Differences between the Concept of Discounting and Compounding - Assignment Example

Financial decision Author’s Name Name of Institution Name of Instructor Subject Code/title Date of Submission Outline Part A Question 1 Question 2 Question 3 Part B Question 4 References Appendix Part A Question 1 a). when an investor is considering investment in a new project need to analyze the financial benefits. Investments made in fixed assets essentially chart the future direction of the returns and this requires the use of the best analytic tools. Faced with a choice between different projects, the first need is to assess the risk characteristics of each project and the discount rate is 5%. This question will solved using the present value of the cash flows and this has been done in excel file and the outcome is Perth- 2,134,885 Rockhampton- 2,178,149 Adelaide mine- 2,165,791 In accordance with the present value technique, the project with highest should be selected thus Rockhampton with $ 2,178,149, however all the projects may be rejected if the initial investment is greater than this figure. Therefore, on these bases, it is recommended that he invests in Rockhampton at a discout rate of 5%. The other two mines should be rejected. b) By discount rates of the project to see the impact is called Scenario or sensitivity analysis of a potential project. This is basically a game of ‘what-if’ in which the preparer takes into consideration potentials such as higher or lower discount rate. This process begins with a specific set of assumptions. From this point, the values are altered to reflect a number of possible scenarios such as significantly reduced discount rate or significantly increased discount rate. Basing a project decision on these scenario statements, one is confronted by several options in interpreting their significance. Best case and worst case scenarios are built, usually with best case scenarios assuming high discount rate and worst case scenarios assuming the opposite. In the scenarios presented, the net present values of the scenarios (worst-base) are compared. One school of thought calls for comparative analysis of cumulative net project profit. Under this school of thought, the scenario values (modified to reflect the net present values of all cash flow amounts) show that the worst case scenario would result in a net loss for the five years being considered. If the potential occurrence of the worst case scenario is high, this may justify abandonment of the project. Another method considers potential benefits (profits) to the potential risk (loss) involved, with a base rule of thumb standing if the base scenario profits are more than twice the potential loss, then the project might be worth pursuing. In our case we have been 4% and 7% . this has been done in excel and the results is as follows 4% 5% 7% Perth 2,201,277 2,134,885 2,010,771 Rockhampton 2,236,875 2,178,149 2,068,095 Adelaide mine 2,230,238 2,165,791 2,045,256 The investment will be made still in Rockhampton as it has higher present value to other projects at all rates. The graph shows that when the discount rate increases the present of the project decreases. The higher the discount rate the lower the returns. Question 2 Differences between the concept of discounting and compounding Discounting: Discounting is when the future cash flows are considered as to their value today that is the time value of money. Time value of money refers to the compensation provided for investing money for a given period of time. For instance, the value of a dollar today may not be worth a dollar next year. If inflation continuous to spike, it will lose value. But if the economy gets better, which is seldom, it may increase in value (Drake and Fabozzi, 2009). In this sense, the time value of money seeks to understand the amount of interest that money can earn or lose through time It is considered necessary to determine the returns associated with or worthiness of an investment. This process of determining an investment’s benefits is known as investment appraisal technique. In financial matters, time is important because it can either increase money’s value or reduce it. Hence, knowing how time functions, a person involved in financial decisions will be able to know if it is better to use money for its value now or invest it so that it can increase in the future. Compounding- this when one earns interest and it is reinvested to earn more interest. This usually refers to a situation where interest earns interest on top of the principal. For an interest to earn interest the interest rate is calculated annually on the outstanding amounts in the books on the principal. Difference between the concept of ordinary annuity and annuity due Ordinary annuity – this is annuity that is received at the end at of a year. Annuity