Functions of financial markets and capital investment decisions

¶ … functions of financial markets and discusses why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. Furthermore, the paper explains the cash flows associated with a bond to the investor. And discusses the term "price-earnings (P/E) ratio." In addition, the paper discusses the certainty equivalent approach to estimating the NPA of A project and discusses the problems associated with capital investment process. Lastly, the paper contrasts and compares capital budgeting and strategic planning assesses the agency problems associated with capital budgeting.

Explain the functions of financial markets

The existence of the financial market is just to help and maintain the relations between the users of the capital and the providers of the capital. They also provide an opportunity for both the parties to do transactions with mutual benefits. It is there so that the investor and the investment can do the business smoothly and at ease. They offer a pricing function for both the parties that mean both the seller and the buyer are provided with reasonable evaluation of assets in the financial markets. Then another point that has to be kept in mind is that the financial markets are properly regulated which further motivates the issuers of the securities to restrict the dealings that market thinks as unsafe to the worth of their assets. There are some particular needs of both the lenders and the borrowers and these needs cannot be dealt by these financial markets and so this is the reason why financial intermediaries exist. They work towards matching the complex requirements of both the parties which means they look for counterparties with precisely opposite needs as this will assist in decreasing the costs. The lenders want some safety as well as liquidity and they have a few wishes such as (Groz, 2009):

* The risk minimisation which means the minimization of the risk of non-payment which is that the borrowers don't meet their repayment requirements and the risk related to assets falling in worth (Groz, 2009).

* The cost minimisation (Groz, 2009).

* The maximisation of return which basically means that all the money invested by the lender is received back by him.

* The ease of changing a financial claim into cash without any loss of capital value this is Liquidity which lenders value.

Borrowers too have some wants (Groz, 2009):

* Funds at a specific time which is that the borrower would appreciate getting funds at his choosen date.

* Funds for a particular time period, most likely long-term for the reason that in order to have positive returns the funds can't be given back in the short-term.

* Funds at the least achievable cost which means low interest rates.

Direct finance and indirect finance have particular dissimilarities. There is an advantage to indirect finance over the direct finance however there are extra costs incurred like spread of interest rate and having additional fees when making use of the financial intermediaries. To announce that indirect finance is a lot more beneficial than direct finance it is necessary that the advantages of such activity offset the costs related with the indirect finance (Groz, 2009).

A dollar tomorrow cannot be worth less than a dollar the day after tomorrow

A minute's reflection can persuade you that the cash at present is always value more than cash tomorrow. If you do not trust me then provide me with the money now. I will give you back every penny of it in exactly 1 year (Taleb, 2008).

You'd be stupid certainly to let go food, attire, home, car and entertainment for 1 year for no payment whatsoever. That's the reason a dollar at present is valued more than a dollar tomorrow. (An additional rationale that a dollar at present is valued more than a dollar tomorrow is that, in current economies, for reasons explained in Chapter 17, Monetary Policy Targets and Goals, prices suppose to increase each year. So $100 in future will buy lesser goods as well as services than $100 at present will. Of inflation on the interest rates will be explained in detail at the conclusion of this chapter. Right now, we will discuss just the nominal interest rates, not actual interest rates.) But let's say you were told that if you provide me $100 at present, I'd provide you $1,000 in 1 year? Most providers would jump at this (provided they think I will pay as said and not run away), but I wouldn't provide it and nor would many borrowers. Actually, about $110 will be the maximum amount that I'd be eager to provide you in 1 year for $100 at present. This is an interest rate of 10% ($10/$100 = .1 or 10%), that, as humorist Adam Sandler will say, is "not too shabby." If we allow the loan ride, as is said, capitalizing the interest or, in different words, giving interest on the interest each year, called annually compounding interest, the $100 investment will increase in value, like shown in Figure 1, "The luck of $100 invested at 10%, compounded annually (Taleb, 2008)."

Figure 1: The destiny of $100 invested at 10%, compounded annually

The values in the table are with no trouble determined by multiplying the last year's value by 1.10, 1 showing the principal amount and .10 showing the interest rate. Then $100 at present that is year 0 is, at 10% interest compounded annually, valued $110 in 1 year (100 x 1.1), $121 following 2 years (110 x 1.1), $131.10 following 3 years (121 x 1.1), and so forth. The fastest way to determine this for several different years is to use the below given formula (Taleb, 2008):

FV = PV (1 + i) n

Where

FV = the future worth (the future value of one's investment)

PV = the current worth (the value of one's investment today)

(1 + i) n = the future worth factor (also acknowledged as the present value variable or discount variable in the equation under)

i = interest rate (decimalized, for instance, 6% = .06; 25% = .25, 2.763% = .02763, etc.)

n = number of terms (at this time, years; somewhere else days, quarters, months)

For $100 borrowed at present on 10% compounded yearly, in hundred years I'd be indebted to you by $1,378,061 (FV = 100 x 1.1100) (Taleb, 2008).

