Description
The time value of money is the value of money with a given amount of interest earned or inflation accrued over a given amount of time. The ultimate principle suggests that a certain amount of money today has different buying power than the same amount of money in the future.
TIME VALUE OF MONEY Time value of money means - value of unit of money is different in different time period. Value of sum of money received today is more than value of money received after some time. Conversely money received in future is less valuable than it is today. In other words present worth of rupee received after some time will be less than a rupee received today. Since rupee received today has more value, rational investors would prefer current receipts to future receipts. Thus the time value of money can also be referred as time preference for money. Recognition of time value of money in financial decision making is extremely important. Given the objective of wealth maximization of business, much of the subject matter of financial management is future oriented. Implications of financial decision taken today are spread into several years in future. For arriving at any viability decision one has to compare cash outflows (outlays/expenditure) and benefits (cash inflows/income/receipts/revenue). For meaningful comparison two variables must be strictly comparable. It is here to fulfill basic requirement of comparability the time element comes into picture. In other words, in order to have logical and meaningful comparison between two cash flows that accrue in different time
period, it is necessary to convert sums of money to a common point of time. The main factor which gives money it’s time value is investment opportunities of the funds which are received early. The funds so invested will earn a rate of return, which would not be possible if funds are received later. The time value of money is therefore expressed generally in terms of rate of return or more popularly as discount rate. The expected rate of return or time value of will vary from individual to individual depending, inter alia on his perception.
TECHNIQUES – In order to have a logical and meaningful comparison of cash flows that occur in different time periods it is necessary to convert the sums of money to common point of time. There are two techniques of doing this namely compounding and discounting.
COMPOUNDING TECHNIQUES -
The term principle refers to the amount of money on which interest is received. Interest is compounded when the interest
earned on initial deposit becomes part of principle at the end of first compounding period. The compounding procedure will continue for indefinite period. The compounding of interest can be calculated by the following formula A = P(1+i)n Where A - amount at the end of the period P - principle at the beginning of period i - rate of interest n - number of years(period)
FINDING GROWTH RATE USING COMPOUNDING TECHNIQUE –
1. Suppose Company has currently 5000 employees. The number is expected to grow at 5% p.a. How many employees Coy will have after 10 years?
2. Phoenix Ltd had revenues of Rs. 250 mio in 1999 which increased to Rs. 2.5 bn in 2009. What is CAGR in revenues?
PRESENT VALUE OF SINGLE AMOUNT The concept of present value is exactly opposite of compound value. In compounding approach money invested now appreciates in value as compound interest is added. In present value approach money received in future will be worth less today as the corresponding interest is lost. Simply stating it means present value of rupee that will be received in future will be less than a rupee in hand today. Thus in contrast to what we do in compounding where we convert present sum into future sum, in present value approach future sums will be converted in present sums. Considering positive rate of interest prevailing in the economy present value of future rupees will always be lower. It is for this reason that the procedure of finding present value is called discounting. Here we presume that decision maker has an opportunity to earn certain return on his money. This rate is called as cost of capital, opportunity cost, hurdle rate, cut-off rate and so on. Example - Holder of bond will receive Rs.1000 from a bond which is maturing one year from now. One can earn interest of 8% on investment. What amount one should be prepared to buy this bond? PRESENT VALUE TABLE
PRESENT VALUE FACTORS(PVIF) YEAR END 1 1 2 3 4 5 TOTAL 500 1000 1500 2000 2500 7500 CASH FLOWS 2 PVIF 3 0.909 0.826 0.751 0.683 0.621 PRESENT VALUE 4(2*3) 454.50 826.00 1126.50 1366.00 1552.50 5325.50
Suppose somebody has promised you to give Rs. 1000/- three years hence, what is present value of the amount if interest rate is 10%? FORMULA – FVn = PV(1+r)n Present value of series of cash flows – summation. ANNUITY IS DEFINED AS SERIES OF EQUAL AMOUNT OF CASH FLOW EACH TIME DURING A PERIOD.