due- this is annual cash flows that will come in immediately; they are received at the start of year not at end. Annuity due = ordinary annuity (1+r) Question 3 Proper retirement planning is a must for financial independence at an age when one is incapable of earning any income. Proper retirement planning ensures sufficient funds for one's financial needs during the autumn of one's life, and this is the reason why many people do retirement planning. In our case here various assumptions needs to be made and this include; 1. Currently she has no saving thus she is starting from zero. 2. Effective annual rate (EAR) rate are application for the first year and last year. 3. The amount is compounded up the age of retire We will begin with the amount she will need to have at the age of 90 when she passes on Retirement years Retirement age 65 years Passes on at the 90 years Estate amount $500,000 This means we need to calculated the amount she will need have at age of 65 when to yield the $10,000 per month until she reaches 90 but subjected to EAR of 10%. The following formula is used Effective Annual Rate = ( 1+)M-1 10% = ( 1+)12-1 Log1.1 = 12 log(1+APR/12) APR = 9.6% PVA= Annual +terminal amount (present value factor) PVA= 10,000X + 500,000x ( ) = 1,635,500 PVA= 1,135,500+ 50,500 = $ 1,186,000 This is the amount she is required to have at the time of retire. Amount to be saved from the 45th birth day The amount that she will have at the age of 45 years will be calculated as follows Monthly contribution = $ 2000 which leads to $ 24,000 annually The formula is Amount = Annuity [] where I is the effective annual rate and n is number of years. In this case the effective annual rate is 15% and n is 10 years while annuity is $ 2,000 . this implies that the amount at the 45th birth day is Amount = 24,000 [] = 487,289 She will use 450,000 to buy a house. This means she will Amount remaining is = 487,289-450,000= $ 37,289 The amount at 65 of $ 1,186,000 is the future value Effective Annual Rate = ( 1+)M-1 15% = ( 1+)12-1 Log1.15 = 12 log(1+APR/12) APR = 14.1% Thus $ 1,186,000 = PMT X + $ 37,289(1+0.15)19 = $ 1,186,000$ - 37,289(1+0.15)19 = PMT X 655,311 = PMT X 1,319PTM = 655,311 PTM = $ 497 Part B Question 4 The difference between net income and cash inflows from both statements The companies selected are commonwealth bank and Woolworth. Looking at the cash flow of the bank we will note that net cash flow is large this is because the bank deals in cash and is required to hold huge cash to cater business transaction. The net cash flow is large than the net income of $ 4,791,000, $ 4,723,000 and $ 5,664,000 for years 2008, 2009 and 2010. The net income and cash flow of Woolworth have different trend that is the net income is large than the net cash flow for the three years of $ 1,906,000,000, $ 2,038,000,000 and $ 2,140,000,000. We can see that the cash flow from the operating activities at least improved immediately from 2009 to 2010 with positive figures. All of this however is still isn’t enough to stem the massive damage from the changes in liabilities in 2008. . It shows whether the company has made profit or loss for the period. The cash flow statement shows the cash position of the firm. Dividing all the cash flow relevant segments in to investing, operating and financing activities, it provides a clear picture of where cash was spent and where it came in. The statement of retained earnings shows the amount of dividend paid, the amount of earnings that was retained by the company and reflects any changes made to the equity of the company. Importance of both statements in decision-making Objective of financial statement is to provide useful information for economic decision making for internal and external users. Internal user is those who make decisions which are directly affecting the internal operations of the enterprise. These are the company management, company employees and Board of directors; and the external user who makes decisions concerning their relationship to the enterprise. They are the creditors and potential creditors, investors and potential investors, financial analysts, government agencies, and other interested parties. For internal users, the accounting system must provide timely information needed to control day-to-day operations and make major planning decisions. While external uses need highly diverse accounting information due to the fact that the type of decisions they make vary widely, particularly the creditors and investors. Investors would also concern themselves with the cash flow statement and the statement of retained earnings. These would show the cash position of the firm and also the amount of equity the firm already has. The latter would be of significant importance as any untoward announcement by the management of the firm