Regret Aversion Bias
In order to be successful at investing, an investor not only needs to have mastery over their numbers, but they also need to have mastery over their emotions as well. In the past few articles, we have already discussed how emotional biases can lead to suboptimal performance in investing. In this article, we will try […]
Revenue Bonds and the Cash Trap Mechanism
Infrastructure projects last for many years. As a result, different sources of funding are used at different points of time in the project. As mentioned in the previous articles, most of the time, bank loans are used during the construction phase of the project. However, at the same time, bonds are the preferred source of […]
What is Jock Tax and How is it Calculated?
In the previous articles, we have already seen that the owners of sporting franchises are able to evade taxes even though they earn billions of dollars from the sporting league. However, this is not the case when it comes to athletes. Since athletes make large sums of money which are known to the media and […]
The Fallacy of Creative Destruction
There is a widely held view that creative destruction is the cause of all business cycles. This explanation is used to convince people that business cycles are a good phenomenon. On the other hand, this explanation does not provide any insight as to why business cycles have been there only for a couple of centuries […]
Redlining: Americas Racist Financial Policies
America is a developed country and an inclusive society. It should ideally no longer face the problems of racism and social inequality and yet it does. It is no accident that a large number of poor and destitute consist of people from African American and Latin American communities. In fact, it is a result of […]
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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