Term Paper on "Finance Extremely High Wages Paid"

Term Paper 15 pages (5377 words) Sources: 0

[EXCERPT] . . . .

Finance

Extremely high wages paid to the chief executive officers of high companies can be explained by successful growth strategies chosen by them that translate into dramatic increases of these companies' stockholders wealth, overall company earnings and value. The existence of not well-performing companies is due to the failure of their managers to foresee the market movements and adjust the company strategies to them. Thus, when hiring a chief executive officer, the company owners make a very important decision as they put their whole wealth in his/her hands and their income will depend on the cooperation of the management company. The accomplishments will depend on good financial education or extensive positive experience which will be appropriately applied to the operations of this specific company.

Corporate finance is an extensive field and requires many years of education and background exposure in order to understand it and be able to even anticipate the effects that some financial aspects will have on the corporate performance. But there are some segments of the huge corporate finance knowledge that must be well realized not only by chief executive officers, but by the majority of managers at even operation level because their misperception can lead to fatal for the company mistakes. Thus, financial managerial decision are usually divided into two groups: financing and budgeting decisions, where budgeting refers to choosing the optimal financing source and timing for a business opportunity which will lead to increasing value of the company, and financing refers to singling out of numerous business opportunities those which will provide the biggest financial and social benefits for the company and its' stockholders. In order to make both decisions, financial analysis of all the alternatives has to be made. In terms of financing decision it implies picking the cheapest source of financing, while when applied to budgeting decision, the best investment opportunity with value gains must be chosen. All the financial analysis decisions are based on comparing the cash flows generated by different business opportunities, or the cash outlays which an investment will require. Thus, the starting point in carrying out a comparison is realizing that cash flows that occur in different times will have different values. This is the 'time value of money concept', which means that 'a dollar today is worth less than a dollar tomorrow'. This is deferred from the fact that even in stable economies inflation exists and the dollar today can buy more goods than a future dollar. The amount of money received in some future point of time is referred to as the 'future value of money' and it will grow at the interest rate at which it is invested. For example, $100 invested today for 5% annual interest rate will generate $100*105% = $105. Another thing is how many goods these $105 will be able to buy in one year comparing to the amount of goods that $100 can buy today.

On the contrary, 'present value' of a certain amount of money' refers to the amount that must be invested today to generate at this future date a certain amount of money. Thus, to receive $105 in one year, one must invest $100 today if the interest rate is 5%. The present value of future cash flows is calculated using the discount rate which 'usually represents the cost of capital for the person or entity calculating the net present value of the stream'. For calculating the present values of further cash streams, the discount factors can be exploited. The discount factor represents how much a future dollar is worth today. For example, the discount rate of 0.95 implies that a future dollar is worth only 0.95 cents today.

The discount factor is derived from the discount rate using the following equation: 1 + (1 + i) n, where I is the rate of interest (discount rate) and n is the number of years. That is why the process of deriving the present value of a future cash flow is knows as discounting. From the formula it is evident that the present value will depend on the year in which the cash flow will be generated and it will be lower, the further the cash flow is received. An important implication is that in order to carry out a precise and accurate estimation of present value of future cash flows or costs, they must be all discounted to a single time period in order to make the proper comparison. As mentioned above, due to the inflation which makes the purchasing power of money different in various points of time, comparing cash flows in nominal terms (the amounts that occur) is misleading. The value of all the future cash flows or outflows for one specific date (discounted nominal cash flows using the discount rate which reflects the accumulated inflation from this specific date till the date when the cash flows occurs) is the sum of present values of all these cash flows. Every project requires certain cash outlays at different spans of the project life, the initial investment, the complementary investments, unpredicted cash spending which occur in the different time. Any business initiative generates capital gains or earnings also in different times. Thus, adding the present values will give the benchmark for estimating the total benefits from the project and the total costs.

Mathematics comes in hand for financial analysts and there are certain shortcuts which make calculating the benefits or costs of the projects much faster. For estimating 'equally spaced level streams of cash flows', or 'annuities', a level of even cash flows starting immediately (annuities due), or a stream of level cash payments that last perpetually (perpetuity), the formulas are used.

Stressing again the importance of adjusting all the future cash flows for inflation and risk, the concepts of nominal cash flows, or payments in current dollars, or real cash flows, or payments equal in constant dollars (one benchmark date for all future cash flows) are used. Usually, the business projects can be rather long-lived, and using effective interest rate (rate of interest per period compounded for the number of periods in a year) to bring all the cash flows to a single date, or using the annual percentage rate (annualized using simple interest rate) can generate different results. Thus, the present value of a future cash flow discounted using the effective interest rate will be smaller, but when the cash flows are large and projects lives are long, the difference can be very significant.

Inflation is not the only determinant which makes the future benefits from accepting a business initiative look less attractive today. Any business idea is risky due to the volatility of the overall economy, volatility of the unique market segment where the project will operate, uncertainty about the demand for the products or services produces by the products due to possible technological innovations and creation of substitutes, the risk of the default of the company and many others. Thus, the risk must be taken into consideration when estimating the relative attractiveness of the project. The riskier the project, the less is the certainty that the initial investment in this opportunity will be recovered. This uncertainties makes investors want to know the rates of returns that the project will generate and how much wealthier it will make them, and they demand higher rates of returns for riskier projects in order to initiate it. The return on the investment opportunity relates to the predicted payoff over the initial outlay and compensation for the investors for both waiting for the profits (time value of money) and worrying whether the profits will be received or not (risk of investing in a specific asset). The risk of the project or an asset, or of the portfolio which consists of several projects or assets is looked upon in terms of volatility of returns (how the assumed returns deviate from the predicted expected average return) and is measured as standard deviation and variance of the expected returns. Initiating every project bears both market risk, or risk that the overall economy/market segment where the project competes will turn down, and the unique risk, or the risk of not receiving payoffs from this very project due to bad management or other circumstances. Diversifying the assets in a portfolio, thus choosing assets that depend on different fundamentals in the market movements, reduces the overall portfolio risk and risk on some projects which may not seem appealing due to high risk can be 'diversified away' when putting these assets together in a portfolio with other low-risk assets, or assets for which performance depends on different fundamentals. The implication is that the big investors, or the smart investors, who hold carefully diversified portfolios, should worry only about the overall market risk (that overall economy will go bad), because with such a portfolio, the loss on holding one asset will be compensated by the gain from another asset, as diversification by mixing assets that move in different directions, will imply that.

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