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The concept of corporate finance lies in time value of money and is often regarded as the foundation of the corporate strategy as well as the financial management. The concept of net present value is applied in a number of financial decisions and the time value of money is dependent on the same principle. Therefore, this paper will be focused on the importance of the time value of money based on the concept of net present value. This concept is clarified by using the example of bond valuation as mentioned in the question. However, this paper is not focused on defining the concept of net present value. Nevertheless, I believe that a simple understanding of the concept is required and the concept of time value of money along with net present value is discussed in the subsequent section of the discussion.
Time value of money and risk is extremely vital in financial decision-making. The fundamental idea of time value of money is that “A dollar today will be worth a dollar tomorrow.” The time value of money gives rise to the concept of net present value, according to which all the future cash flows are discounted to present value. The concept of net present value and time value of money incorporates the risk associated with future cash flow in the form of discount rate. If the timing and risk of cash flow are not considered, the firm may make decisions, which may allow the company to miss its objective of maximizing the owner’s welfare with the net present value concept (New Age Publishers, 2011). Therefore, whenever an analysis is done, then, the concept of net present value must be used. Investopedia (2010) defines net present value as the current value of a future cash flow stream or an amount of money less any present value of cost given that the analysis considers the pre-specified discount rate i.e. rate of return.
The bond is the debt instrument that is generally issued at a discount, which will reach its face value on maturity. The value of a bond is determined by discounting it's all future cash flows and face value with the appropriate discount rate. The maturity value is discounted at some rate to find the present value to be paid in the current. The discount rate should incorporate the inflation rate (the rate at which the value of money is degraded), the market interest rate or the opportunity cost of the investment and other associated risk premium as a reward for taking the risk in the market. Not only this, it also incorporates other several kinds of risks associated with the cash flow like reinvestment risk, interest rate risk, liquidity risk, default risk etc.
For this SLP, I would like to choose Estee Lauder as a company whose bond I am going to purchase. My personal preference includes the inflation rate, market interest rate, and other associated risk premiums with the bond. Looking at several kinds of risk connected with the company, I find the risk associated with the company more than industry average. Estee Lauder is one of the most competitive companies in the sale and manufacturing of products for beauty, haircare, skincare, fragrances, and makeup. It sells its products in over 150 countries under different brand names including Aramis, Tommy Hilfiger, and Lab series among others.For the past 3-4 years, the company is performing really well. It has not become able to maintain its debt ratio as per industry average but have increasing sales and operating profit. The company has also expanded its equity base. With the total revenue of around 10 billion, and net profit of 1 billion, the company looks good. The earnings growth was 19% last year and it is expected to grow by 11% for coming 5 years.Whatever be the simple financial data shows, we find this company in a mid-position between and riskiness and safety one when analyzing the company in terms of ratio and other financials.The debt to equity ratio of Estee Lauder is 31.64 times (industry average 12.42 times) while the net profit margin is 9.74% (industry average 10.29). This shows that the debt portion is very high i.e. for each dollar of equity the company spends $ 31.64 of debt, which makes the company very risky. ROA and ROE of the company are 13.48% and 28.83% (industry average of 3.95% and 7.59% respectively), which show that the company has a satisfactory level of cash flow and ability to pay for the bond. The current ratio is 2.44 times. Quick ratio of 1.85 times shows that the company is investing fair amount in current assets. Not only this, beta of 1.2 shows that Estee Lauder is less risky than the market (Reuters, 2014). Reviewing all these factors and considering my preference for risk and return, I would pay $90,000 for the bond in the market.
The discount rate, I have considered here is 11.11 percent. The discount factor considered here is the required rate of return expected from the bond, with reference to the bond with similar risk in the market. Here for the calculation part:
Maturity value = $100,000
Present Value = $90,000
If we consider my amount of investment i.e. $90,000 as the present value of the bond
Net Present Value=maturity value1+discount raten
Thus, the calculated net present value of the bond at 11.11% discount rate is $90,000 that can be paid today to get maturity of $100,000 at the end of one year.
Similarly, if we look at the financial data fromRevlon and L’Oreal, then we can find following observation.
