Question

What can each of the five principles of finance teach us about the problems in the apartment building industry? Which of the five principles (can list one or two) will be most useful in devising a public policy solution to these problems and why?

Five principles:

- Money has a time value

- There is a trade-off between risk and return

- Cash flows are the source of value

- Market prices reflect information

- Individuals respond to incentives

Answer 1

The five principles which teach us about the problems in the construction industry, have been discussed below, the first two principles in my opinion are most useful in devising a public policy solution to the problems arising out of the construction industry.

Financial management has an important bearing in the Construction industry (apartment building), reason being it's comprehensive principles. Let's analyse their application in the given industry:

1. Money has a time value:

Time value of money, is the value of money at a given point of time. For example INR 1000 received today is more valuable than it would be after a period of one year. it's value does not depreciate over time but the opportunity of accruing benefits by its current investment (eg. invested in fixed deposits @ 7%) and earning an additional interest income with the given amount is lost. The other understanding could be that with fluctuating inflation rates, what one could purchase with a given amount, will still be able to purchase the same after a year is uncertain. Construction industry has a wide application of this principle, as these are huge investment project plans, with the capital locked in for a longer period of time.

2. There is a trade-off between risk and return:

The greater the risk of an investment the higher the required rate of return. Generally it is assumed that in order to earn higher returns one must take higher risk, but there is uncertainty as this may or may not always result into a positive reward. The trade-off is to underline the concept that one must strike a balance between one's capacity to take risk and manifold reward expected out of the risk. In the Constructon industry it is definitely a higher rsk due to it's huge capital investment and rewards are manifold, also extending over a longer period of time.

Solution to the above problems:

One must determine the time value of money, discount the future cash flows which one would pour into a capex project of this sort. This would help one determine the real worth of money invested today, and it's actual value if invested elsewhere, then given the profit on returns from the project, if higher than the returns from other investments, this would give a clear picture and helps in decision making.

The second principle is an effective decision making tool. It aids in taking a calculated risk such that, profits are maximised or capital is safe to the extent of risk deducted.

3. Cash flows are the source of value:

Cash flows are important for a business cycle to run continuously, as profits are uncertain, and continuous buisness operations should be independent of such uncertainities. Construction industry requires both huge capital investment and consistent boost of cash flows,also a lot of other expenses arising out of legal or compliance demands. Such commitments are usually funded through the loans from banks or one's previous projects.

4. Market prices reflect information:

There is an mportant saying that 'Market discounts prices', any news in market, takes time to reach the consumer market but the stock market discounts or rather incorporates the effect of the news immediately. This principle may or may not impact the construction industry directly, but definitely has an immediate effect on the Realty sector which an index of the Real estate sector. The only possible solution to this would be verification of the news or rumour in circulation and effective well informed marketing campaign so that the consumers are not swayed away by the rumours.

5. Individuals respond to incentives:

Individuals respond to incentives, i.e. their decisions are often biased or driven by incentives or benefits provided to them in the light of which they tend to ignore the organization's best interest. Construction industry, specially an apartement building industry, it's very important for them to think about the consumers which is also in the best interest of the company. Customisaton with uniform quality would be the best possible solution, as customisation is an important aspect and most attractive incentive which could be provided by the construction industry.