Financial Value of Money

Question: Describe about the Value of Money and Time Value of Money? Answer: Value of Money The money is more valuable today than future. The concept is that a certain amount of money available today is more valuable than the same amount in the future due to earning of certain interest. If a certain amount of money is deposited in bank or invested, it adds some interest. So, any amount of money is more valuable than the future received (Brigham Houston 2004). Such as, it is assumed that the rate of interest is 13%. If $100 is invested now will worth $130 in one year. Reversely, $100 received after one year, is only worth $88.49 today, assuming same interest rate. So, the importance of time value of money is crucial in financial management. It is used to appraise various available investment alternatives and to solve problems in various financial decision making process such as loans, mortgages, lease, savings, annuities, and project investment. Loan Covenant Loan covenant is a provision or condition in a loan agreement where certain activities will or will not be carried out by the borrower or lender. It states certain stipulations or limits which are put in place by lenders to protect themselves from borrowers. If the borrower does not act in accordance with the covenants, the loan can be declared in default. Penalties can be charged or lender has the right to demand full payment (Crane 1983). Limitations often depend on the extent of the company. The limitations for a low risk company will be minimal and on the other hand, limitations will be greater for a high risk company. Distinguish between positive negative covenants Covenants are usually of two types; protective and restrictive. Positive or Protective covenant is concern about taking certain actions the issuer such as maintaining adequate level of working capital, possessing adequate insurance both life and property, and providing the bank with month-end or quarter-end financial statements (Johnson 1971). On the other hand, Negative or Restrictive covenant states the restriction that the debtor must perform according to the loan agreement such as limitation on dividend distributions, covering of standard cash flow and restriction on extra borrowings. Both the Positive and Negative covenant are used to protect the interests of both parties (lender and borrower). Initial Public Offering (IPO) Initial public Offering (IPO) is the primary market where shares or securities of a company are directly sold to the investor. IPOs are used by companies to raise the expansion capital. Also new company, who has never issued equity to the public and go for raising the capital directly issuing to the investors, can be known as IPO (Milburn 1988). Advantages of IPO Huge Capital: IPO is an extremely good way for a company to acquire huge amount of capital. In IPO, shares are issued to the general public which helps in acquiring a huge amount of fund. Public Awareness: In supplement to the capital gain, the public awareness of the company will also increase for going to public directly. Credibility of the company may also increase with its vendors, customers, and creditors. Increased Liquidity: It increases the liquidity of company shares. In IPO, investors are allowed to buy shares directly. The risk concerned with holding the securities reduces because there is option freedom to sell. As a result, share value increases. Employee Retention: It is difficult to attract and retain quality employee. Employees can be attracted and retained by offering them the shares of the company (Paramasivan Subramanian 2009). Disadvantages of IPO Lack of Control: Only management decisions cannot end the lack of control. Openly going to investors can make company risky for future takeover. It should also retain a sufficient percentage of outstanding shares. Time consuming and Expensive: IPO process is both time consuming and expensive. Employees can distract from daily operations. It includes very high expenses like that of underwriting fees, appointment of lead manager and participant of investment banker, etc. Regulation: Company also bound to follow the rules and regulations which are regulated by the Security Exchange Commission (SEC). Disclosure: It is difficult to disclosure of information for investors time to time maintaining secrecy over internal strategies. Limitations of the Dividend Discount Model of share valuation DDM is the method of evaluating stock price by using future dividends discounted back to present value. The value calculated through DDM if greater than the current market price of the securities, the stock is called undervalued. Though the DDM is useful for stock valuation, it has also some limitation. The main problem is that the value cannot be calculated unless the company pays dividends. In present market, the maximum companies do not pay regular dividend. They mainly focus on growth and invest their profit back into the company. So, DDM is worthless for those companies (Patnaik 2009). Lot assumptions are required for the application of DDM formula. The assumptions such as company will continue to pay same dividend or it will continue paying dividends at all. If the assumptions do not predicted properly, the DDM becomes worthless. Security K has more total risk because it has greater standard deviation (30%) than security C (20%). Security C has more systematic risk because its beta value (1.25) larger than the beta value of security K i.e. 0.95. Also the security C should have the higher expected return because its beta larger than the security K. Payback Period Method Payback period is calculated to find out the span of time need to recover the cost of investment. According to that the decision is taken whether to undertake the project or not. Longer the payback period is not suitable for investment. It is usually expressed in years and calculated as follows: Payback period = Cost of Project / Annual Cash Inflows The project is accepted when then it is smaller or same