If we look at the above table, then we find that Revlon is very risky in comparison to L’Oreal and Estee Lauder. Higher rate of beta shows that Revlon is much more risky than the market itself (because the market has a beta of 1) while L’Oreal is less risky. Higher the beta, higher is a risk. Higher the beta, the higher is the risk. Investors must be compensated for bearing risk –the greater the risk of the stock, the higher is the return (Brigham, &Daves, 2010, p. 54).With debt/equity ratio of 1.73 times, which is least among all and also it is below than industry averages, L’Oreal stands as the safest company as a low D/E ratio indicates lower risk of default. The higher the debt ratio, the higher the financial risk and, while a very high ratio might be unattractive because of high level of risk, a very low ratio would also be unattractive because of leveraged returns foregone (Correia, Flynn, Uliana, &Wormald, 2007, p. 5-16). The profit margin of L’Orealis more than that of Revlonas well asit's ROA and ROE is far better than that of Revlon. Estee Lauder also has a good profit margin, ROA and ROE as compared to Revlonbut it is not as good as that of L’Oreal in other financial terms. While we look at all the information we have, we see that all three companies have more or less similar financial information, but if we analyze the situation more carefully, then we see that L’Oreal is the safest company to invest while Estee Lauder stands second. So, to conclude L’Oreal is the safest company to invest as it has the lowest beta of all and its other ratios are also good enough. Revlon stands as the most risky company as it has high beta, high debt/equity ratio, low ROA and ROE.
The present value of the bond is determined by the discount rate at which the maturity value is discounted. The discount rate is a function of the inflation rate, the opportunity cost in terms of market interest rate and other risk factors associated with the investment. More or less, the first two factors are similar for the organization, but the risk premium is purely associated with the organizational and their subjective risk factor.
If any of the organization is in a risky position, then the risk premium demanded by its investor is higher. The higher the level of risk, the more the average investors require as compensation for bearing risk (Brigham & Houston, 2012, p. 283). This results in increase in the discount rate. Increase in discount rate means less present value. Thus, the willingness to pay for the current value of the bond decreases with the risk condition of the company. On the other hand, if the other company is comparatively less risky compared to the earlier case, then the risk premium demanded by investors is also less. With less discount rate, the present value to be paid for the bond becomes higher, thus, the investor pays a high amount compared to that of previous bonds in order to get the same maturity value. This shows that investors will pay a higher amount for the bond of L’Oreal while they pay the lowest for bond of Revlon.
Brigham, E. F., &Daves, P. R. (2010). Risk and Return: Part I. In Intermediate financial management (10th Ed., p. 52). Mason, OH: South-Western.
Brigham, E. F., & Houston, J. F. (2012). Risk and Rates of Return. In Fundamentals of financial management (7th ed., p. 283). Mason, Ohio: South-WesternCenagee Learning.
Correia, C., Flynn, D. K., Uliana, E., &Wormald, M. (2007). Financial Statement Analysis. InFinancial management (6th ed., pp. 5-16). Cape Town, South Africa: Juta.
New Age Publishers. (2011). Time Value of Money. Retrieved March 3, 2014, from New Age Publishers: http://www.newagepublishers.com/samplechapter/001945.pdf
Present Value (PV) Definition | Investopedia. (2010). Retrieved from http://www.investopedia.com/terms/p/presentvalue.asp
Reuters (2014). Estee Lauder Companies Inc (EL.N). Retrieved March 11, 2014, from http://http://www.reuters.com/finance/stocks/financialHighlights?symbol=EL.N
Reuters.com. (2014). Revlon inc (rev.n) quote| reuters.com. [online] Retrieved from: http://www.reuters.com/finance/stocks/overview?symbol=REV.N [Accessed: 11 Mar 2014].
Reuters.com. (2014). L'orealsa (orep.pa) financials | reuters.com. [online] Retrieved from: http://www.reuters.com/finance/stocks/financialHighlights?symbol=OREP.PA [Accessed: 11 Mar 2014].
Time Value of Money | EconEdLink. (n.d.). Retrieved March 4, 2014, from http://www.econedlink.org/lessons/index.php?lid=37&type=student