Question

Why does capital budgeting rely on analysis of cash flows rather than on net income? Explain the role of financial intermediaries in the flow of funds through the three-sector economy? Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds?

Answer 1

Capital budgeting relies on the analysis of cash flows rather than net income as the addition or decrease in firm value could only be determined on the basis of present value of cash flows rather than net income. Net income is in a sense a notional item and do not reflect the actual cash inflows or outflows that a firm may experience and is affected by depreciation & amortization as well as management of working capital, whose effects are not captured in net income.

The role of financial intermediaries are important in the three sector economy wherein three players - business, households and government are the major stakeholders. Financial intermediaries act as channels to ensure funds are efficiently allocated to entities who require funds such as the government and the business for the growth of the economy and that investors (the households) receive a positive return in exchange for such supply of funds.

The relationship between bond prices and interest rates is inverse in nature. An increase in interest rates implies a reduction in bond prices while a reduction in interest rates give rise to increase in bond prices.

The changing interest rates have a larger change/impact on the bond prices of long term bonds as compared to their impact on the short term bonds. So for an equal change in interest rates, the prices of the long term bonds change by a larger amount as compared to the change in the prices of a short term bond for the same change in interest rates.