Corporate Finance in Its Very Simple Form Term Paper

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Corporate Finance

In its very simple form, the cost of money can be defined as "interest that could be earned if the amount invested in a business or security was instead invested in government bonds or in time deposit." The cost of money is thus, at the same time, the interest rate receive, but also an opportunity cost by which the investors changes the return he can obtain on his business or security and choose the return for a government bond or time deposit.

Before discussing the cost of money, one also has to refer to the opportunity cost as this is also an opportunity cost. The idea behind the opportunity cost is related to the matter of choices and economical alternatives that an individual has. As needs are unlimited and resources limited, the individual will also need to prioritize and make choices between the different things to be purchased. At a simple, household level, this will probably be a choice between buying pizza or eating in for dinner (McConnell, 2004). At a more complex level, the choice will be between investing in research and development or investing in expanding the markets. At this investment level, the choice is between putting the money into a business, for the return coming out of that, or deciding to take a riskier path and put the money in the bank for the deposit returns.

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The cost of opportunity also means another additional thing. Going for one alternative instead of another alternative is equivalent, generally, with renouncing 1 unit of the alternative being given up on for 1 unit of the alternative which is retained and chosen (McConnell, 2004). However, this can vary: sometimes 2, 3 or more units of one thing can be considered as the reasonable cost of the alternative. This means that the cost of opportunity can be calculated as an approximate proportion of the cost of another alternative.

Going back to the initial definition of the cost of money, the alternatives that need to be judged here are (i) investing in a business and (ii) investing the money into a time deposit or governmental bond. Let's take each of these in part and see how each can be evaluated in terms of several factors, including risks or the revenues generated in each case.

Term Paper on Corporate Finance in Its Very Simple Form, Assignment

In the case of investing in a business, there are several things that need to be taken into consideration. First of all, if the business is started from the very beginning, the investors will have important starting costs. If this is a bricks and mortar business, the investors will need to consider the initial costs of starting the business, such as selecting a location, purchasing the merchandise, arranging administrative details like rent and other related costs etc.

On the other hand, the simple investment of the money in a time deposit is almost cost- free: generally, most banks charge nothing when opening a deposit (they cannot, since this is their actual source of business and the way they acquire the funds they can use in their activity) and little or no sums when taking the money out of the deposit. The investment with time and money into opening the deposit is equal to zero as compared to the time and money allocated into starting an individual business.

At the same time, the investor can also consider investing into a security, which is virtually the equivalent of investing in a business that is already set up and where the investor is simply putting in the money, sometimes without being part of the decision making process. The cost here in terms of time and money is similar to that of opening a deposit: usually there are specialized individuals who can take care of these investment details so that the investors are really not using any of their time, only the money they decide to put in the business.

This brings us to one of the most significant differences between investing in securities or a business and putting the money in a time deposit, with a great impact on the cost of money: risks associated with the two forms of investment. As an initial assertion, it should be clear that the risks associated with investing in securities or in businesses, either initial or existing ones, are higher than the option of simply depositing the money into a bank deposit of any kind.

There are several reasons for this. The main one is that the time deposit can basically be affected only by a reduced amount of external factors and risks. These include the bank's bankruptcy and the potential decrease of the interest rates for the respective deposits, which will minimize returns. The bank's bankruptcy is not necessarily a full risk, however: many governments guarantee a certain amount of the sum that can range from $5,000 to even higher. This guarantee means that the individual investor will not lose his or her money even in the case of the bank's bankruptcy.

The second risk that may affect a bank deposit is the risk of decreases in the interest rate. The interest rate generally follows certain cycles (Keown, Martin and Petty; 2006) determined by the macroeconomic perspective of the government. Usually, an increase in interest rates is used when the macroeconomic outlook reflects a potential increase in consumer prices and prognoses potential inflationary pressures. The mechanism is as follows: inflationary pressures are generally affected and produced by an increase in consumer demand and increased investments on the market.

The third risk that may affect the cost of money or the interest rate is given by the effect that the inflation can have on the return obtained from a portfolio. In a nutshell, this can be understood by the fact that if the interest rate is lower than the inflation rate during that respective year, the net gain on the portfolio invested in the bank will be negative. This is why sometimes the real inflation rate is calculated, reflecting the actualized interest rate, adjusted for inflation levels (Keown, Martin and Petty; 2006), given a better perspective on things.

There is also a correlated factor that affects the discussion of cost of money/interest rate as this is affected by inflationary pressures and the rate of inflation. The fact that the interest rate may be even equal to the inflation rate does not reflect a positive situation for the investor, because he would still have his money blocked for the period of time until his deposit matures, without being able to use that money to invest in something else or to simply purchase products and services.

This is related to the time value of money. An individual would rather have the money now to spend rather than receive it some time in the future. This reflects the fact that he will be able to use the money for a decision he makes in the present rather than save it for a decision to be made some time in the unforeseeable future. This is why the cost of money will also need to incorporate in its final value the idea of the time value of money as well, besides considerations on risk, alternatives or the inflation rate.

Time has another very important effect on the cost of money and on determining the interest rate. If the period of the deposit is longer, the interest rate is also likely to increase. The reason for this is given by the fact that inflation is likely to increase in time, but also because it will be more difficult to predict what is likely to happen in the future, as compared to it being much easier to understand a shorter period of time from a financial and economical perspective. There are also higher risks of default from the banks.

The alternative, as reflected by the cost opportunity mechanism previously discussed, is that the investor will do something else with his money rather than spend it on the market either purchasing products or investing in existing or new business. In order to temper this investment on the market, an increase in interest rates by the central bank will create a potentially viable alternative for the investor: spend the money in a bank deposit. At the same time, increasing the interest rate also increases the cost of credit, which will limit business.

However, with business risks, these tend to be significantly higher, as are the costs of investing in securities. Market factors have a significant impact on the evolution of the price of securities. At the same time, additional market factors, such as the presence of competitors on the market or a potential economic recession that will decrease the demand on the market, will affect the business and lower the returns obtained by the investor.

This brings us to the direct relationship between risk and return, an important factor in determining the cost of money as well. It is generally accepted that the higher the risk, the greater the return that an… [END OF PREVIEW] . . . READ MORE

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