What if somebody says they will pay you, about, $1,000 in five years? How much will you be keen to pay at present for that? Definitely somewhat less than $1,000 and rather than using a PV and increasing it through multiplication to decide an FV, you should do the reverse or in other words, lessen or "discount" an FV to a PV. You will do this by using below given equation (Taleb, 2008):

PV = FV / ( 1 + I ) n or PV = 1000 / ( 1 + I ) 5

Clearly, we can't work out this formula except when one of these two outstanding variables is provided. If the interest rate is provided as 5%, you will pay $783.53 at present for $1,000 payable in five years (PV = 1000/1.055). If it is 20%, you will provide only $401.88 (PV = 1000/1.25). If it is one percent, you will provide $951.47 (PV = 1000/1.015). Observe when the interest rate increases (falls), the value of the bond decreases (rises). It can be said that, the value of some prospect payment (some FV; basically, a bond) and the interest rate have an inverse relation between them. This can be seen algebraically by observing that this term is in the denominator, therefore, as it becomes bigger, PV should be less (holding FV unvarying, of course). Economically it is alright because a greater interest rate basically means a greater opportunity cost for value, more important the money the less valued in the sum owed in the future (Taleb, 2008).

If payments were to be provided in 10 years instead of 5 of the bond explained just above, at 1% interest per year, you will pay $905.29 (PV = 1000/1.0110). See here that, keeping the interest rate unvarying, you pay less at present for a payment in the future ($905.29 < $951.47). This also makes some sense since you're with none of your money required to be rewarded for this by giving a lesser price for the bond/promise/IOU today (Taleb, 2008).

Explain the cash flows associated with a bond to the investor

Bonds are vulnerable to a variety of risks and these risks include the following (Bernardo, Cai, and Luo, 2002):

Interest-rate risk: Interest rates may increase or decrease at any time, ensuing in a rise or fall in a bond's value. Increasing interest rates need that the prospective cash flows should have a greater rate of return. The principal value of the bond must be lessened to recompense for an elevated required return since future cash flows are fixed in bonds (Bernardo, Cai, and Luo, 2002).

Inflation risk: An increase or decrease in inflation may end up having a rise or fall in the bond value. For many bonds, a greater inflation rate ends up decreasing the value of bond. The opposite of this condition is also true. Increasing inflation rates needs that future cash flows should have a greater rate of return, which decreases the current value of a bond (Bernardo, Cai, and Luo, 2002).

Company risk: The price of bond may increase or decrease because of issues with the organization that is providing the bond. Better the future prospects for an organization, the lesser rate of return required by the investors and greater the present value of a bond. The opposite of this condition is also true (Mandelbrot, Benoit & Hudson, 2006).

Financial risk: Whether or not an organization is seen as a financial threat has the capability to affect the value of the company's bonds. Organizations that are not much risky or have good prospects can typically borrow money at lesser interest rates; so, these organizations have fewer expenses and greater earnings. The opposite of this condition is also true (Mandelbrot, Benoit & Hudson, 2006).

Liquidity risk: Investors bear the risk that they perhaps are not capable to find a seller or buyer for a bond at the time that they will require one. Many times, liquidity is much directly related to conditions of the market than organizational conditions (Mandelbrot, Benoit & Hudson, 2006).

Political or regulatory risk: Unexpected ups and downs in the tax or legal system may have an effect on a company because taxes and the legal system affect the viewpoint for an organization, any regulatory ups and downs that improve an organizations long-term prospects will typically result in a greater price for that organization's bonds. The opposite situation is also true (Dessein, 2002).

Exchange-rate risk: Ups and downs in exchange rates might have an effect on the profitability for international organizations. As exchange rates support, the cost of locally manufactured goods which are sold internationally increases. The opposite condition is also true (Dessein, 2002).

Discuss the term "price-earnings (P/E) ratio"

AP/E ration is basically a valuation ratio of an organization's present share price as compared to its per-share earnings. Calculated as follow (Graham and Harvey, 2001):

Market Value per Share/Earnings per Share (EPS)

For instance, if an organization is presently trading at $43 a share and it's earning in the past 12 months was $1.95 per share, the stock would have a the P/E ratio of 22.05 ($43/$1.95) (Graham and Harvey, 2001) (Graham and Harvey, 2001).

