RECEIVED GUIDENCE BY: PROF.

KAMAL ROHRA

Royal College of Arts, Science and Commerce SUBJECT: 4.2

PROJECT ON :TIME VALUE OF MONEY S.Y.BANKING & INSURANCE SEMESTER 4 (2010-2011) GROUP NO: 09

AZIM SAMNANI (37) DHAVAL SHAH (38)

ANKUR KALANI (35) SANIF MOMIN (36)

We would like to express our profound gratitude to our project guide Prof KAMAL ROHRA, who has so ably guided our research project with her vast fund of knowledge, advice and constant encouragement, which made us, think past the difficulties and lead us to successful completion of the project. We have tried to cover all the aspects of the project & every care has been taken to make the project faultless. We have tried to write the project in our words as far as possible and simplified all the concepts by presenting it in a different form. Well be looking forward in future for such type of project. We are eagerly waiting for fruitful comments & constructive suggestions.
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SR.NO 1. 2. 3.

TOPIC Introduction What Is Time Value? Concept of Inflation Wholesale Price Index and Consumer Price Index Concept of Interest as compensation for loss of purchasing power due to inflation: Four tier structure for rates of interest in any economy What are the factors that a bank would consider to determine its lending rate? Doubling period CONCLUSION WEBLIOGRAPHY

PG.NO 5 6 10

4.

11

5. 6.

12 13

7. 8. 9.

16 28 29

Introduction
Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1. A key concept of TVM is that a single sum of money or a series of equal, evenlyspaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-hand column below. The left column has references to more detailed explanations, formulas, and examples.

What Is Time Value?

If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of moneydemonstrates that, all things being equal, it is better to have money now rather than later. But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money. Back to our example: by receiving $10,000 today, you are poised to increase the future valueof your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look. Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450 You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450 Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450

 Final equation: $10,000 x (0.045 + 1) = $10,450 The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920: Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25 The above calculation, then, is equivalent to the following equation: Future Value = $10,000 x (1+0.045) x (1+0.045) Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basics

If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future. To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following: Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now. Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following: Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.

Present Value of a Future Payment

Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following: Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

Concept of Inflation Wholesale Price Index and Consumer Price Index

Inflation means to increase. In this context, it means increase in prices of commodities. The price increase is due to the difference between supply and demand for a given commodity. If the supply is more than demand, prices decline and if the demand is more, prices increase. In a developing country like India, the demand for most of the commodities will always be more than the supply. Hence inflation will always be experienced in developing markets. The increase is constantly measured in all the countries. The items included for determining the prices would be different from country to country. For example, in India, essential commodities like sugar, kerosene, a loaf of bread etc. are included in the basket of commodities considered for calculation of inflation. Different from this, in a developed country, items that are luxury items in a developing country would also be included. For example, automobile could be included. The increase is expressed in % terms. For example if the rate of inflation is 5%, this means that over a period of one year, the prices have increased by 5%. The details of inflation are published regularly in all leading dailies in the country.

Wholesale price and not the retail price The prices of the selected commodities for determining the rate of inflation over a period of one year could be on the wholesale or retail. The latter one is mostly referred to as consumer price. Thus we have a wholesale price index and consumer price index for expressing rates of inflation. Conventionally in India the rate of inflation has always been expressed in wholesale price index basis rather than consumer price index basis although the consumer price index increase is also published regularly. At present the wholesale price index inflation is around 3%. We will explain this concept through an example. Example no. 1 I had spent Rs. 100/- in getting a basket of commodities one year ago. If the rate of inflation is say 3%, now I will be required to spend Rs. 103/- to get the same basket of commodities. How do we get Rs.103/-? Rs. 100/- x 1.03 = Rs. 103/-. This means that due to inflation, the purchasing power of the local currency decreases with the passage of time. This is exactly the concept of time value of money. In simple words, time value of money means that with the passage of time, money loses its value.

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Is there a situation in which the prices decrease over a period of time and opposite of inflation takes place?
Usually in a developing country, such a situation does not arise, as the demand is always greater than supply. However currently Japan is experiencing deflation in which current prices would be less than the past prices. This is harmful to a developing economy, as units that save money would get very low interest or no interest. Hence there will be no incentive for the units to invest money in bonds, fixed deposits etc.

