Almost all organizations and individuals raise or earn money, and spend and invest money. According to Drake & Fabozzi (2009), finance refers to the process by which capital or money is transferred among individuals, governments and businesses. In other words, according to Fabozzi & Drake (2009), it is the process of financing and investing. Some authors have also defined financing as the study of how people, businesses or governments allocate their assets over time under uncertainty and certainty conditions. The key concept in finance that affects decision is the time value of money. This concept state that a currency unit today is worth more than the currency unity in future. In this context, future can be one second from now. Finance aims at pricing assets according to their expected rate of return and level of risk. In this regard, this paper discusses the finance and financial environment. In addition, it will also discuss the various the four concepts of time value money.
The activities undertaken in the field of finance are evident in the financial news reported on television shows. Financial decisions are made daily within organizations lead to financial actions. Each of these financial actions reflects a decision on either how to earn or raise funds, or how to invest funds. According to Jain (2007), these financial actions are significant to both the involved firms and the current and prospective investors in the firm. Financial decisions have an effect on the value of the firm as shown in the stock price. As such, these decisions affect how much money invests earn on their investments on the firm. Therefore, many of the financial news tend to focus on the effect of financial event on the stock price of a firm. In addition, the field of finance also integrates the financial markets’ conditions in which businesses compete for financing and investors.
The understanding of finance prepares scholars for careers and equips them with the skills of making major investment decisions. Irrespective of how much an individual has to invest, finance can assist in deciding whether to invest, which financial instrument to invest in, how much to money to invest, and how the invested finances should be allocated among the various investments.
There are various bodies responsible for making the financial environment. In an economy, financial environment deals with the monetary transactions that are based on time, money and risk. Labatt & White (2003) defined financial environment as the markets that are created with the sole purpose of trading financial securities. Buyers and sellers create financial markets and, just like banks, financial environment is developed. According to ROOO, financial environment enables the raising of capital or finances by creating capital markets. Financial environment also lead to the transfer of risk in the derivatives market. Through currency markets, financial environment accomplishes international trade.
Financial environment consists of three principal components that include financial managers, financial markets and investors. Financial managers are charged with the responsibility of deciding how to invest a firm’s finance in order to expand business, and how to raise or obtain finances. The actions undertaken by financial managers in making financial decisions for the individual firms are known as managerial finance or financial management. Financial managers are anticipated to make necessary financial decisions that maximize the value of the firm. As such, the decisions made by these managers should maximize the stock price of the firm. The chief financial officers (CFO), who directly reports to the chief executive officer, popularly make the major financial decisions of a company.
Most business needed financing during their startups. However, the finance function of the business is not limited to this initial financing. Instead, the finance function is continuous and is incorporated with other business functions. Firms engage in various functions such as marketing to forecast sales, and promote and distribute goods. Since firms often incur costs for the production and marketing functions before earning revenue, they might also need to obtain financing. The amount and financing and the period for the financing is required relies on the information drawn from the marketing and production functions.
Financial managers evaluate the possible investment opportunities. Financial manager’s decision substantially influences the degree of success of the firm. This is because they determine what types of business their individual firms participate in. According to Melicher & Norton (2011), investment decisions determine the composition of the assets included in the balance sheet. Financial managers attempt to sustain the optimal levels of each current asset, like inventory and cash. Financial managers also decide fixed asset, such as machinery or building, in which to invest. These decisions are significant since they influence the success of the firm in attaining its goals.
According to Drake & Fabozzi (2009), financial markets are forums facilitating the flow of finances among firm, investors, and government agencies and units. Every financial market is served by financial institutions, which act as intermediaries. The equity market enables the sale of equity by companies to investors. Some of the financial institutions act as intermediaries by performing transactions between willing sellers and buyers of stock at an agreed price. The debt markets allow firms to acquire debt financing from individual and institutional investors or to transfer the ownership of debt securities among investors (Melicher & Norton 2011). On the other hand, some financial institutions act as intermediaries by enabling the exchange of finances in return for debt securities. As a result, it is common for one financial institution to serve as intermediary by performing transactions transferring funds to a firm while the other serves as an institutional investor.
