Time value of money
The present value of money differs from the future value of the same amount. The changing value of money is brought about by the changing economic factors in the money market structure globally. The fluctuating time value of money arises from investment return, inflation, and credit terms. Money can be invested in acquiring new assets and making a new product which may give returns to money hence increasing the value of money to a certain level (Ross et al.,2008). The returns gained through investment accumulates with time t at a rate, r. the returns gained increases the value of money over time t if the returns supersede the costs of investment. Inflation, an increase in the general prices of goods and services, fluctuates the purchasing power of goods and services with time. Purchasing power mostly declines with time; contemporarily, money could be used to make more purchases of a commodity in earlier years than current ones. For instance, with $ 40, one could purchase more boxes of candies comparatively with the current market pricing. Money is lent at interest; the interest paid on credit given helps add to the value of money at a given period. The credit terms of money change its value to a different value. The time value of money fluctuates on an unstable formula; all the fluctuations entities contribute to the change in money value with time.
A technique problem faces the calculation of the time value of money. The calculations of the returns gained by money over time are faced by annuities disparities (Jallbert et al., 2004). These recent disparities in calculating the time value of money make it difficult to determine the value of money. Technique problem raises the problem to both businesses and learners. There has been the development of various techniques applied to specific case scenarios in determining the time value of money (Jalbert et al., 2004). The annual variations also present a challenge due to different economic status within years.
The technique of calculating the time value of money is a valuable mechanism in business decision making. Each business must evaluate to determine the profitability of an investment with time and the rate at which the profits accumulate; hence have a forewarned approach in the business structure. The return per unit should guide the production of a new commodity and investment in building up a new asset. The researchers who inform business decisions should integrate the product life cycle, inflation, and unit cost. The integration of probability distribution and risk assessment helps determine the possible outcomes of the time value of money before any business decision arrives (Moon & Lee,2000).
in the wake of limited resources and constraints on the resources to fulfil human need, there is a need to invest money to build up more profit, hence giving the investors a chance to diversify their production. The traditional way of evaluation on investment focused on the profits margin without paying much attention to the time on money value. It is advisably to a business structure to integrate the concept of time on money. Projects and investment to be made must be guided by the principle of where money best gives adequate returns in the present and future (Vecchi et al.,2021). An analysis of the cost, resources needed to carry out a project, risks associated with a project and economic variables and benefits should be highlighted before the money is invested or utilized in any way.
Discounted cash flow variations
Discounted cash flow (DCF) is an estimation method used to project the value of an investment based on its expected cash flows in the future. Cash flows determine the inflow and outflow of money in a project. In a project, the inflows should override the outflows to allow the project to meet its costs and reward the investors. DCF analysis is used to try to figure out the value of an investment in the present, based on projections of returns it will generate in the future. Discounted cash flow applies to investment decisions of investors in various investment opportunities in companies or securities, such as acquiring a company, investing in a technology startup, or buying a stock, and for entrepreneurs and managers looking to make capital budgeting or operating expenditures decisions such as venturing into a new asset new equipment. The future cash flow calculated through the discounted cash flow rate is expected to be more than the present value of money (m b\Grabowski,2021). If the future value is more than the present value, then it is expected that the investment may be rewarding to the investors hence a good investment. However, this is subject to economic variations in the country and the globe. To arrive at a reliable discounted cash flow, we need to apply weights of business profitability determiners such as the average cost of capital which considers the rate of return expected by shareholders. The use of DCF is also limited due to estimation on future cash flow, and most estimation is based on assumptions; hence it may be inaccurate.
Recent development and AnalysisAnalysis
Growth in net cash flow is a determiner used in discounted cash flow. DCF has raised questions on establishing the criterion to evaluate the cash flows influenced by other factors beyond the in and outflows of the investment and cash arising from the outliers in the investment of the business. A business, except the non-profit organizations, is built around making a profit. A company must evaluate the cash flows brought about investments in the company. The cash flows model helps determine the returns by any money inputted in the corporation after the inflows of money are calculated, and costs accounted for in the business. The DCF method is a commonly used valuation method, particularly when valuing sizeable companies where management routinely prepares forecasts of future financial performance. For example, the DCF method would appear to be the favoured valuation method for valuations presented to the Delaware Court of Chancery.