Concept of Interest as compensation for loss of purchasing power due to inflation:

You keep money in a deposit with a bank. It could be a Savings Bank or a Fixed Deposit. What does the bank pay to you? Interest. This is the return on your investment. Why should the bank pay interest to you? Let us enumerate the possible reasons for the banks action. The bank does the business of lending. For this, it requires funds through deposits. It earns interest on loans and pays interest on deposits; With the passage of time, the purchasing power of money reduces. The same thing will happen to your deposit with the bank. The bank gives compensation to you for this loss in value of money; In case the bank does not pay interest, it will not get funds for lending. You will not keep deposits with it. You will choose other willing banks or avenues of investment. While all of them are correct, we are more interested in the second reason. Value of money erodes due to inflation as we have seen in the earlier paragraph. The rates of inflation would be different for different countries. Further, it could be different for the same country at different times. Sometimes it could be high while at some other times, it could be low.

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Would interest be less in case the rate of inflation comes down?

Absolutely. As an example, we have already seen what is happening in Japan. The Japanese banks are practically not paying interest on deposits right now. The rate of inflation in the US is around 2% p.a. and accordingly the rate of interest on investment would be around 3% to 3.5% p.a. Thus the rate of inflation in a country and the rate of interest on investment are closely linked to each other. For further details, please look at the Tier structure of rates of interest given below. Consider Indian market conditions. Hypothetically if the inflation comes down to say 1%, the rat e of interest on bank deposits and bank loans in turn would also come down. The banks would not pay the current rate of interest. If the students may recall in India, the rates of interest on savings are constantly coming down. This is the result of the rate of inflation coming down constantly at least till the last year.

Four tier structure for rates of interest in any economy

The starting point for any interest is the rate of inflation in the economy. Like for example, in India at present, it is around 3% now. We have seen earlier that interest is the compensation for loss of purchasing power of Indian Rupee. This loss is due to the phenomenon of inflation. We have also learnt that the banks would normally offer a rate of interest higher than the rate of inflation. Based on this, let us construct a 4-tier system of interest rates. This would build up stage-wise rates of interest till investment in a project. Tier 1 Rate of inflation, say 3% Tier 2 Rate of interest on investment say in bank deposit Rate of inflation + some compensation from the acceptor of deposits, say banks. = 3% + 4% = 7%, that is the lowest interest offered by a public sector bank now on fixed deposits. The exact premium paid to the depositor depends on the following: The duration of the deposit the longer the duration, the higher the premium and vice-versa. That is why the longer duration deposits would attract higher rates of interest and shorter duration deposits would have a lower rate of interest. The need for deposits by the banking company for a specific period. The bank would offer a higher rate for that period. Suppose a bank wants more deposits for six months rather than one year. It will attract deposits for six months by offering higher rate of interest than the market. Tier 3 What does the bank do with the deposits that it accepts? It gives loans. The rate of interest on loans becomes the next tier, Tier 3.

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What are the factors that a bank would consider to determine its lending rate?
Average interest paid out on deposits and expenses Minimum expected profit from lending operations Degree of risk in lending specific to a borrower, depending upon his business Continuing discussion on Tier 3, we see that the minimum rate of interest on loans would be 7% + 3% + 1% = 11%. This is the lowest interest that any bank offers now in India on loans. There is a specific name for this rate. It is referred to as Prime Lending Rate or PLR. The bank would add further to this rate depending upon risk etc., which is called risk premium1. This would again be different from borrower to borrower.

Why discuss about a loan here? Who takes loans in a big way from the banks? This does not refer to the housing or consumer loans taken by salaried persons. Obviously, business enterprises. It is for investment in their business/projects. Hence the rate of return on a project would be the last Tier, called Tier 4. Can you determine this rate? Yes and no. Yes, as you will be able to determine a formula for this. No, because, it is not always possible to evaluate risk associated with a project correctly. The formula is: Rate of interest on loans, say 11% + compensation for the additional risk taken by the project owner. For an outsider, it will not be possible to put a figure on this. This will depend upon the risk associated with the specific project. From whose point of view? - Both from the points of view of the owner and the lender/investor. This compensation is referred to as risk premium of the project. The question that could come to ones mind while reading these lines is: Why should a project owner expect a higher rate of return than the rate of interest on loans?