According to Melicher & Norton (2011), investors and financial managers face the same investment decision. They need to decide on the type of investment, how much to invest, and the investment period. Nevertheless, the distinctive investments made by financial managers are different from the investment decisions made by investors. Financial managers’ decisions usually focus on the real assets like machinery, buildings, and office equipment. On the other hand, investors’ investment decisions tend to focus on financial assets. Like bonds and securities. Similar to firms, investors try to make decisions enhancing their future cash flows. The cash outflows of investors result from the buying of stocks. Therefore, investors might wait until the stock price declines before buying the stock. Investors can inflows result from the proceeds from selling the stock, dividends. Consequently, they prefer selling stock when the share prices rise.
The return earned by an investor on their equity investment in a company relies on how the value of the firm changes during the period they hold the stock. Since investors recognize that managers make decisions affecting the cash flows of the company, they try to make sure that the managers actions maximize the firm’s value. There are three common methods deployed by investors to affect management actions: investor trading, shareholder activism, and threat of takeover.
In relation to investor trading, investors depend on information to foretell the future of cash flows. If they anticipate the performance of the firm to be weak, they might sell shares of the stock. This places downward pressure on stock price of the company. On the contrary, investors will try to buy more shares if they expect the performance to be strong. In relation to shareholders activism, shareholders might try to affect the decision of the company in which they are invested, in order to streamline the actions of the firm closely with their financial interests. When using the threat of takeover, investors might consider purchasing enough of the company’s stock in order to gain control of it, especially if managers fail to act to maximize the firm’s value.
Time Value of Money
The fundamental concept behind the time value of money is that the value or attractiveness of financial alternatives relies not only on the amount of money that will be involved but also the time when it will be exchanged. Time value of money requires a critical analysis of the anticipated cash flows. The time value of money uses four basic tools: future value of sum, present value of sum, present value of annuity and the present value of annuity.
The future value of sum involves a single sum of cash that is available presently. This tool is used to determine the amount that will grow from a single sum of money over a certain time when invested at a compound interest rate. Compound interest implies that the interest is earned on interest. The following formula is used to calculate the future value of sum.
FV= present value (PV) × (1+i) n
Where i is the rate of interest per compounding period.
Where n are the numbers of the compounding period.
The present value of sum involves a single sum of cash, which will be available at a certain point in the future. This tool is deployed in determining the smaller amount an individual will be willing to settle for presently rather than waiting for the money. According to ROOO, this is a process of discounting the future amount to the current value. The formula below is used to calculate the present value of sum.
Present Value (PV) = C/ (1+i)n
Where C refers to the future amount that need to be discounted, n refers to the number of compounding periods between the current date and the date where the sum is worth C, and i is the rate of interest for one compounding period.
The future value of annuity is almost the same as first value of sum except that the tool deals with a series of equally sized amounts, and not s single sum. Annuity refers to a series of equally sized amounts. This tool is used to determine what series of equally sized amounts will grow over a certain period at a certain interest rate. The following formula calculates the future value of annuity.
Where C is the cash flow per period, i is the rate of interest, and n is the number of payments.
The present value of annuity is also similar to the present value of sum, except that it deals with a series of equally sized amounts, and not a single sum. This tool is used to determine the smaller amount of sum that an individual would be willing to settle for currently rather than waiting for the future receipts of equally sized payments. The following formula is used to calculate the present value of an annuity.
Finance refers to the process by which capital or money is transferred among individuals, governments and businesses. The activities undertaken in the field of finance are evident in the financial news reported on television shows. Financial decisions are made daily within organizations lead to financial actions. There are various bodies responsible for making the financial environment. In an economy, financial environment deals with the monetary transactions that are based on time, money and risk. Financial markets are forums facilitating the flow of finances among firm, investors, and government agencies and units. There are three common methods deployed by investors to affect management actions: investor trading, shareholder activism, and threat of takeover.
Drake, P & Fabozzi, F 2009, Foundations and applications of the time value of money, John Wiley & Sons, New York.
Fabozzi, F & Drake, P 2009, Finance: Capital markets, financial management, and investment management, John Wiley & Sons, New York.
Jain, P 2007, Financial management, 5th edn, Tata McGraw-Hill Education, London.
Labatt, S & White, R 2003, Environmental finance: a guide to environmental risk assessment and financial Products, John Wiley & Sons, New York.
Melicher, R & Norton, E 2011, Introduction to finance: markets, investments, and financial management, John Wiley and Sons, London.