Even when the Gordon Model is used as a single period income capitalization method, there is an implicit forecast of future performance. Many courts fail to understand an implicit forecast of earnings in the valuation method employed under the income or market approaches to valuation.
Following the initial discussion of levels of value, we will then use the Gordon Model and implicitly, the DCF method, to define what I refer to as the marketable minority level of value. This is the level at which public companies trade in regular and active markets. It is also one level at which appraisers develop valuation indications. Along the way, we’ll discuss the relationship between the DCF method and valuation by reference to what is called guideline public companies.
After several other posts where we address valuation theory, we will begin to look at some fair value cases. I believe that the investment in the background will pay dividends in our collective understanding of the statutory fair value in any particular jurisdiction and similarities and differences among and between the various states.
Stock and Bond Valuation
The value of stocks and bonds determine the suitability of that investment. Stocks are securities that reflect the ownership of a part of a corporation. Stocks are an investment that pays off the interest that fluctuates with the profit-loss situation of a corporation. Bonds are corporate loans issued by companies and are tradeable. The bonds are an investment that earns a fixed rate of interest in a specific period. The valuation of bonds and stocks is essential to investors and analysts to determine the returns of the investment. Valuation of bonds and stocks is done to determine their current value and the end value after accumulating interest in a given period. Its par value is used to considerately calculate the effectiveness of investing money in stocks and bonds overall underlying investments opportunities that are readily available. Bonds give a fixed rate that is considerable unless risky investment since inflation and other market variations compared to other investment.
The bonds are evaluated among various rates: coupon bond variation, bonds have interest rates given to investors after some time, such as semi-annually till their maturity. The maturity date of a bond leads to the payment of the principal to the investors; the payment of bonds principal price may be below, at par or above par depending on other investments returns in the country. Stocks valuation is done intrinsically. Stock’s value is determined by a specific company’s business structure and model rather than the comparative degree to other companies. Stocks valuation is done in many ways, some simple and others very complex. In determining the price cost of a stock, present value at market prices is calculated, and returns per share at a given time with consideration to the market stability is used to estimate the possible returns of the stocks at a future date.
Stocks and bonds would form a reasonable basis of investment if a precise analysis of the present value of the investments were done using the market’s available techniques. The investments can be relied on, although the interest rates may fluctuate with the markets of the corporation.
Making capital investment decisions
People invest in projects and corporations to get profits and value their money, which is hard to achieve by saving the money in a bank account. Investments are made with an apparent consideration of the AnalysisAnalysis of possible profits earned by the investors. Decisions on what to invest in a complex analysis of various market determinants. There exist gaps in the market that can give investors the possibility of earning profits from their investments. The inaccuracy and incomplete information on markets is a considerable obstacle in making capital investment decisions. Companies make capital investment decisions on whether to invest in new or already existing corporations. The investment decision is guided by capital budgeting. Capital budgeting involves evaluating the needed resources to make the investments. After evaluating the investment cost, there is a need to evaluate the returns to be gained from the investments. Capital budgeting is done to analytically determine the value and return of existing investment options hence help make a decision well guided by information.
Companies are required to invest and increase the shareholders’ wealth through increased profitability of a company, consequently increasing dividends earned from the investments. Capital budgeting creates accountability and measurability. Businesses that seek to invest their capital in a project without understanding the risks and returns are held accountable to their owners or shareholders. Additionally, if a business has no way of measuring the effectiveness of its investment decisions, chances are the business would have slim opportunities to survive the competitive marketplace.
Businesses, apart from non-profits, are established to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. Capital budgeting decision is a financial commitment and an investment to a given project. By taking on a project, the business is making a financial commitment. Still, it is also investing in its longer-term direction that will likely influence future projects the company considers engaging.
Different businesses use different valuation methods to either accept or reject capital budgeting projects. Although the net present value (NPV) method is the most favourable one among analysts, the internal rate of return (IRR) and payback period (P.B.) methods are often used as well under certain circumstances. Managers can have the most confidence in their AnalysisAnalysis when all three approaches indicate the same course of action. When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove profitable. The payback period (P.B.), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management’s preferences and selection criteria, more emphasis is put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods.