to desire period expected by the company. In case of comparison of two o more alternatives projects, the project which has smaller payback period is accepted. It is useful for cash poor firms because it shows the period for quick inflow of cash and it is very simple to calculate. The liquidity position can enhance shortly with smaller payback period and it can make the funds available soon for investing in another project (Peterson Drake Fabozzi 2009). Drawbacks of Payback period are as follows: Payback period method does not consider time value of money. But some companies modified this method by adjusting the time value of money to get to get the discounted Payback period. According to Payback period method, the project with smaller payback period is suitable for investment. But the company can earn extra profit after the payback period. So, it does not measure profitability. Conflict between IRR and NPV In case of independent project or a single conventional project both IRR and NPV provide same indicator about whether to accept or reject the project. But the conflict arises for mutually exclusive project. It can be observed that one project higher NPV while the other has a higher IRR. The conflict appears because the size is different for different projects and also the cash flows are not same for all projects (Sandel 2012). When facing such situation, the higher NPV project should be accepted because NPV is an absolute measure because it gives exact monetary value. The projects are ranked through higher monetary value despite the actual investment needed. But IRR is a relative measure because it does not give monetary value rather it finds out the rate of return. The projects are ranked according to the higher investment return despite the total value added. So, NPV results superior to the IRR results. Concept of depreciation tax shield in the context of a capital budgeting Depreciation is a non cash expenses. It does not affect cash flow directly. It is not treated as expenses account, company keeps it in cash. But the income tax has a significant effect on the cash flow of the company. Depreciation is tax deductible expense that reduces income tax of the company by reducing taxable income. The actual amount of tax that is reduced by depreciation is called as depreciation tax shield. If the depreciation amount goes higher, the lower will be taxable income and as a result the lower amount tax has to pay by the company. Therefore, depreciation indirectly affects the cash flow by reducing the amount of taxes paid (Scott Moore 1984). Modigilani and Miller Proposition I with as well as without taxes Modigliani and Miller is a theorem on capital structure, stating that the market value of company is derived through its earning capacity and risk associated with its underlying assets. According to that value the company selected the way to finance the investment and distribution of profits. This is an irrelevance proposition to the capital structure assuming no taxes and no bankruptcy costs. A firm can choose any financing method for sourcing the finance by choosing debt or equity or the various combinations of these two. This theorem suggests whether the company bears high risk for financing equity and debt or bears a low risk with lower debt financing which has no bearing on the value of a firm. If it is assumed that there is no tax, the capital structure does not influence the valuation of a firm. Explicitly it can be said that leveraging the company does not increase the market value of the company. So, it can be also said that the equity and debt shareholders in the company have the same priority (i.e. earnings are divided equally amongst them) (Shwayder 1968). Debt Capital as mitigating factor of Agency Cost Agency cost of debt arises to an increase in cost of debt when the different interests are paid to shareholders and debt-holders and gap or dissimilarities of information is generated between principal and agent. The management directly deals with the operation of the business. So, they should have more information about business prospects comparing to shareholders and debt-holders. The information asymmetry and the agency cost have the direct relationship. The greater the gap or dissimilarities in information, the agency cost will increase. The management can distribute the profits to shareholders many ways without providing anything to debt-holders. In such situation, debt-holders can take various actions to refuse management from doing so. They may hike the interest rate to keep themselves from losses and also may apply negative covenants. The management gives priority to dividends. Cash dividends may be paid to the shareholders, providing very less amount to debt-holders. To overcome this situation, interest must be paid before dividends (Van Horne 1980). Indirect Costs of Financial Distress Indirect costs of the financial distress are costs such as lost business as a result of bankruptcy or liquidation. This is usually occurs because potential customers do not wish to take the risk of using a company that may not be able to deliver its goods or services. As well as, it occurs when banks hike the interest rates. Because the cost of capital will be higher. Like other indirect costs, the indirect costs of financial distress are not easy to calculate with certainty. Financial distress can create negative effect on cash flow and balance sheets of companies by losing customers, key employees, business opportunities and favorable credit terms (Woodhall Stuttard 1999). Dividend policy of a firm is irrelevant in terms of its impact on the share value When a company makes profit, they must go for a decision what to do with that profit. Company may retain the profits or could pay a portion to the shareholders. Once it is finalized, they may establish a permanent dividend policy. There are various theories through which the relationship between a companys dividend policy and share value can be explained such as Traditional model, Walter