Posted: November 27th, 2013
Financial Management Principles
The time value of money is concept showing a given amount of money is worth more in the present than what the same amount would at after a given duration. This is made possible by the interest earning capacity of money. If one were given the option whether to receive a hundred dollars right now or have to wait a couple of years to receive the same amount, the most reasonable option would of course be the first option. The reason being that one would do a lot with the money now than when one was given after a couple of years. Currently numerous investment options that would take would result in the hundred dollars earning interest to a larger amount by the time the few years are past. For the given situation, the time value of money would come about in consideration on whether the capital invested and the expected income after a given amount of time would be equal if the same amount were invested in another project.
The concept of time value of money would help us as division managers to make the most prudent decisions on which projects to fund and which ones to neglect. There are those projects that seem enticing but when the time factor is put into consideration, it reveals the interest capital accrues over a given time is far much less. Given the above situation, it would be prudent to calculate the exact amount of profit the project is projected to generate. The profit generated is then compared with the capital and the interest accrued on the capital calculated. This interest on capital is calculated in consideration with other factors like taxation, market changes et al. if the interest in capital accrued is reasonable enough in that it is the equal to or above if the capital were invested elsewhere, and the option is then taken as a feasible option.
Businesses reach a time when they need to expand hence the requirement of additional capital. The sources of this additional capital are mainly two. These are either to borrow money from the lending sources or sell a piece of the business entity as a form of stock or equity. Regardless of the option the manager opts for, he is going to incur debt and will result into paying interest on the debt incurred. The weighted average cost of capital is a formula used to know which of the options above is best of the business entity. It involves calculating the average for the two sources is weighted in accordance with the amount that the business entity utilizes in funding for its activities (Keane, 1996).
The weighted average cost of capital is based on the formula that the weighted cost of capital is the equivalent of the addition of the proportion for the debt financing. This summation is later multiplied by the charge incurred in equity capital. This is then multiplied with the proportion of equity financing. The result will enable me as the division manager to identify the most feasible option. The option giving the lowest cost of capital will mean it is the best to run the business in profitability. The weighted average is a good way of identifying the most feasible source of additional income that will not have the business entity to incur unnecessary expenses in paying up interest on loans.
The marginal cost in capital is the cost the business entity will incur when there is an accumulation of one dollar of capital. The amount of marginal cost incurred by a business varies according to the capital source selected by the manager. The marginal cost of capital enables me as the division manager to determine the cheapest way of raising capital while maximizing profit. This constraints my choice to those options whose marginal cost on capital is at least equal to the cost incurred by the business in raising the capital. In this sense, it would be unwise to source capital at a cost of say eight percent and invest it in a project that will earn the company an interest of less than eight percent. The basic idea is money borrowed ought to be invested in such a way that it is able to repay itself and the interest accrued (Gallagher, & Andrew, 2008).
Gallagher, C. & Andrew, K. ( 2008). Financial Management; Principles and Practice. New York, NY: Freeload Press, Inc.
Keane, C. ( 1996). Financial Management Principles: National Information Technology Training Package Series. San Antonio, TX: Tertiary Press.
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