Capital structure refers to the mix of long-term sources of funds, such as debentures, long-term debts, preference share capital and equity share capital, including reserves and surplus. Capital structure is the funds used and used to run the company’s operations for an extended period (I.M., 2015). The capital structure of corporate is used in the market emerging and existing ones to determine the business stability and operations capital structure is evaluated by existing analytical tools, secondary data and regression-based models for the AnalysisAnalysis. In contrast, studies on small-sized firms are very meagre (Kumar et al.,2017). The majority of research on capital structure omits the leverage on industries and their owners.
Capital structure analysis is a periodic evaluation of all components of a business’s debt and equity financing. The AnalysisAnalysis intend to evaluate what combination of debt and equity the business should have. This mix varies over time based on the costs of debt and equity and the risks to which a business is subjected. Capital structure analysis is usually confined to short-term debt, leases, long-term debt, preferred stock, and common stock. The AnalysisAnalysis may be on a regularly scheduled basis, or it could be triggered by one of the following events: The upcoming maturity of a debt instrument, which may need to be replaced or paid off, The need to find funding for the acquisition of a fixed asset, The need to fund an acquisition, A demand by a pivotal investor to have the business buy back shares, A demand by investors for a more significant dividend and An expected change in the market interest rate.
When engaging in a capital structure analysis, consider the following questions: How does the current or projected capital structure impact any loan covenants, such as the debt to equity ratio? If the effect is negative, it may not be possible to acquire any additional debt, or existing debt may need to be paid down, Are there any expensive tranches of debt that can be paid down? This involves discussing alternative uses for any available cash, which could be more profitably employed elsewhere. Are the uses for cash within the company’s business beginning to decline? If so, does it make more sense to return cash to investors by buying back shares or issuing more dividends? Are the company’s financial circumstances so difficult that it will be more difficult to obtain loans in the future? If so, does it make sense to restructure operations to improve profitability and reopen this financing alternative? Does the investor relations officer want to establish a floor for the company’s stock price? This can be achieved by engaging in an ongoing stock repurchase program triggered whenever the stock price falls below a certain amount. Does the company want to achieve a specific rating for its bonds? If so, it may need to restructure its financing mix to be more conservative, thereby improving the odds of investors repaid by the company for their purchases of the company’s bonds.
The capital structure continues to be the backbone and financial foundation for any organization. Certainly, Modigliani and Miller’s Capital Structure Theory is not the most accurate, but it helped develop, understand, and learn capital structure. However, let it be clear that an organization truly depends on its capital structure to generate value, as, without any financing, it cannot accomplish its strategic management plans. The management at every organization should focus on the infrastructure of the company’s capital structure. Despite the many theories about capital structure, the management team must lead the organization to a successful path by making efficient use of the company’s capital structure. The organization needs to always generate value for the stockholders by making efficient use of debt and equity. The focus should be on increasing the ROE. A company with a high ROE has strong solvency and allows its investors to use their wealth somewhere else (Kennon, 2011). In 2009 IBM reported $95.8 billion in revenue, $13.4 billion in net income, and total assets of $109.00 billion (2010 IBM Annual Report, 2011). Despite the slow economy in the past 2 to 3 years, IBM has succeeded in its industry and continues to be a top performer. The company has made the necessary investments in assets; and has allocated resources efficiently in its worldwide operations.
Jalbert, T., Jalbert, M., & Chan, C. (2004). Advances in teaching the time value of money. Journal of College Teaching & Learning (TLC), 1(8). https://doi.org/10.19030/tlc.v1i8.1972
Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of corporate finance. Tata McGraw-Hill Education.
Moon, I., & Lee, S. (2000). The effects of inflation and time-value of money on an economic order quantity model with a random product life cycle. European Journal of Operational Research, 125(3), 588-601.
Vecchi, V., Casalini, F., Cusumano, N., Leone, V. M., Vecchi, V., Casalini, F., … & Leone, V. M. (2021). Value for Money Analysis: Standard and Value-based Methodologies. Public-Private Partnerships: Principles for Sustainable Contracts, 145-164.
Grabowski, R. J. (2021). Comparing Growth Rates Used in Discounted Cash Flow Valuations. Business Valuation Review, 40(1), 2-12.
Kumar, S., Colombage, S., & Rao, P. (2017). Research on capital structure determinants: a review and future directions. International Journal of Managerial Finance.
I.M., P. (2015). Financial management (11th ed.). Vikas Publishing House.
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