Using the Time Value of Money to Make Managerial Decisions
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You are considering expanding your line of equipment and apparel for high school athletic teams to include soccer teams. Based on research conducted by the marketing department, you estimate an increase in sales for your division of $150,000 per year the first 2 years and then $250,000 per year over the following 3 years. To manufacture the necessary equipment, you will need to invest in some new manufacturing equipment that you estimate will cost $300,000. You figure that you will be able to manufacture the equipment and apparel utilizing your existing manufacturing staff and will not need to hire additional workers.
After gathering the information, you arranged a meeting with the chief financial officer (CFO), Don Morgan. During the meeting Don listened to your proposal, reviewed your information, and stated that he would need to do some additional calculations to see if the capital project would fit into the firm's financial plan. Don used some terminology that you did not quite understand. For example, he mentioned the time value of money, the company's cost of capital, market risk, weighted average cost of capital, and marginal cost of capital.
You walk back to the manufacturing plant in search of other division managers to find out what these terms mean.
What is the time value of money, and how does it apply to this situation?
How might you (as division managers) use the time value of money to make managerial decisions?
What is weighted average cost of capital, and how does it impact the decision to expand your division?
What is marginal cost of capital, and how does it impact the decision to expand your division?
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Solution Summary
The solution discusses how a division manager may use the time value of money to make managerial decisions.
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What is the time value of money, and how does it apply to this situation?
The basic idea of time value of money is that a dollar today is worth more than a dollar tomorrow. (finance professor, 2009) The investor has time preference of money because he can reinvest the funds, which are received early and can earn additional money.
Present value is an important concept of the financial management. This is concept derived from the time value of money. The investor has time preference of money because he can reinvest the funds, which are received early and can earn additional money Present value, is the future cash flow being discounted by the rate of interest.
Hence Present value= Future value/(1+rate of interest)^duration
Here it would be used to find the present value of future cash flows.
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