Question

"Time Value of Money and Bond Valuation" Please respond to the following: · Examine the concept of time value of money in relation to corporate managers. Propose two (2) methods in which time value of money can help corporate managers in general.

Answer 1

Time value of money (TVM):

• It is a concept which says that the money received at different point of time has different value. It is the idea that a particular sum of money in your hand today is worth more than the same sum at some future date. The primary reason being inflation & investment rate behind it.
• Time value of money is a concept to understand the value of cash flows occurred at different point of time. Money that we hold today is worth more because it can be invested and interest can be earned.

Two (2) methods in which time value of money can help corporate managers in general.

(A) Net Present Value (NPV):

• Direct measure of money contribution to stockholders. The Net Present Value is a great method to determine if an investment is worthy or not. They calculate the present value of both a sum of money and a stream of cash flow to determine its value today using Time value of money concept. For example investing in an equipment, plant or buying a building.
• If we are given the choice to accept $1000 today or one year from now, then we should certainly accept the $1000 today due to time value of money. Every sum of money received earlier has reinvestment opportunity.
• For example, if we deposited $ 1000 in saving account at 5% annual rate of interest, it will increase to $1050 at the end of one year. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money that we receive in future has less purchasing power than the money that we have at present due to the inflation.

(B) Internal Rate of Return (IRR):

• Internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.
• That is it helps to determine at what rate are we earning by an investment. Because if our expected rate is equal to earning rate then only in this situation our NPV will be zero.
• The Internal Rate of Return method recognizes time value of money and utilizes cash flow. The method is transparent and clear to understand. The highest Internal Rate of Return is the winning investment.
• IRR is sometimes referred to as "economic rate of return" or "discounted cash flow rate of return." The use of "internal" refers to the omission of external factors, such as the cost of capital or inflation, from the calculation.
• For Example: let's assume that you want to open a restaurant.

  You estimate all the costs and earnings for the next five years, and then calculate the net present value for the business at various discount rates.

  At 8% you get a NPV of $1000.

  But, in IRR you need the NPV to be zero, so you try a higher discount rate, say 10% interest:

  At 10% your NPV calculation gives you a net loss of (-)$600

  Now it's negative! So you try a discount rate in between the two, say with 9% interest:

  At 9% you get an NPV of (-)$5.

  That is close enough to zero, so you can estimate that your IRR is just slightly Lower than 9%.

These two methods can help corporate managers in general for capital budgeting.