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Principles of Mathematical Finance Essay

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Updated: May 19th, 2021

There has been a trend across corporate America of promoting financial officers to CEO. What are some advantages and disadvantages of this practice?

The trend of promoting CFOs to CEOs is a relatively recent one. It began in 2014 and went on in full-force by the end of 2016 when many newspapers and financial analysts started noticing this widespread trend (Wilkinson, 2016). The reason for that is the uncertainty of business climates and the effects of economic crises that hit the world in the past few years. Companies and corporations are aiming to “play safe” and avoid unnecessary risks. While CEOs are known for coming up with daring ideas and charismatic leadership, their goal is to win. The goal of a CFO is not to lose. A CFO in the position of CEO knows the company’s financial flows and can organize the company to minimize spending and playing it safe. They are excellent for the position if the company seeks to maintain its position through hard times. However, having a CFO in a position of CEO has its disadvantages. CFOs are often without leadership skills and are poor at motivating people. Besides, they have a tendency of retaining control and concentrating power, rather than delegating it to others (Wilkinson, 2016).

What is your discount rate or rate of preferences? That is, how much would you pay for a promise of $1,000 to be received one year from now? Would you discount it by 10%, 5%, etc?

The formula for implied discount rate looks like this (McClure, 2016):

[(Future Value / Present Value) ^ (1/(years))] – 1.

For a promise of 1000 dollars to be returned to me in a year, I would be willing to pay 800. If we put these numbers into our formula, the result would look like this:

[1000/800 ^ 1/1] – 1 = 0.25

Thus, my discount rate or rate of preference for this sum would be 25%. Average discount rates, according to numerous sources, tend to fluctuate around the area of 10%. However, in those situations, sums are much larger, so 10% becomes a much more sizeable sum. Giving away money to receive a negligible 10% from 1000 dollars in a year is not an appealing option, which is why I raised my discount rate for this sum.

Would you ever use CAPM to make personal investment decisions?

CAPM is a theory widely used in international investment communities. It is a relatively simple and straightforward tool that allows for measuring risks and calculating profits over short intervals (McClure, 2017). Studies have shown that CAPM’s linear correlation does not always work over longer periods. An investor can use CAPM to create an investment portfolio specifically tailored to their risk-reward requirements. For example, investors may invest in portfolios with a beta of the security >1 if the market is stable or is growing. Should the market situation be close to falling, they could switch and instead retain securities with betas less than one (McClure, 2017). The message CAPM sends to the investors is that if they want higher profits – they should invest in riskier enterprises, while if they want security – with low-risk businesses that have a low beta. As an investor, I would likely use CAPM as it has proven itself to be a trustworthy and relatively reliable tool to many investors.

How accurate do you think a company’s estimates of the net present value of a proposed project are?

Net present value calculations are commonly used to determine the profitability of a project by taking into account numerous factors, such as revenues, operating expenses, taxes, depreciation, inflation, and a myriad of other factors (“Net present value,” n.d.). As such, NPV projections can be somewhat inaccurate, as they rely greatly on estimations and assumptions (“Net present value,” n.d.). The more assumptions there are – the more likely it is for the NPV to be inaccurate. Out of three scenarios presented in this question, I believe that the NPV for the pharmaceutical company would be the most accurate. They will have accurate numbers about how much money is required to launch their new drug and will have a better awareness of the market situation as they will be launching the new drug in their own country. Thus, return rates and inflation rates would be the only fluctuating variables to affect the NPV formula.

References

McClure, B. (2016). Web.

McClure, B. (2017). Web.

Net present value – NPV. (n.d.) In Investopedia. Web.

Wilkinson, J. (2016). Can a CFO be a CEO? Web.

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