model, Gordon model and MM model. The market price of share increases when the company declares to pay dividends from its profits. But at the same time the reserves for reinvestment decreases. Hence, company can issue new shares for the expansion of its capital. So, total number of shares increases. As a result, market price per share will lead to fall. Time Value of Money Money value is associated with time. The value of money changes with changing of time. Money received now is more valuable than the future because money received now has opportunity to invest and raise a certain interest more than that in the future. Rate of interest is the factor which raises the earnings on an investment. The applications of time value of money are in several areas such as Capital Budgeting, Bond Valuation, Stock Valuation, loans, mortgages, leases, savings and annuities. It can be divided into two groups: Future Value and Present Value. When the value of cash or an asset in future date is equivalent to current value, is called Future Value. The calculation of FV is different for simple annual interest a compounded interest annually (Woodhall Stuttard 1999). Present Value is the todays value of expected cash flows which will generate. The expected cash flows are converted in current value through discounting with a specified discount rate. The greater the discount rate, lower the present value of the expected cash inflows. In case of commercial banks, various formula of time value of formulas is used daily. There are so many problems which are solved by using the formula of present value of annuity such as determining of monthly payment amount, determining of amount of mortgage required to pay by borrowers. It is used by insurance companies. Structured settlement is the example of it. Such as, if a certain amount of money is payable in 10 installments i.e. $3000 over the next 10 years. If the current value of settlement is calculated it will be lower than $3000. So, it can earn benefits if the person pays a lump sum amount at present. The schedules of loan payment can be prepared through time value of money. The formula of present value of annuity is used to schedule the payment structure of loan. The formula of future of annuity is used to calculate the end value of the loan which needs to pay by the borrower at the end of loan. For long term investment it is very important such as appraising the available investment opportunities of long-term by discounting expected cash flows, calculating the value of assets which will acquire under deferred payment agreements, measuring impairment of assets (Woodhall Stuttard 1999). In case of sinking fund, it is used to determine the amount need to deposit on a continue basis for accumulating the maturity amount of a debt which comes due at future date. Various accounting items of a business are determined through time value of money such calculation of receivables, payables, liabilities, and accruals, etc. It is also applied to measure the value of future cash flows from oil and gas reserves for disclosure in supplementary information. It is not only useful to decision making to the companies but it is also useful to decision making for personal decision such as purchasing of property (Land, house, etc.) amount to be saved for the education of child and savings planning related to retirement. There are three factors which have impact on the time value of money. Consumption preferences for all people are not same. The present preference for consumption is well then it results better consumption for future. Inflation rate of a country may vary time to time which can create a far difference between current cash flow and the same cash flow of future. Future cash flows are expected to generate. But, in reality it may not match with the actual due to various reasons. Risk-return Relationship Risk is inherent with the return of security. For high return, investors should bear high risk. Investors attract with high return to invest the money. As a result, flow of capital for future increases. Low levels of uncertainty are associated with potential returns. There are two types of volatility which are involved in return of investment. First type of volatility depend on the company related factors such as running of projects are not happening according to the plan, participant of competitors both from inside and outside of the state, changing of various management procedure time to time generally related with financial aspect. On the other hand, the other risk is called as market risk or systematic risk. The factors related with market risk include budgetary process, GDP, foreign reserves, and interest rates of a state. Stock markets are influenced by the above factors. The rate of fluctuation influences the stock prices to push up or down. Movement of some stocks goes gently with the market. Some move on direct proportions on the markets same side and some move in opposite proportion (Woodhall Stuttard 1999). Therefore, it is very important to measure market sensitivity with the help of beta coefficient. Previously, financial experts usually engaged to estimate the beta coefficient. But now, risk return relationships are emerging to investigate the financial market. Maximum of numbers of investors can bear higher risk for getting higher return. In other words, it can be said that avoiding the risk means sacrificing of some return from the investment. In this context, it is assumed that investors can choose risky asset also to gain higher return accepting the risk associated with it. So, the systematic risk can be reduced by choosing of effective portfolio. Standard deviation of securities decreases by choosing more and more securities. But the appropriate securities should be chosen in the portfolio. As a result, the volatility of market tallies with the volatility of portfolio. Therefore, the risk associated with the investment cannot be reduced totally. (Woodhall Stuttard 1999). 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