CASH FLOW VERSUS ACCOUNTING FLOWS -
Capital budgeting is concerned with investment decisions which yield returns over long period of time in future. The foremost requirement of evaluation of any capital investment proposal is to estimate the future benefits accruing from investment proposal. Theoretically two criteria are available to quantify the benefits one is accounting profits and another is cash flows. The basic difference between them is primarily due to inclusion of certain non-cash items such as depreciation in P&L account. Therefore profits and loss account is to be adjusted for all non cash items. Cash flow approach is superior to accounting approach because CF are better measure of the net economic benefits and costs associated with the project. CF are superior to Accounting flows on account of following considerations – 1. Firm is interested to calculate economic outflows and inflows related to the project. The firm must pay for purchase of asset in cash. This is a foregone opportunity to use cash for some other alternative productive use. Similarly firm must measure future benefits in cash terms. On the other hand accounting practices the cost of investment is allocated over economic useful life of the assets in the nature of depreciation rather than at time when the costs are actually incurred. The accounting treatment clearly does not reflect the original need for cash outflow and inflow in later years. Only cash flows reflect the actual cash transaction
associated with the project. Since investment analysis is concerned with finding out whether future economic flows are large enough to undertake investment. Thus only cash flow method is appropriate for investment decision analysis. 2. Use of cash flow analysis avoids ambiguities. There are various ways to value inventory, allocate costs, calculate depreciation, and amortise various other expenses. Thus different net profit figures will arrive under different accounting procedures. As against this there is only one set of cash flows associated with the project. 3. CF approach takes cognizance of time value of money where as accounting approach ignores it. Under usual accounting practice revenue is recognized as generated when product is sold and not when cash is collected. Such a revenue may remain paper figure for months or years before payment is actually received. Expenditure too is similarly recognized when incurred and not when actual payment is made. Accounting approach has lot of scope for manipulation. The management can show more or less profit by using various provisions. However this is not possible in cash flow technique. Accounting profits are better way as performance measure and are less useful as decision criteria. Cash flow approach can be seen as basis for estimating investment proposals.
INCREMENTAL CASH FLOWS For capital budgeting process the basis on which relevant cash outflows and inflows are to be estimated. According to incremental analysis only difference due to decision need to be considered. Other factors may be important but not for the decision to be taken. For the purpose of estimating cash flows in capital budgeting, incremental cash flows that is only those cash flows which are directly attributable to the investment are to be taken into account. It is for this reason that fixed overhead costs which remain same whether project is accepted or rejected are not considered. However if there is increase in cost due to the proposal the same must be considered.
doc_180789912.docx
The time value of money is the value of money with a given amount of interest earned or inflation accrued over a given amount of time. The ultimate principle suggests that a certain amount of money today has different buying power than the same amount of money in the future.
TIME VALUE OF MONEY Time value of money means - value of unit of money is different in different time period. Value of sum of money received today is more than value of money received after some time. Conversely money received in future is less valuable than it is today. In other words present worth of rupee received after some time will be less than a rupee received today. Since rupee received today has more value, rational investors would prefer current receipts to future receipts. Thus the time value of money can also be referred as time preference for money. Recognition of time value of money in financial decision making is extremely important. Given the objective of wealth maximization of business, much of the subject matter of financial management is future oriented. Implications of financial decision taken today are spread into several years in future. For arriving at any viability decision one has to compare cash outflows (outlays/expenditure) and benefits (cash inflows/income/receipts/revenue). For meaningful comparison two variables must be strictly comparable. It is here to fulfill basic requirement of comparability the time element comes into picture. In other words, in order to have logical and meaningful comparison between two cash flows that accrue in different time
period, it is necessary to convert sums of money to a common point of time. The main factor which gives money it’s time value is investment opportunities of the funds which are received early. The funds so invested will earn a rate of return, which would not be possible if funds are received later. The time value of money is therefore expressed generally in terms of rate of return or more popularly as discount rate. The expected rate of return or time value of will vary from individual to individual depending, inter alia on his perception.
TECHNIQUES – In order to have a logical and meaningful comparison of cash flows that occur in different time periods it is necessary to convert the sums of money to common point of time. There are two techniques of doing this namely compounding and discounting.
COMPOUNDING TECHNIQUES -
The term principle refers to the amount of money on which interest is received. Interest is compounded when the interest
earned on initial deposit becomes part of principle at the end of first compounding period. The compounding procedure will continue for indefinite period. The compounding of interest can be calculated by the following formula A = P(1+i)n Where A - amount at the end of the period P - principle at the beginning of period i - rate of interest n - number of years(period)
FINDING GROWTH RATE USING COMPOUNDING TECHNIQUE –
1. Suppose Company has currently 5000 employees. The number is expected to grow at 5% p.a. How many employees Coy will have after 10 years?
