Restricted Stock Options (RSU’s)
In the previous article, we have already studied about option pools. We now know the various advantages that they offer and why they are preferred by startup companies as a means to compensate their employees. However, some companies and investors are not happy with the concept of stock option pools. This is because they dilute […]
The Stages of Descent into Bankruptcy
Bankruptcy is a common phenomenon in the business world. There have been many cases wherein the stalwarts of yesterday, the companies which were running multi-billion dollar profits, have later filed for insolvency. For the benefit of the readers, let us define bankruptcy. Bankruptcy is the stage at which companies find it financially unviable to function. […]
Role of a Financial Manager
Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to take care of these activities a financial manager performs all the requisite financial activities. A financial manger is a person who takes care of all the important financial functions of an organization. The person […]
Techniques Used in Ratio Analysis
Ratio, as the name suggests, is nothing more than one number divided by the other. However, they become useful when they are put in some sort of context. This means that when an analysts looks at the number resulting out of a ratio calculation he/she must have a reasonable basis to compare it with. Only […]
Concept of Special Drawing Rights (SDR’s)
What Are Special Drawing Rights (SDRs)? Special Drawing Rights (SDRs) were a part of the monetary system that was created post World War-2 in the Bretton Woods arrangement. Since the United States had almost all of the gold reserves of the world at that time, the Special Drawing Rights (SDRs) were intended as a supra-national […]
The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing and investing decisions. So, why is there a need for a complicated subject called corporate finance to make these decisions? Well, it turns out there is a need? The need arises because of this concept of nominal and real value of money. This article will explain why corporate finance is required:
We are all intuitively aware of the concept of inflation. We know that money loses its value every year. The same amount of money will purchase less and less every year. Let’s say that $100 is required to purchase a certain commodity of goods today. So if there is an inflation of 10%, the same goods will be available for a $110 next year.
So, if we made an investment that was yielding 9% return this year, we would have a total of $109 next year from the $100 we had invested. In accounting terms we would have a profit of $9. This is because we are only considering the nominal values. Nominal values do not consider the effect of inflation, opportunity cost of capital and such other forces which cause the value of money to decrease in a given time period.
The Problem with Nominal Values to Measure a Firm’s Performance:
Nominal values present a distorted image of the firm’s performance to its shareholders and this is to say the least. Consider the case we discussed above. Here, the firm has lost 1% purchasing power. This means they were better off consuming the $100 in year 1 and could have purchased more goods with it rather than investing it and consuming $109 a year later. Thus, if nominal values are considered, firms will end up eroding their capital by investing their money in projects that offer a rate of return that is below the firm’s cost of capital.
To offset this problem, specialists in corporate finance have come up with the concept of real value of money. The real value of money takes into account inflation, opportunity cost of capital and such other forces. Thus, firms that base their calculations on these inflation adjusted values make better financial decisions as compared to those that do not. The calculation for both real as well as nominal values is simple and can be done with the help of the following formula:
Real Value = Nominal Value / (1 + (i / 100))
i = The prevailing inflation rate in the market
Subjectivity in Real Value of Money:
It must be understood that the real and nominal values of money are subjective. This is because, they are determined using the inflation rate. There is no single measure of inflation. The government itself produces multiple estimates of inflation. Also, for the purpose of the company’s calculation, these measures may not be good enough. So the company may create its own inflation index depending on which the real values are calculated. Thus, there is widespread subjectivity in this calculation. Different companies use different rates to convert nominal values to real values.
The biggest take-away from the concept of nominal and real values is that money in one time period is not directly comparable to money in another time period. It is for this reason we have to calculate present values, future values and the like. These calculations form the backbone of corporate finance.
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