EPS is normally from the previous four quarters (trailing P/E), but occasionally it can be calculated from the approximations of earnings predicted in the upcoming four quarters (projected or forward P/E). A third difference uses the total of the last two real quarters as well as the approximation of the upcoming two quarters (Graham and Harvey, 2001).

Also occasionally known as "price multiple" or "earnings multiple (Graham and Harvey, 2001)."

Discuss the certainty equivalent approach to estimating the NPA of A project.

It is a 100% return that anyone will agree to accept instead of taking a risk on a higher but unsure return (Harris and Raviv, 2002).

If you've ever considered about giving up your job to commence your own company and make additional money, but thought to stay and carry on drawing a salary in its place, then the value that your salary has is your certainty equivalent. You should have a business idea with much more potential payoff to be persuaded to give up the security that you have at your current job (Harris and Raviv, 2002).

Investments must give a risk premium to reimburse investors for the likelihood that they might not get their funds back. If someone has an option between a U.S. government bond giving a 3% interest and a corporate bond which is paying 8% interest, he decides to go for the government bond, the payoff that he will get is the certainty equivalent. The organization would require offering this investor a possible return higher than 8% on the bonds, to encourage him to buy. Therefore, an organization looking for investors can make use of the certainty equivalent as grounds for deciding how much more it has to pay to the investor, so to persuade investors to take into consideration the riskier alternative. The certainty equivalent will differ, because each investor has an exclusive risk tolerance (Harris and Raviv, 2002).

Post audit

In reality, many capital investment choices are reached in particular time period and information usually going out one or more steps in capital investment making procedure. The political movement within a company might also affect a capital investment choice, where people or groups have a particular concern in certain projects (Zabojnik, 2002).

The capital investment choices aren't regularized by 1 or 2 elements or factor for the reason that the issue of investment is not only a single problem of substituting old machines with new, but it's connected with changing a current process within a system by a new process that builds up the whole system to be better and much more successful. These are few of the elements that have an impact on the capital investment decisions (Zabojnik, 2002):

The viewpoint of the management

Opportunities that are formed by the technological changes

Cash flow budget

Competitors' strategies

Market Forecast

Fiscal Incentives

Other non-economic factors

These reasons would tell clearly why capital investment choices are tremendously significant for a company (Zabojnik, 2002):

Expansion: Capital investment choices are targeted at operational level growth. It's obtained via getting fixed assets by purchasing plant facilities and land, which ensures the balance between capital and good investment in return (Zabojnik, 2002).

Replacement: After the time of maturity, when the expansion of a company slows down, the company's worn out or obsolete assets need to be changed, such as machinery, vehicles, equipment, etc. Therefore, a company can turn back to its production full-fledge and earn the required advantages (Zabojnik, 2002).

Renewal: As an alternative to replacing, renewal can involve reconstruction, retrofitting or overhauling a current asset. This without doubt raises the company's profits as well as productions (Zabojnik, 2002).

Contrast and compare capital budgeting and strategic planning

The term capital budgeting basically refers to the process in which it is determined that various different projects are worth pursuing or not. A lot of times the future inflows and outflows of cash associated with the project are assessed to see if it meets the benchmark or not and it is also known as "investment appraisal." Preferable the projects that provide an opportunity for enhancement in shareholder investment should be pursued (Pilbeam, 2010).

Though, due to the quantity of capital accessible at any time for latest projects is inadequate, administration needs to pursue capital budgeting tactics to decide which projects will earn the larger return over an appropriate period of time. Famous techniques of capital budgeting comprise of net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period. Process of describing its strategy or direction as well as making decisions regarding the allocation of its resources to follow this strategy is known as the strategic planning in an organization. In order to decide the future course of the organization, it is essential to recognize its present state and the likely avenues via which it can follow particular courses of action. Usually, strategic planning handles one of three main questions (Pilbeam, 2010):

"What do we do?"

"For whom do we do it?"

"How do we excel? (Pilbeam, 2010)"

What are the agency problems associated with capital budgeting

In a world without agency and information problems capital budgeting won't be very difficult. The person who is making the decision would basically calculate a project's IRR and make its comparison with the cost of capital. However, in the actual world, those giving the funds for venture must depend on self-interested agents to categorize projects and give information on likely returns. Therefore, the value of capital allotment is based on how successful the decision process is in attenuating agency issues and giving precise and correct information. Corporations use a lot of different decision processes in practice. Some decisions are completely given to division and plant supervisors (usually, growth and extension of a current plant); some decisions need authorization of headquarters (usually, building of a new plant); and other decisions need authorization, conditional on the kind of proposal, like when projects need more than $1 million to have an approval from headquarters while small value projects can be permitted locally (Pilbeam, 2010).