could render their investment less profitable, or even lead them to make a loss on the particular investment. Their decisions have a significant affect on the company’s allocation of its resources and the information that are provided to them should likely be generally useful to the group members who are interested in the same financial aspect of the business as them. Agency challenge between managers and shareholders Agency problem is where shareholder’s contribution is manipulated and utilized by management team to their benefit at the expense of the equity investor Nevertheless, tremendous changes have been experienced in the twenty first century where corporate institutions and government agents have drastically lowered their return of capital invested by shareholders. This has been contributed by various influential factors. For example, most corporate organizations in these developed countries have acquired a strong fiscal backbone essential to keep them in operation for decades. They no longer need to acquire extra capital to support their existence in the market. While bearing in mind the agency problems which exist between the management and shareholders, the management team directs a substantial amount of the generated profits to other investments. According to Burt (1993), an agency problem arises when the management group has conflicting corporate interests with the shareholders’. For instance, equity investors lend their money to any corporate organization with the aim of attaining high returns in terms of dividends. On the other hand, management teams are busy rewarding themselves with hefty salaries and posh facilities. Ebrill (1994) adds that, though most of these organizations in these developed countries have significantly reduced their operation risks through diversification, they are much affected by external factors like market risks and foreign exchange risks. As a result, investors have kept away from equity investment due such factors of agency problem and associated high risks. Due to low interest rates links to management issues in equity investments, equity investors have been seeking favourable market economies where they can have full control of their finances. For instance; investments in real estates have dominated in majority of developed countries. According to studies done in such countries, investors are turning to real estate investors so that they can have full control of their resources. They feel that a resource management delegation issue to managers has been exploited beyond control all at the expense of the equity investor. References Ahmed, R.-B. (2004). Accounting theory (5th Edition ed.). Cengage Learning EMEA Burt, M.R. 1993. Over the edge: the growth of homelessness in the 1980s, Russell Sage Foundation Publisher, New York, NY. Drake, P. & Fabozzi, F. (2009). Foundations and Applications of the Time Value of Money. NJ: John Wiley and Sons. Ebrill, L.P. 1994. Poland: the path to a market economy, International Monetary Fund Publisher, New York, NY. Schuyler, J. R. (2001). Risk and Decision Analysis in Projects. Newtown Square, PA: Project Management Institute, Inc. Appendix Perth 0 1 2 3 4 5 total Cash inflow 300,000 500,000 500,000 600,000 600,000 Bonus Total cash inflow 300,000 500,000 500,000 600,000 600,000 PVF at 5% 1 0.952380952 0.907029 0.8638376 0.822702 0.783526 present value 0 285714.2857 453514.7 431918.8 493621.5 470115.7 2,134,885 PVF at 4% 1 0.961538462 0.924556 0.8889964 0.854804 0.821927 present value 0 288,461.54 462278.1 444498.18 512882.5 493156.3 2,201,277 PVF at 7% 1 0.934579439 0.873439 0.8162979 0.762895 0.712986 present value 0 280373.8318 436719.4 408148.94 457737.1 427791.7 2,010,771 Rockhampton 0 1 2 3 4 5 total Cash inflow 480,000 480,000 480,000 480,000 480,000 Bonus 100,000 Total cash inflow 100000 480000 480000 480000 480000 480000 PVF at 5% 1 0.952380952 0.907029 0.8638376 0.822702 0.783526 present value 100000 457142.8571 435374.1 414642.05 394897.2 376092.6 2,178,149 PVF at 4% 1 0.961538462 0.924556 0.8889964 0.854804 0.821927 present value 100000 461538.4615 443787 426718.25 410306 394525 2,236,875 PVF at 7% 1 0.934579439 0.873439 0.8162979 0.762895 0.712986 present value 100000 448598.1308 419250.6 391822.98 366189.7 342233.4 2,068,095 Adelaide 0 1 2 3 4 5 total Cash inflow 450,000 450,000 500,000 500,000 500,000 Bonus           120,000 Total cash inflow - 450,000 450,000 500,000 500,000 620,000 PVF at 5% 1 0.952380952 0.907029 0.8638376 0.822702 0.783526 present value - 428,571 408,163 431,919 411,351 485,786 2,165,791 PVF at 4% 1 0.961538462 0.924556 0.8889964 0.854804 0.821927 present value - 432,692 416,050 444,498 427,402 509,595 2,230,238 PVF at 7% 1 0.934579439 0.873439 0.8162979 0.762895 0.712986 present value - 420,561 393,047 408,149 381,448 442,051 2,045,256 Read More