Question

Time Value of Money and Bond Valuation" Please respond to the following:

Examine the concept of time value of money in relation to corporate managers. Propose two (2) methods in which time value of money can help corporate managers in general.

Examine the pros and cons of a sinking fund from the viewpoint of both a firm and its bondholders. Determine the fundamental manner in which this knowledge could be helpful to a financial manager. Provide a rationale for your response.

Answer 1

Time value of money in relation to corporate managers;

Time value of money refers to the value of money in present. Time value of money means value of money determined on the basis of time factor. As we know that corporate manager has to take various investment related decisions. And we also know that investment related decisions are taken on the basis of present value calculation.

In other words we can say that without knowing present value of all possible cash inflows from an investment option we can not take decision about the accepting or rejecting an investment option.

Now let’s understand how present value technique can help corporate manager? Let’s take some examples;

Suppose a firm has option to receive $10000 in present and $10500 after two years. Normal interest rate in market is 10%. Then on the basis of above information it is clear that corporate manager will choose option of receiving $10000 in present because NPV of this option is higher in compare to other option. Thus it is clear that present value technique is very helpful.

Now take other example;

If corporate manager has to take decision about an investment proposal which requires initial inevestment of $50000 and it will generate $10500 per annum for coming 5 years. Discounting rate is 5% then for taking decision regarding accepting or rejecting this investment option, corporate manager will take help of NPV (net present value) technique.

Pros and cons of a sinking fund from the viewpoint of both a firm and its bondholders;

Sinking fund is a modern time technique which help a firm in making arrangement about the payment of fixed debt in future time period. In other words we can say that with the help of sinking fund method a firm keeps regular funds in a separate account so that after a certain time period required funds for paying a debt can be easily arranged. In this method a regular income is kept in separate account and a regular amount of interest is also accumulated in this account. Hence at the time of payment of debts this account is closed and required amount is realized from this account.

So overall we can say that sinking fund method is very helpful to a firm in managing its funds for repayment of debts and it is also very helpful for bondholders because they will receive their invested amount at a fixed date of repayment.

But there are some negative points of this method too. As we know that time value of money is very important for any firm but this sinking fund method does not consider this time factor that is why this method does not provide accurate funds for repayment of a debt at a certain point of time.