2. Phoenix Ltd had revenues of Rs. 250 mio in 1999 which increased to Rs. 2.5 bn in 2009. What is CAGR in revenues?
PRESENT VALUE OF SINGLE AMOUNT The concept of present value is exactly opposite of compound value. In compounding approach money invested now appreciates in value as compound interest is added. In present value approach money received in future will be worth less today as the corresponding interest is lost. Simply stating it means present value of rupee that will be received in future will be less than a rupee in hand today. Thus in contrast to what we do in compounding where we convert present sum into future sum, in present value approach future sums will be converted in present sums. Considering positive rate of interest prevailing in the economy present value of future rupees will always be lower. It is for this reason that the procedure of finding present value is called discounting. Here we presume that decision maker has an opportunity to earn certain return on his money. This rate is called as cost of capital, opportunity cost, hurdle rate, cut-off rate and so on. Example - Holder of bond will receive Rs.1000 from a bond which is maturing one year from now. One can earn interest of 8% on investment. What amount one should be prepared to buy this bond? PRESENT VALUE TABLE
PRESENT VALUE FACTORS(PVIF) YEAR END 1 1 2 3 4 5 TOTAL 500 1000 1500 2000 2500 7500 CASH FLOWS 2 PVIF 3 0.909 0.826 0.751 0.683 0.621 PRESENT VALUE 4(2*3) 454.50 826.00 1126.50 1366.00 1552.50 5325.50
Suppose somebody has promised you to give Rs. 1000/- three years hence, what is present value of the amount if interest rate is 10%? FORMULA – FVn = PV(1+r)n Present value of series of cash flows – summation. ANNUITY IS DEFINED AS SERIES OF EQUAL AMOUNT OF CASH FLOW EACH TIME DURING A PERIOD.
CASH FLOW VERSUS ACCOUNTING FLOWS -
Capital budgeting is concerned with investment decisions which yield returns over long period of time in future. The foremost requirement of evaluation of any capital investment proposal is to estimate the future benefits accruing from investment proposal. Theoretically two criteria are available to quantify the benefits one is accounting profits and another is cash flows. The basic difference between them is primarily due to inclusion of certain non-cash items such as depreciation in P&L account. Therefore profits and loss account is to be adjusted for all non cash items. Cash flow approach is superior to accounting approach because CF are better measure of the net economic benefits and costs associated with the project. CF are superior to Accounting flows on account of following considerations – 1. Firm is interested to calculate economic outflows and inflows related to the project. The firm must pay for purchase of asset in cash. This is a foregone opportunity to use cash for some other alternative productive use. Similarly firm must measure future benefits in cash terms. On the other hand accounting practices the cost of investment is allocated over economic useful life of the assets in the nature of depreciation rather than at time when the costs are actually incurred. The accounting treatment clearly does not reflect the original need for cash outflow and inflow in later years. Only cash flows reflect the actual cash transaction
associated with the project. Since investment analysis is concerned with finding out whether future economic flows are large enough to undertake investment. Thus only cash flow method is appropriate for investment decision analysis. 2. Use of cash flow analysis avoids ambiguities. There are various ways to value inventory, allocate costs, calculate depreciation, and amortise various other expenses. Thus different net profit figures will arrive under different accounting procedures. As against this there is only one set of cash flows associated with the project. 3. CF approach takes cognizance of time value of money where as accounting approach ignores it. Under usual accounting practice revenue is recognized as generated when product is sold and not when cash is collected. Such a revenue may remain paper figure for months or years before payment is actually received. Expenditure too is similarly recognized when incurred and not when actual payment is made. Accounting approach has lot of scope for manipulation. The management can show more or less profit by using various provisions. However this is not possible in cash flow technique. Accounting profits are better way as performance measure and are less useful as decision criteria. Cash flow approach can be seen as basis for estimating investment proposals.
INCREMENTAL CASH FLOWS For capital budgeting process the basis on which relevant cash outflows and inflows are to be estimated. According to incremental analysis only difference due to decision need to be considered. Other factors may be important but not for the decision to be taken. For the purpose of estimating cash flows in capital budgeting, incremental cash flows that is only those cash flows which are directly attributable to the investment are to be taken into account. It is for this reason that fixed overhead costs which remain same whether project is accepted or rejected are not considered. However if there is increase in cost due to the proposal the same must be considered.
doc_180789912.docx