M3 (i) response | Economics homework help

NEED FOLLOW-UP RESPONSE (IT ONLY NEEDS TO BE 2-3 PARAGRAPHS WITH 1 REFERENCE)

ORIGINAL QUESTION:

Assignment 1: Discussion—Value of Money

Business decisions are based on the time value of money. Bonds, stocks, loans, and other business investments are valued by determining the present value of an expected cash flow, which is also called discounting the cash flow. The time value of money finds considerable application in the decision-making processes of a business.

In this assignment, you will apply the basic principles of the time value of money to business decisions.

Tasks:

Part 1:

You are the chief financial officer of a firm. The firm has an expected liability (cash outflow) of $2 million in ten years at a discount rate of 5%.

  • Calculate the amount the firm would need on the present date as savings to cover the expected liability.
  • Calculate the amount the firm would need to set aside at the end of each year for the next ten years to cover the expected liability.

Part 2:

Using the Argosy University online library resources, identify an article that demonstrates the application of time value of money principles to a business decision.

  • Explain the specific business decision that management made after computing this value. Analyze how management used the concept of the time value of money principles to make this decision.
  • Analyze factors other than the time value of money that management considered or should have considered in reaching the business decision.

MY RESPONSE:

Part 1:

You are the chief financial officer of a firm. The firm has an expected liability (cash outflow) of $2 million in ten years at a discount rate of 5%.

  • Calculate the amount the firm would need on the present date as savings to cover the expected liability.

Future Value

Period

5%

Total

10

Multiply

1.629

Equals

$325,800,000.00

Therefore, the amount of $325,800,000.00 is what is needed on the present date as savings to cover the expected liability.

  • Calculate the amount the firm would need to set aside at the end of each year for the next ten years to cover the expected liability.

Present Value

Period

5%

Total

10

Multiply

0.6140

Equals

$122,800,000.00

Therefore, $122,800,000.00 would have to be set aside at the end of each year for the next ten years to cover the expected liability.

Part 2:

  • Explain the specific business decision that management made after computing this value. Analyze how management used the concept of the time value of money principles to make this decision.

Time value of money (TVM) refers to the idea that the same amount of money is worth different amounts at different time periods. Why? First, money tends to have differing degrees of purchasing power at different times, (Using the Time Value of Money Decision Tree to Calculate an Athlete’s Contract Offers, 2017).

Example 1:

Imagine in 1940 you had $1. Because the cost of living was extremely lower in 1940 as compared to today, you could have purchased a ticket to the latest movie in the theater (24¢), a loaf of bread (10¢), a gallon of gas (11¢), and still would not have spent half of your money (Box Office Mojo, n.d.; People History, n.d.). Today, $1 doesn’t get you a pack of gum. This erosion of purchasing power is known as inflation and is a natural outcome within relatively free market economic systems (Brayley & McClean, 2008). (Using the Time Value of Money Decision Tree to Calculate an Athlete’s Contract Offers, 2017).

Second, money loses its value because of opportunity cost. 

Example 2: 

If a woman sticks $10,000 under her mattress for five years, at the end of five years she will still have $10,000. But, if she were put that money into a savings account that pays a 2% return, she would have $11,041. Thus, her decision to put the money under her mattress carries an opportunity cost of $1,041, (Using the Time Value of Money Decision Tree to Calculate an Athlete’s Contract Offers, 2017).

The manager for a major baseball athlete, chose to use the TVM Decision Tree method. On one side are the PV formulas and the other side has the FV formulas. If the manager is discounting payments, the PV side would be used; if manager is compounding payments, the page would be flipped to show the FV side; however, before evaluating any offers from a major team, the manager must first master the TVM Decision Tree by working through a few practice problems, such as asking pertinent questions, while taking in to account, delayed annuity for PV, growing annuity for FV, and deferred compensation to know exactly what formula to use to calculate the PV and FV, (Using the Time Value of Money Decision Tree to Calculate an Athlete’s Contract Offers, 2017). 

  • Analyze factors other than the time value of money that management considered or should have considered in reaching the business decision.

In the baseball world, there are many reasons why a team would want to structure deals using deferred money. One such reason might be that the owner has other ways to earn a return on his/her money. In the case of the Mets and Bonilla, the Mets owners (the Wilpon family) were receiving 12–15% returns through their investments with Bernie Madoff (Rovell, 2016), so investing the $5.9m with Madoff would cover the future Bonilla payments while still providing a multimillion dollar return for the Wilpons. Of course, in hindsight this approach failed since Madoff’s returns were the result of a Ponzi scheme, but at the time it seemed like a smart financial decision. More often, the owner has other [legitimate] businesses where the owner feels he/she could earn a better return on the money. 

Example:

If the discount rate is 4% and the owner can invest potential salary money in a different venture that will get a 7% return, the owner may want to defer payments to the player and net 3% from the investment in the alternative venture, (Using the Time Value of Money Decision Tree to Calculate an Athlete’s Contract Offers, 2017).

Reference

Using the Time Value of Money Decision Tree to Calculate an Athlete’s Contract Offers. (2017). Retrieved from Case Studies Sport Management: http://eds.a.ebscohost.com.libproxy.edmc.edu/eds/pdfviewer/pdfviewer?vid=0&sid=89cfbf20-9fce-41a1-a3da-68ff707b819c%40sessionmgr4007

INSTRUCTOR RESPONSE:

Does putting $325M in the bank today to be sure you can make a payment of $2M in 10 years seem reasonable to you? Would you recommend this for a company?

NEED FOLLOW-UP RESPONSE TO THE INSTRUCTOR (2-3 PARAGRAPHS & 1 REFERENCE):

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