Understanding the Concepts of Market Prices, Valuation Principle, Net present Value, Interest Rates and Bonds Usefulness to Financial Managers
- Explain why market prices are useful to a financial manager.
Market prices are very useful to the financial managers since they are the current prices at which a service or an asset can be bought or sold. Hence, it helps the financial managers to budget for the company using viable statistics of the prevailing prices of goods or services in the market. However, the economic theory usually contend that the market price will always converge at n equilibrium point where the forces of demand and supply meet. Therefore, changes in either the demand or supply leads the changing of the market prices (Brigham & Ehrhardt, 2010).
Hence, this information would be very helpful to financial managers since they able determine when to buy at affordable market prices (during high supply and low demand) and when to sell at best market prices (during low supply and high demand). Moreover, the market prices are also very useful in helping the financial managers to forecast on the future market trends which is crucial for a business (Shim & Siegel, 2008).
- Discuss how the Valuation Principle helps a financial manager make decisions.
Valuation principle is a very crucial process through which the estimation of goods or services worth is carried out. Hence, the items that are often valued can either be financial assets or liabilities (Shim & Siegel, 2008). Therefore, valuations can actually be done on assets such as investments in stocks and business enterprises or on liabilities such as the bonds that are issued by a company to the public. This is mainly because the determination of the value of both the assets and liabilities of a business are always very crucial in ensuring that the proper decisions are made about the business.
Therefore, the Valuation Principle is very useful to financial managers in making decisions involving merger and acquisition transactions, capital budgeting, investment analysis, financial reporting, as well as the taxable events for determining the proper tax liability, together with the situations of litigation (Brigham & Ehrhardt, 2010). Moreover, it also helps in determining the value of present and future cash flows which is very helpful in making feasible financial decisions that can be conveniently implemented. In addition, the Valuation Principle is also very helpful for the financial managers to determine the market capitalization achieved by multiplying the share price and the total number of shares issued to the market (Shim & Siegel, 2008).
- Describe how the Net Present Value is related to cost-benefit analysis
Cost-Benefit Analysis and Net Present Value are very crucial factor that must be considered before implementation of any project. For instance, the Net Present Value is difference between the present cash inflows value and the present cash outflows value. Therefore, Net Present Value is used in the process of capital budgeting for the analysis of an investment or project profitability. Hence, it is usually sensitive to the future cash inflows reliability likely to be yielded by the project or investment. However, if the Net Present Value is positive for a prospective project it is then accepted, but if it is negative, the project is supposed to be rejected since the cash flows will also tend to be negative (Shim & Siegel, 2008).
However, cost-benefit analysis is related to Net Present Value because it is a process through which analysis of business decisions is carried out. This usually involves summing the benefits of a given business project followed by subtraction of the associated costs. This is the case as it is done in Net Present Value which compares the cash inflows (benefits) and the cash outflows (costs). Therefore, prior to embarking in a new project implementation these two factors must be carried out to evaluate all potential revenues and costs likely to accrue from the project (Brigham & Ehrhardt, 2010). Thus, the outcome of the analysis of both of these factors is used to determine if a project implementation is financially feasible, or a different project should be pursued.
- Explain how an interest rate is just a price
Interest rate is just a price since it is the fee paid by an assets borrower to the owner to serve as a compensation for the usage of such assets. Therefore, it is the price paid on the borrowed money usage or in other words the money charged by depositing funds. For instance, when you borrow money from a bank at an interest rate of 3%, then this is the price you pay to the bank for using its money, hence it is the price of the loan taken (Shim & Siegel, 2008). In addition, when you deposit money in a fixed or savings account you are actually lending the bank your money on which they pays an interest. Therefore, you are indirectly charging the bank because you have let them use your money. Hence, the interest is the price charged on lending the bank your money.
Economically, interest rate is actually the cost of capital hence it is usually subject to the money supply laws of supply and demand. Therefore, interest is just like price, since it is usually determined by demand and supply (Brigham & Ehrhardt, 2010). For instance, if there are many people applying for loans, then the banks increases the interest rate in order to reduce the rates of applications mainly because the banks are not able to lend unlimitedly. The opposite is also true, low levels of loans applications leads to reduction of interest rates. However, this is governed by the central banks and not individual banks.
- Describe how a bond is like a loan
There are various ways of accumulating debt and loans and bonds are one way of doing so. Hence, both loan and a bond a debt whereby a loan is a debt to the bank customers while bond is a debt to the government or big organizations that issues bond to the public or banks. Therefore, a bond is just like a loan because the issuer of the bond is the debtor (borrower), while the bond he holder is usually the creditor (lender) which is the same case in loans (Shim & Siegel, 2008). In addition, a coupon is actually paid to the bonds within a specified period of time which is equivalent to the interest which is charged on loans.
Both the loan and bonds provide the borrower (either corporations or individuals) with external funds for financing both long-term investments or for financing current expenditure in governments (Brigham & Ehrhardt, 2010). However, both the bond and a loan have a maturity time whereby at which the payment should be completed. For instance, most loans are paid on a reducing amount basis within a certain period of time while the bond is usually repaid after a specific period of time but in lump-sum.
Brigham, E. F. & Ehrhardt, M. C. (2010). Financial Management: Theory and practice, (13th ed.). Mason, OH: South-Western Cengage Learning.
Shim, J. K. & Siegel, J. G. (2008). Financial Management, (3rd ed.). Hauppauge, NY: Barron’s Educational Series, Inc.
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