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Chapter 3
Time Value of Money: An Introduction

Copyright © 2012 Pearson Education.

Chapter Outline
3.1 Cost-Benefit Analysis 3.2 Market Prices and the Valuation Principle 3.3 The Time Value of Money and Interest Rates 3.4 Valuing Cash Flows at Different Points in Time

Copyright © 2012 Pearson Education.

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Learning Objectives
• Identify the role of financial managers and competitive markets in decision making • Understand the Valuation Principle, and how it can be used to identify decisions that increase the value of the firm • Assess the effect of interest rates on today’s value of future cash flows • Calculate the value of distant cash flows in the present and of current cash flows in the future Copyright © 2012 Pearson Education.

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3.1 Cost-Benefit Analysis
• Role of the Financial Manager
– Make decisions on behalf of the firm’s investors
• For good decisions, the benefits exceeds the costs

Copyright © 2012 Pearson Education.

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3.1 Cost-Benefit Analysis
• Role of the Financial Manager
– Real-world opportunities are often difficult to quantify and involve using skills from other management disciplines: • • • • • Marketing Economics Organizational Behavior Strategy Operations

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3.1 Cost-Benefit Analysis
• Quantifying Costs and Benefits
– Any decision in which the value of the benefits exceeds the costs will increase the value of the firm

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3.1 Cost-Benefit Analysis
• Quantifying Costs and Benefits
– Suppose a jewelry manufacturer has the opportunity to trade 200 ounces of silver and receive 10 ounces of gold today. – To compare the costs and benefits, we first need to convert them to a common unit.

Copyright © 2012 Pearson Education.

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3.1 Cost-Benefit Analysis
• Quantifying Costs and Benefits
– If the current market price for silver is $10 per ounce, then the 200 ounces of silver we give up has a cash value of: (200 ounces of silver) × ($10/ounce) = $2,000

Copyright © 2012 Pearson Education.

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3.1 Cost-Benefit Analysis
• Quantifying Costs and Benefits
– Assume gold can be bought and sold for a current market price of $500 per ounce. Then the 10 ounces of gold we receive has a cash value of: (10 ounces of gold) × ($500/ounce) = $5,000

Copyright © 2012 Pearson Education.

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3.1 Cost-Benefit Analysis
• Quantifying Costs and Benefits
– Therefore, the jeweler’s opportunity has a benefit of $5,000 today and a cost of $2,000 today. In this case, the net value of the project today is: $5,000 - $2,000=$3,000 – Because it is positive, the benefits exceed the costs and the jeweler should accept the trade.

Copyright © 2012 Pearson Education.

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Example 3.1 Comparing Costs and Benefits
Problem:
• Suppose you work as a customer account manager for an importer of frozen seafood. A customer is willing to purchase 300 pounds of frozen shrimp today for a total price of $1,500, including delivery. You can buy frozen shrimp on the wholesale market for $3 per pound today, and arrange for delivery at a cost of $100 today. Will taking this opportunity increase the value of the firm?

Copyright © 2012 Pearson Education.

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Example 3.1 Comparing Costs and Benefits Solution: Plan:
• To determine whether this opportunity will increase the value of the firm, we need to value the benefits and the costs using market prices. We have market prices for our costs: Wholesale price of shrimp: $3/pound Delivery cost: $100 • We have a customer offering the following market price for 300 pounds of shrimp delivered: $1,500. All that is left is to compare them. Copyright © 2012 Pearson Education.

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Example 3.1 Comparing Costs and Benefits Execute:
• The benefit of the transaction is $1,500 today. • The costs are (300 lbs.)  $3/lbs. = $900 today for the shrimp, and $100...
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