In this lesson students will:
- understand what is meant by the valuation principle
- use a time diagram to determine the fair market value of a stream of payments at a given reference point
The Valuation Principle
Often, when working as an accountant, we will need to determine a fair price for a company asset. For example, when my parents’ rental company Par-Tee Rentals shut down, my parents had to determine a fair value for their rental products. Just how much would their company be worth? They had to take into account depreciation, which is a decrease in market price due to wear and tear. Certainly, they would be unable to sell an item for the exact price that they had paid for it several years earlier. This demonstrates the valuation principle – the concept that the value of an asset or commodity is determined by its market price. In a competitive market the value of an asset might fluctuate according to supply and demand. In our course, however, we will be mostly concerned with time-value of money. That is, market value of money will be completely determined by given interest rates, and not by supply and demand.
The Fair Market Value of Money
So just what is the fair market value of money? Another way to ask this question is to ask how much is my money worth at any given time? In order to answer this question, we will have to recall the time value of money principle from Chapter BM3.4. In other words, we will always assume that, given the opportunity, the lender or borrower will invest their money at the given interest rate during a period of time. Due to the time value of money principle, we can determine the fair market value of money at a reference point by either determining the future value, or by discounting, using the given interest rate.
Often when working with multiple payments, or multiple loans, it can be helpful to determine the fair market value of money at a specific point in time. This is especially helpful if we are buying a payment plan from the bank, or wishing to pay off multiple loans all at once. The following video will guide you through a couple examples of using the time value of money principle to determine the fair market value of multiple streams of money.