Managing Start-ups During an Economic Downturn
Economic cycles are a reality of life. Founders need to be aware of the fact that their start-up company could find itself in the middle of an economic downturn. Such situations tend to be the real test of start-up companies. The poorly managed start-ups face severe cash flow issues during such recessions. A lot of […]
How Epic Games Changed the Gaming Industry?
The gaming industry is notorious for being full of fads. Games tend to become popular very soon. However, their popularity dwindles at a greater pace as the next attraction hits the market. This is the reason that gaming customers have been known to be fickle and inconsistent. As a result, building a multi-billion dollar in […]
Financial Systems and Economic Development
Financial institutions and markets are together called the financial system. This financial system is the backbone of the national economy. This is because the efficiency with which the financial system works plays a very important role in the economic development of a nation. The role of the financial system may not be apparent since we […]
The 4 Basic Types of Derivatives
In the previous articles we discussed about what derivative contracts are and what are the uses of such contracts? However, one important point needs to be noticed. Today, if a new person wants to buy a derivative contract, they will be bewildered at the sheer amount of choice that they will have at their disposal. […]
Why Startup Companies are Staying Private?
Once upon a time, a successful IPO was considered to be a transition point for a startup company to be recognized as a full-fledged public company. The goal of every startup company was to finally go public on a reputed stock exchange. The only startup companies which did not want to go public were the […]
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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