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Finance 100 – Understanding the Concepts

A market price is the current price at which an asset or service can be bought or sold according to Investopedia Financial Dictionary online. So a market price can be used to evaluate the cost and benefits of a decision in terms of cash today. (Berk, DeMarzo, Harford, (2009). By having that information available, the financial manager can make informed decisions as to which investments and which projects will increase the value of his firm. The Valuation Principle is helpful to financial managers because, it seeks to increase Shareholder’s wealth.

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The Valuation Principle states that when the value of the investments or project (benefit) exceed the value of the cost, the financial manager should choose this option because, the decision will make a profit and increase the firms value. “Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation. ” (http://en. wikipedia. org/wiki/Valuation_(finance)

Net Present Value rule relates to cost-benefit analysis because they both examine, compare, and quantify the cost and benefits of the investment that’s being considered. The Net Present Value does so by examining the ins and outs of cash flows at a discount rate. If those inflows are greater than the outflows (or positive NPV) the investment option should be taken. Cost-benefit analysis looks at the projected returns less the projected cost of the entire project with the consideration of the time value of money.

An interest rate is the cost of borrowing money. It is the cost of using money today that you will pay back later. Most of us could not buy a house without a loan or mortgage. Interest rates are based on risk. The less likely you are to repay the money the higher the risk and the higher the interest rate you will pay. Banks would have no incentive to lend money if they did not receive payment in the form of interest for lending to their borrower’s, therefore an interest rate is just a price. Bonds are another word for loans taken out by large organizations, such as corporations, cities, and the U. S. Government. Since these entities are so large, they need to borrow the money from more than one person or bank. “ (http://useconomy. about. com/od/themarkets/f/Bond_Market. htm) Bonds are used to finance things like roads and bridges and schools. Bonds pay interest, just like loans, some by coupons and some only at maturity. Bonds have a fixed interest rate or payment, and tend to be more attractive when the economy, and the stock market decline.

Investors are not as interested in bonds when the economy and the stock market are doing well, and the value in bonds declines. Being a good financial manager requires a great deal of focus and fiduciary responsibility. Not only are there requirements for investing opportunities, but also in choosing how to finance those options to produce profits for the company. They must do all of this while insuring that there is still enough working capital on hand to meet the companies day to day operations.

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