close-out package consists of copies of legal documents, liens, warranties, certificate of occupancy, test results, operations and maintenance manuals, and other relevant paperwork and documentation. Gather these documents and send them to the client in a timely manner to ensure prompt payment of retainage.

And finally, it is important to submit the retainage invoice to the client as soon as possible after all other necessary steps have been completed. Prior to submitting the invoice, finalize all subcontractor pricing.

Three Steps for Retainage Collection

1. Complete the punch list
2. Assemble the close-out package
3. Mail the retainage invoice

Complications

Certain matters can complicate retainage negotiations, retainage collection, and retainage release. These issues can arise from change orders and arrangements with subcontractors.

Often, over the course of a contracted project, the client will request changes deviating from the original project plans. For instance, in a construction project the client may request to move a wall, alter or relocate windows or doorways, or add or change other features. These change orders inevitably add to the cost of the project as a whole and change the amount withheld.

Getting pricing in from all subcontractors on additional work can be difficult. A project manager must rely on subcontractors to submit pricing in a timely manner so that they can generate the final progress billing and retainage billing. Oftentimes, pricing can snowball at the end of a project.

A dedicated project manager will be pro-active with regards to pricing from subcontractors. So that he may invoice the retainage as soon as possible after they complete the project.

Retainage bonds further confuse the matter, with needs varying by location and governing body. Generally, file some kinds of retainage bond with the local municipality. Amounts and requirements are subject to the preferences of local government. Make sure to consult an expert when filing for any type of payment bond.


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retainage

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retainage

See Also:
Progress Billing for a General Contractor
How to Maintain an Effective Job Schedule
Work in Progress
How to manage inventory
Trade Credit

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Maturity Date Defined

See Also:
Coupon Rate Bond
Covenant Definition of a Bond Contract
Long Term Debt
Non-Investment Grade Bonds
Par Value of a Bond

Maturity Date Defined

In finance, maturity date defined is the date on which a debt instrument is due. For example, when a bond reaches maturity, the issuer must pay the bondholder the principle and the final interest payment. A debt instrument’s maturity is one of the factors that determine the price and yield of the instrument. Because of the time value of money and the increased risk of volatility, debt instruments with longer maturities often have higher yields.


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Maturity Date Defined

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NPV vs Payback Method

See Also:
Payback Period Method
Bailout Payback Method
Rule of 72

NPV vs Payback Method

NPV (Net Present Value) is calculated in terms of currency while Payback method refers to the period of time required for the return on an investment to repay the total initial investment. Payback, NPV and many other measurements form a number of solutions to evaluate project value.

Payback method, vs NPV method, has limitations for its use because it does not properly account for the time value of money, inflation, risk, financing or other important considerations. While NPV method considers time value and it gives a direct measure of the dollar benefit on a present value basis of the project to the firm’s shareholders. NPV is the best single measure of profitability.

Payback vs NPV ignores any benefits that occur after the payback period. It also does not measure total incomes. An implicit assumption in the use of payback period is that returns to the investment continue after payback period. Payback method does not specify any required comparison to other investments or investment decision making. It indicates the maximum acceptable period for the investment. While NPV measures the total dollar value of project benefits. NPV, payback period fully considered, is the better way to compare with different investment projects. If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

NPV vs Payback method

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NPV vs Payback method

For additional information on NPV, please read Net Present Value Method.

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Future Value

See Also:
Valuation Methods
Net Present Value Method
Adjusted Present Value (APV) Method
Present Value (PV)
Opportunity Cost

Future Value Definition

Future value (FV) is the value of a sum of money at a future point in time for a given interest rate. The idea is to adjust the present value of a sum of money for the time value of money over the specified time period.

If the present value is $1.00, and the interest rate is 10%, then the FV of that dollar one year from now would be $1.10. If someone offered you a dollar now or a dollar one year from now, you’d prefer the dollar now. Because by taking the dollar now and investing it, it will be worth more than one dollar a year from now. By applying that same concept to larger quantities of money, you can see that money now is more valuable than the same amount of money later and that it is necessary to consider the time value of money when making financial decisions.

Future value can be calculated with simple interest or compound interest. Practically speaking, it is more useful to calculate future value using compound interest. Simple interest accounts for interest accumulation over time without compounding. It is simply the principal amount adjusted for the annual interest rate. Compound interest accounts for the interest earned on the value of previous interest earned.

Future Value Formula for Simple Interest

FV = Present Value x (1 + (Interest Rate x Time Periods))

One dollar at 10% for one year: $1.10 = $1.00 x (1 + (.10 x 1))

One dollar at 10% for five years: $1.50 = $1.00 x (1 + (.10 x 5))

Future Value Formula for Compound Interest

FV = Present Value x (1 + Interest Rate) Time Periods

One dollar at 10% for one year: $1.10 = $1.00 x (1 + .10)1

One dollar at 10% for five years: $1.61 = $1.00 x (1 + .10)5

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Future Value Definition, Future Value Formula for Simple Interest, Future Value

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Capital Asset Pricing Model

See Also:
Cost of Capital
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is an equilibrium model that measures the relationship between risk and expected return of an asset based on the asset’s sensitivity to movements in the overall stock market.

CAPM is used to price the risk of an asset or a portfolio of assets. The model is based on the idea that there are two types of risk, systematic risk and idiosyncratic risk, and that the investor should be compensated for both types of risk, as well as, the time value of money. Systematic risk refers to market risk. Idiosyncratic risk refers to the risk of an individual asset. Time value of money refers to the difference between the present value of money and the future value of money. Also, use the model to measure the required rate of return for capital budgeting projects.

The CAPM states that an asset’s expected return equals the risk-free rate plus a risk premium. The risk-free rate refers to the return on an investment without risk, such as a US Treasury Bond, and represents the time value of money. The risk premium represents the incremental return for investing in a risky asset. In the CAPM, it is defined as the market premium, or the overall stock market return less the risk-free rate, multiplied by the beta of the asset. Beta is a factor that measures an asset’s sensitivity to movements in the overall stock market. According to the CAPM, riskier assets should yield higher returns.

The CAPM Formula

Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

For example, if the risk free rate is 5%, the market return is 10%, and the stock’s beta is 2, then the expected return on the stock would be 15%.

15% = 5% + 2 (10% – 5%)

Problems with Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is based on assumptions. First, the model assumes that a riskier asset will yield a higher return. But this is not necessarily true. A risky asset could decline in value. Second, historical data determines beta. The model assumes this historical data an accurate predictor of future results. But the asset’s future volatility may not necessarily reflect its past volatility.

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Capital Asset Pricing Model

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Black Scholes Option Calculation

See Also:
Common Stock
Dispersion
Binomial Options Pricing Model
Efficient Market Theory

Black Scholes Option Calculation Model

The Black Scholes option calculation (stock option pricing formula) uses five variables to compute the price of a stock option. The variables are the time remaining until the stock option expires, the price of the underlying security, the strike price of the stock option, time value of money, and the volatility of the underlying security.

Black and Scholes

Fischer Black and Myron Scholes developed the Black Scholes stock option pricing formula in the 1960s in an effort to solve the problem of determining fair prices for stock options and other financial derivatives. Therefore, use the formula to price various financial derivatives. There are several variations of the Black-Scholes formula, and there are also other formulas used to price options and other financial derivatives.

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