Explain why market prices are useful to a financial manager. A competitive market is one which a good can be bought and sold at the same price. We can use prices from competitive markets to determine the cash value of a good. Whenever a good trades in a competitive market, the price determines the value of the good. Financial Managers must be able to evaluate costs and benefits in order to make the appropriate decisions that benefit the company. Once we use the market prices to evaluate the cost and benefits of a decision in terms of cash today, it is then a simple matter to determine the best decision for the company.
The best decisions make the company and its investors wealthier, because the value of its benefits exceeds the value of its cost. In a competitive market the value of a good is set by its price, and any personal opinion or preference is irrelevant when determining value. Discuss how the Valuation Principle helps a financial manager make decisions. The task of every financial manager is to make educated decisions on behalf of the investors and shareholders of each company.
People in these positions are faced with questions regarding investments, production, etc. ; each and every day of their lives. It is too often that within a company, someone will propose an idea that sounds good at the time but may not be of benefit. It is the job of the financial manager to break the idea down into detail to analyze the benefits and the costs, and then make a decision based on concrete numbers. This process is known as the Valuation Principle, an analysis between the value of the benefits and the value of its costs.
It provides a basis for making decisions within a company. The Valuation Principle is known as the foundation of financial decision making (2011 Tangient LLC). Manager’s Basic Tools Used for Making Financial Decisions Describe how the Net Present Value (NPV) is related to cost-benefit analysis. When the value of a cost or benefit is computed in terms of cash today, we refer to it as the present value. The net present value of a project or investment is the difference between the present value of its benefits and the present value of its cost.
The NPV expresses the value of an investment decision as an amount of cash received today. As long as the NPV is positive, the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money. The NPV decision rule implies that we should undertake projects with a positive NPV. Managers only take the good projects, those for which the present value of the benefits exceeds the present value of the costs. The end result, the value of the firm increases and investors are wealthier.
Projects with negative NPVs have cost that exceed their benefits. Accepting them is equivalent to losing money. Explain how an interest rate is just a price. To understand interest rates, it’s important to think of interest rates as a price, the price of using money. When you borrow money to buy a car, you are using the bank’s money now to get the car and paying the money back over time. The interest rate on your loan is the price you pay to be able to convert your future loan payment into a car today.
Similarly, when you deposit money into your savings account, you are letting the bank use your money until you withdraw it later. The interest the bank pays you on your deposit is the price it pays to have the use of your money. Describe how a bond is like a loan. In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to Manager’s Basic Tools Used for Making Financial Decisions pay interest (the coupon) and/or to repay the principal at a later date, termed maturity.
A bond is a formal contract to repay borrowed money with interest at fixed intervals. Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds. Bonds must be repaid at fixed intervals over a period of time (2011 Wikipedia).