Question

1. How do you think today's low interest rate environment is impacting the time value of money? How might this change the value of an asset or liability?

2. What is the relationship between the concepts of net present value and shareholder wealth maximization?

Answer 1

1. Interest is the cost that the borrower has to pay to use the funds over a period of time, hence interest reflects the time value of money i.e. value of money for its use over a future period of time by the lender. The lender pays this interest cost to the borrower at regular frequency. With lower interest rates, the time value of money also decreases. The value of a interest bearing asset goes down and similarly value of a interest bearing liability also goes down along with decrease in interest rates. This has the impact of shrinking the size of balance sheet of the company.

2. The objective of every economic organisation which is to maximize the wealth of its shareholders. Wealth of shareholders is created when the value of its shares increases over a period of time.

Net Present value is present value of future cash flow of a firm. A higher net present value denotes a higher value of firm's value.

Hence the concept of net present value and shareholder wealth maximization are closely related. An increase in net present value means a higher shareholder's wealth creation and vice-versa.