Understanding Financial Concepts – Assignment I
1. Explain why market prices are useful to a financial manager
Managers are interested in market prices for reasons better explain by market of economic theory. The classic market of economic theory is a call auction market where all market participants meet in one place at one time to arrive at a market clearing price through open outcry of bids and offers. In agricultural societies, these markets were often held annually, at harvest time, but the development of futures contracts has spread commodities trading over the year. Financial markets have traditionally been open each business day. As volume in many markets has grown, efficient ...view middle of the document...
In addition, there are specific situations where financial managers must undertake valuations, for example, when valuing a proposed acquisition, or assessing the value of their own company when faced with a takeover bid. Directors of unquoted companies may also need to apply valuation principles if they intend to invite a takeover approach from a larger firm or if they decide to obtain a market quotation. Valuation skills thus have an important strategic dimension.
3. Describe how the Net Present Value is related to cost-benefit analysis.
The Net Present Value (NPV) is the sum of discounted net cashflows over the period. When properly calculated, the NPV is a relatively objective method of determining the improvement in national wealth resulting from a proposal. It is mechanistic, and because of this, starting assumptions need to be explicitly identified. Once calculated, the NPVs of several projects can be compared. In a commercial setting, it is typical for the project with the highest NPV to be chosen, but in a government setting where many costs and benefits may be difficult to quantify, the NPV may be just one of the decision-making criteria.
Put simply, a proposal with a higher NPV ranks ahead of the alternative, assuming the proposals are otherwise equal. If the proposals are not the same in all other respects, a higher NPV is not conclusive. For example, one proposal may have much greater intangible net benefits. A negative NPV does not rule out proceeding with a proposal. There may be other qualitative influences on the decision to proceed, and these may be important.
Note that NPV analysis is not the same as Cost Benefit Analysis. Cost Benefit Analysis is the wider process of proposal selection. NPV analysis is just one tool which may be applied in Cost Benefit Analysis.
4. Explain how an interest rate is just a price.
Think of interest rate as price. If the price of a good is low, lots of people will want to buy it high demand, thus factories will be less inclined to produce it because they make smaller profits, low supply. If the price of a good is high, fewer people will be able to afford it, factories...