Financial Decision-Making for California Clinics - Essay Example

"Share Value of California Clinics" Module: Stock Value = Dividend of Next year/ (Required Rate of Return - Constant Growth) = d1/ (kd - g) = 2 + (2 * 5/100) / 0.15 - 0.05) = 2 + 0.1 / (0.1) = 2.1 / 0.1 = $21 2) Stock Value = 2.1/ 0.08 = $26.25 3) Stock Value = 2 + 2 * 7/100 / (0.15 - 0.07) = 2.14 / 0.08 = $26.75 4) i) Productive Opportunities: Any increase in the productive opportunities will increase the demand and supply of capital investment. This will occur because the firm will be able to find many viable productive projects. However, this may not necessarily increase the supply of investment capital. This is because the supply of investment capital is an independent variable largely dependent on people's income. As a result of all this, increase in demand of investment capital is going to push up the interest rate because people will command higher interest and firms will try to find more investment capital at higher interest rates. This will in turn increase the required rate of return. ii) Time Preference for Consumption: If people choose to consume their income now rather to save, this will reduce the supply of investment capital oblivious to the demand of investment capital at that time. In this conditions, the firm's will find lesser sources lending investment capital and they try to attract more investment capital by offering them higher interest rate and this will again increase the required rate of return from the investment following the higher rate of interest that these firms will be offering. Similarly, if people decide to save now and spend later, this will lead excess supply of investment capital in the market. The firms here will be able to obtain investment capital at lower rates and will enjoy decreased interest expenses. Some projects that were not feasible because of high interest rates in the market will now become feasible and firms will borrow more. However, due to excess investment capital available in the market, the interest rate will decrease and so as the required rate of return. iii) Risk: Risk requires compensation and likewise it will affect the interest rate of capital of investment. If the risk of an investment is high, then the investors will only be willing to invest in that project at very high interest rates. If the risk of a certain project is low, then the investors will be investing in that project at lower rates of return and interest rate. Hence, we can develop a relationship between interest rates and the risk of a project. These two variables are directly related with risk being the independent variable and interest being the variable depended upon risk factor of a project. Any increase in the risk factor is going to increase the interest rate or required rate of return of a project. Similarly, if the risk factor of an investment is low, so will be the interest rate. This clearly shows that risk requires compensation and interest rates vary depending on the risk factor of a project. A logical explanation to this is the fact that very few people are interested in investing in highly risky project fearing that they may lose out their money. As a result, the supply on investment capital is very low for these projects and vice versa. Inflation: Inflation reduces the purchasing power of money. It erodes the purchasing power of people if their money is not invested into projects yielding interest rates which are at least equal to the going rate of inflation. If the interest rate earned is less that inflation, then you are losing out the real value of your money. This means that it won't be able to buy in the future, as much as it buying now. This is a dangerous situation for investors as they are faced with a situation in which the real value of their assets is decreasing. In times of inflations, investors see that returns that they are going to get from a project and going rate of inflation. If these return are lower than the going rate of inflation they choose to spend money rather than investing it in these project. So, in time of inflations, the supply of investment capital is limited whereas demand for investment capital is high as businesses know that the prices are rising and they profit from any venture they put their money into. This increase in the demand of investment capital and reduced supply of investment capital forces interest rates and required rate of return to go up. 5) Risk aversion is one of the broadest concepts of finance. It describes how investors and rational people are unwilling to accept risk unless they are getting extremely large benefits from a venture. This means that people will be more willing to put their income into bank accounts and earning small rates of returns rather than investing their money into risky project yielding higher rates of returns than a bank account. In finance, investors are unwilling to take high risks or earn low rate interests. It is difficult for investment companies to provide them with low risk and high rates of return. However, investment companies in the recent years have found a solution for this. Nowadays, many investment companies invest in portfolios which provide for safety of the investment and at the same time giving good returns on this investment. This is extremely important in financial decision making as investors are required to compare their returns with the going rate inflation. If inflation rate is higher than return on investment, many people will be unwilling to invest in such a project even if there is no risk involved in such project. So, it can said that risk aversion is an important concept in financial decision making, but it become useless if the rate of returns are lower than the going inflation rates. As a result of this many companies try to provide the investors with portfolios made up of not only safe investments but also those providing high rates of returns, unless it will be very difficult for the companies to find the supply of investment capital. Hence, risk aversion is very important, but once the rate of returns gets low, it become more important to focus on higher rate of return than clinging to risk aversion. 6) From the above discussion, it can be safely concluded that time value of money is perhaps the most important concept of financial decision making. It is even more important than risk aversion, and companies and individual have to take into account the time value of money, before deciding and selecting the best place to invest their money. If the time value of money in future is lower than present value, then the project is not worth investing in and vice versa. The three techniques to solve time value of money include formulae, tables and a financial calculator. Some very important formulae pertaining to time value of money have been developed by mathematics experts. These formulae have been developed using differential equations and other mathematical tools. They lead to an accurate answer and are used by people who do not have Time-vale-of-money tables or a financial calculator. Tables make it easier to perform calculations for time value of money problem. They simplify the complicated formulae into easier factors which be solve using a basic calculator. A financial calculator is perhaps the easiest way of solving these problems and only certain values have to be put in for the answer. It is probably the easiest way of solving these problems. References: James Van Horne and John Wachowicz. (2004). Fundamentals of Financial Management. Prentice Eugene Brigham and Michael Ehrhardt. (2004). Financial Management: Theory and Practice South-Western College Harold Randall. (2004). Accounting. Letts Educational. Read More