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Time Value of Money: Taking a Risk

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Time Value of Money: Time Value of Money is one of the most important concepts in the financial world. The principles of time value analysis have many applications, ranging from setting up schedules for paying off loans to decisions about whether to acquire new equipment for a company. Time value of money is also called discounted cash flow analysis.

Your task is to apply the concept of present value to Extra Space Storage (NYSE: EXR). Suppose your company is selling a bond that will pay you \$100,000 in one year from today. Keep in mind that if your company has financial difficulties in one year you might not get your full \$100,000 back. Given that a dollar one year from now is always worth less than a dollar today, you most certainly would not pay a full \$100,000 for this bond.

If you are highly risk averse or strongly prefer having money today than to having money tomorrow, then you would pay significantly less than \$100,000 for this bond. Higher inflation or high interest rates would also lead you to pay less for the bond. Also, the greater the chance of bankruptcy of your company the less you should be willing to pay for the bond.

Given the concepts of the time value of money, answer the following questions:
1) How much would you pay for this bond today? Take into consideration your own personal risk preferences, interest rates, inflation, and the probability your company will not be able to pay you back in one year. Note: no need for any math equations for this part. Just explain how much you would personally pay for a \$100,000 bond from this company.
2) Based on your answer to the previous question, what would be your discount rate for this bond? Use the present value formulas from the background materials and show your work.
3) Pick two other companies in the same industry as your Extra Storage Space (NYSE: EXR) One should be one that you would pay less for a \$100,000 bond than you would from Extra Storage Space and another one that you would pay more for a \$100,000 bond from Extra Storage Space. Explain why you would pay more or less for their bonds.

- Total debt/equity ratios of all three companies (Note that the higher the debt, the higher the default risk).
- Profit margin, return on assets, and return on equity ratios of all three companies (Remember your bond payment will depend on the profit margin and cash flow of the company).
- Betas of all three companies (Note that the higher the beta, the higher risk; the higher the risk, the higher the discount rate).
- Explanation on the riskiness of all three companies in brief (e.g., the higher the beta, the higher the risk).
- Current ratio and quick ratio of all three companies.

The above factors/ratios will help you to decide the discount rate that you will use to calculate bond prices. You can find the above information by using the website http://ca.finance.yahoo.com/. For example, you want to use General Electric Company. You will need to key in company code "GE" and then click on "Key Statistics" (http://ca.finance.yahoo.com/q/ks?s=GE). You will be able to find all the ratios and beta of the company.

Solution Preview

Time Value of Money and Investment in Bonds
As part of this assignment, I would like to explain the concept of time value of money for taking investment decisions, particularly in bond investments. I have selected the company Extra Space Storage (NYSE: EXR).
Extra Space Storage, Inc. a Salt Lake City, Utah based real estate investment trust (REIT) was founded 1977. The company's main activities are development and management of property that include acquiring, managing, developing, and selling, as well as the rental of self-storage facilities. Extra Space Storage owned interests in 567 properties across different states in US and manage 74 properties owned by franchisees or third parties.
Now suppose Extra Space Storage is selling a bond that will pay \$100,000 in one year from today. Keeping in mind that a rational investor is risk averse and so am I, I would prefer having money today to having money tomorrow. Therefore, I would like to pay an amount significantly less than \$100,000 for this bond. The reasons for my willingness to pay significantly less amount are as below:
• Inflation - Because of inflation the purchasing power of \$100,000 one year later would be less than what I can buy using the same amount now. Higher the inflation, lower will be the money I would be paying for the bonds now.
• Interest rate - I can invest the money I have now in bank and can earn some extra income in the form of interest. Thus, I would like to earn some income from my bond investment. Higher the interest rate, lower I would be willing to pay for the bonds now.
• Default - There would be a risk ...

Solution Summary

The time value of money for taking a risk is examined.

\$2.19