The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing and investing decisions. So, why is there a need for a complicated subject called corporate finance to make these decisions? Well, it turns out there is a need? The need arises because of this concept of nominal and real value of money. This article will explain why corporate finance is required:
The Concept of Inflation
We are all intuitively aware of the concept of inflation. We know that money loses its value every year. The same amount of money will purchase less and less every year. Let’s say that $100 is required to purchase a certain commodity of goods today. So if there is an inflation of 10%, the same goods will be available for a $110 next year.
Introduction to Nominal Value of Money
Inflation and the Time Value of Money. Valeria has a basic idea of inflation — that $100 today probably will not buy the same amount of goods that $100 will buy next year — but she’s not sure how investing will help. Investing takes advantage of compound interest over time, so the more time you invest — in general — the more.
So, if we made an investment that was yielding 9% return this year, we would have a total of $109 next year from the $100 we had invested. In accounting terms we would have a profit of $9. This is because we are only considering the nominal values. Nominal values do not consider the effect of inflation, opportunity cost of capital and such other forces which cause the value of money to decrease in a given time period.
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The Problem with Nominal Values to Measure a Firm’s Performance:
Nominal values present a distorted image of the firm’s performance to its shareholders and this is to say the least. Consider the case we discussed above. Here, the firm has lost 1% purchasing power. This means they were better off consuming the $100 in year 1 and could have purchased more goods with it rather than investing it and consuming $109 a year later. Thus, if nominal values are considered, firms will end up eroding their capital by investing their money in projects that offer a rate of return that is below the firm’s cost of capital.
Introduction to Real Value of Money
To offset this problem, specialists in corporate finance have come up with the concept of real value of money. The real value of money takes into account inflation, opportunity cost of capital and such other forces. Thus, firms that base their calculations on these inflation adjusted values make better financial decisions as compared to those that do not. The calculation for both real as well as nominal values is simple and can be done with the help of the following formula:
Real Value = Nominal Value / (1 + (i / 100))
i = The prevailing inflation rate in the market
Subjectivity in Real Value of Money:
It must be understood that the real and nominal values of money are subjective. This is because, they are determined using the inflation rate. There is no single measure of inflation. The government itself produces multiple estimates of inflation. Also, for the purpose of the company’s calculation, these measures may not be good enough. So the company may create its own inflation index depending on which the real values are calculated. Thus, there is widespread subjectivity in this calculation. Different companies use different rates to convert nominal values to real values.
The biggest take-away from the concept of nominal and real values is that money in one time period is not directly comparable to money in another time period. It is for this reason we have to calculate present values, future values and the like. These calculations form the backbone of corporate finance.
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In the previous section, we learned about the time value of money using a relatively simple model. In reality, there are more factors that affect the value of a potential investment. These factors will be described briefly in the following section.
In the previous example, we were blending the concept of “inflation” with another concept called “discount rate”. Inflation is how the price of goods generally increases, and can be an appropriate substitute for figuring out the future value of money. However, “discount rate”, is a term which is unique to individuals and business entities. A “discount rate” is the rate at which any given entity can expect to earn on their money invested. For example, most people keep money in banks. A bank will pay a customer interest for the customer to keep their money in the bank. The interest rate is typically extremely low, say, %0.05. So if you invest your $1000 in a bank for 10 years, you would get a predicted return as described above with a %.05 increase per year. If you invest your money in a stock, you might get a higher return than in a bank. Maybe you can get something like 4% return on your investment. If you can consistently get 4% return, that becomes your discount rate. That way, when evaluating what investments are good for you, you need to compare the investment’s rate of return against your own discount rate.
As you can see, an individual’s (or business’) discount rate is often different than the rate of inflation. But if the general purchasing power of money is decreasing (because the cost of goods increases – i.e. inflation), and you can grow your money at a different rate, how can you figure out how much cash you need today, in order to make a large purchase in the future? The formula for this is shown below.
The first step is finding the “Present Worth Factor,” FPW.
Where iINF again is the inflation rate, and d is the discount rate. “n” represents the number of terms (often years) of the calculation. Once the FPW is known, you can calculate the “Present Worth” (PW) of an investment. The PW is the amount of money needed at the present (invested at d) in order to purchase something in the future (with an inflation rate of iINF). The PW is:
Where C0 is the cost of the object you wish to purchase. An example below uses both discount rate and inflation to find the present worth.
Money Growth And Inflation
Example: Your Company has recently installed a large utility scale PV power-plant. The overall plant cost is $100M and the plant is operational. There are dozens of large inverters as a part of the system, which will need to be replaced in about 7 years. If there are 20 inverters, which cost $20,000 each, how much cash does your company need to have now, invested at your company’s discount rate of 6%, in order to purchase the inverters in 7 years? Assume an inflation rate of 3%.
Define Inflation And How It Affects The Real Value Of Money
Solution: If your company would make the purchase today, it would cost $20,000*20 = $4M. However, the company will actually make the purchase in 7 years, and the cost of the inverters will go up, due to inflation. So instead we use the Present Worth formula. First we’ll calculate the present worth factor.
Now we apply the present worth factor to the cost of the inverters:
Therefore your company needs to have about $3.3M today invested at 6% in order to make the inverter purchase in 7 years.
Sometimes in order to make these large purchases, a company will need take out a loan from a bank. When a bank loans money to an entity, they consider it an investment, and expect more money in return. This money (from the perspective of the entity taking the loan) is called interest. Interest is paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt. If you take out a loan from a bank for $1,000 at an interest rate of 3%, you will need to pay the bank back $1,030 at the end of one year.