Question

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

1. 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.

2. 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

Answer1: The concept of time value of value as the name suggests, valuation of money received at different time is different.Basically any amount of money, we are holding today is more worthy than same amount in some future point of time.So, per USD value is simply more than it will be 10 years down the line.To apply this broader concept, time value of money is used to determine the cash flow values at different point of time.The real reason of the money being more worthy today than future depends on the fact of investment and interest earning.

Corporate managers use the concept to determine the present value of sum of money, stream of cashflow.Let's consider the first example: when companies invest in assets like machine, buildings, the time value of value is used to calculate the present value of asset's cashflow.Simlarly if I give you $100 today or offer same $100 after 1 year, you would simply prefer $100 today. You know that, same $100 you can invest at 4% interest rate and at the end of the year you will receive $4 as interest. So, value is increased to $104. Apart from reinvestment opporunity, same amount of money in future would be able to buy lesser quantity than now, simply purchasing power would be be lesser.Gradual increase in inflation will be responsible for the decrease in purchasing power.

Answer2: Sinking fund is one such measure which helps any entity in building certain point of capital and debt repayment become easier.This fund provides bond issuing firm more affordability in retiring the debt.Bond issuing entity first establishes the find and then uses its money for purchasing open market outstanding bonds.However this sinking funds major cons is rising interest rate condition. The issued bond value would be lesser in interest rising condition and that will lose the demand. So, for firms sinking fund is useful when only rate falls.Once low interest bond loses worth, firms can buy bonds using the sinking fund.So, they will earn more than they pay out in debt payment.For the bondholders, behaviour will be exactly opposite. They will prefer interest rising condition.

So, any financial manager would use his/her judgement in predicting interest rate growth or fall and use sinking fund accordingly.In interest rate falling scenario, manager of a firm will sell bonds now and use sinking funds to pay back the debts. In rising interest rate scenario, go for the buying more bonds using sinking funds. For expansionary firms this sinking funds use is really useful.

For any investor, companies using sinking funds is always a good indicator as firms trying to address debt earlier.As an investor, you will always prefer companies having more certainity on bond repayment. However as sinking fund holding companies can purchase bonds at discount, investor would actually lose money in that scenario.