This is the reason that for different activities, the same bank charges different rates of interest at the same time. Similarly for different borrowers pursuing the same activity, the rates of interest would be different as per perception of risk associated with them.
1

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Consider the following and learn the risk associated with a project. The project owners investment does not have the backing of assets. A lender, on the contrary, has backing of assets for his loan. The enterprise pays the lender interest periodically. The owners on the contrary, get return in the form of dividend. This is not certain. Besides interest, the enterprise should also have sufficient surplus after paying interest to repay the loan amount Risk of project failure affects the owners more than the lenders for the same reason as mentioned in the first bullet point

Example No. 2 Let us summarise the above as under: Rate of inflation = Tier no. 1 = 3% p.a. Rate of interest on investment = Tier no. 2 = 7% p.a. Rate of interest on loans = Tier no. 3 = 11% p.a. Rate of return from investment in projects = Tier no. 4 = 15% p.a. (This is just an example. The rate of return expected from a project would actually depend upon the degree of risk associated with the project in the perception of the project owners primarily and project lenders secondarily)

Future value of Re.1 - Process of compounding

Refer to Example no. 1. We found out that we would require Rs.103/- to purchase a basket of commodities that we could purchase at Rs.100/- a year ago and the rate of inflation works out to 3% p.a. Can we give another name for the value after one year? Yes. It is called the future value, while Rs.100/- is called the present value. The other name for the future value is compounded value as this is obtained by a process called compounding.

Can we have a formula for this process of compounding? Future value (F.V.) at T1 = PV at T0 x (1+r/100)n , wherein T1 is the end of year 1 and T0 is the beginning of year 1.

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(1 + r/100)n is known as compounding factor. Let us apply this formula to another investment example and determine the future value.

Example no. 3 You have a fixed deposit for Rs.10,000/- in a bank. Terms of deposit are: Period Two years Rate of interest = 10% p.a. The bank does not pay interest periodically. Interest gets accumulated to the principal amount; it gets paid at the end of the period along with principal amount. What is the future value of this investment? The future value is Rs.12,100/-. In the compounding formula, by substituting 10% for r and 2 for n, we get this value. The break-up of principal and interest amount for the period of investment, i.e., two years is as under: Principal Rs.10,000/Interest Rs.2,100/-

Does the future value alter with the change in the frequency of compounding?
In the above example, we have assumed that the bank pays interest at the frequency of one year. Suppose the bank pays interest at a higher frequency, would the future value turn out to be different? Let us see the following example.

Example no. 4 Suppose the bank increases the frequency of compounding from yearly to half-yearly. What will be the future value? We can use the same formula with an amendment. The amended formula would be: Future value = Present investment x (1 + r/200) n x 2

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As interest gets compounded twice as frequently, r is divided by 200. Similarly the number of periods for compounding also gets doubled and hence it is 2 x n instead of n. Accordingly, in our formula, what would be the values of r and n? r = 5% and n = 4 With these values, the future value FV at T2 works out to 10,000 x (1.05) 4 = Rs.12,155/-. Similarly we can see that in case the frequency of compounding increases to quarterly from half-yearly, the future value works out to Rs. 12,184/-.

Let us summarise what we have learnt so far on compounding and future value: The amount that you get back at the end is called future value Future value is determined by compounding Future value depends upon: Rate of interest and Frequency of compounding The multiplying factor is known as compounding factor The more the frequency, the higher the amount of interest

Doubling period
A frequent question posed by an investor is: How much time it will take for my investment to double in value? This question can be answered by a rule known as Rule of 72. It is an approximate way of finding out the doubling period. Suppose the rate of interest is 12%. The doubling period is 6 years. A more accurate answer can be had by a better formula like: 0.35 + 69/interest rate in % terms. Employing the same rate of 12%, we find that the doubling period is 6.10 years instead of 6 years. This is more accurate than the Rule of 72 formula.

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Present value of a future rupee Process of discounting So far we have seen future value. We are now going to see present value of a future sum. Suppose we want to have Rs.10,000/- after say two years (T2). We want to know how much we should save now (T0). This situation is exactly the opposite of the earlier future value situation. The investment at T0 should increase to the desired future value at a desired rate of interest. The process of determining the present value from future value is known as discounting. Discounting is converse of compounding.

Example no. 5 We want to get Rs.108/- at the end of T1. The desired rate of interest is 8% per annum. What is the amount that we should invest at T0? Can we use the future value formula here? Yes with necessary modification as under: Future value = Present investment x (1 + r/100) n Future value at T1, Rs.108/- = PV at T0 (to be determined) x (1.08) PV at T0 = Rs. 108/1.08 = Rs.100/-.

Thus the formula for present value is as under: Present value = -------------------(1 + r/100) n Future value = Future value x [1/(1 + r/100) n]

The reciprocal of compounding factor is referred to as discounting factor. We need to multiply the future value by this discounting factor and not divide. In the above formula, 1/(1+r/100)n is referred to as discounting factor.

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Discounting factor = 1/compounding factor; discounting factor x compounding factor = 1. Discounting factor would always be less than 1.

Example no. 6 We want to get Rs.10,000/- after two years. The desired rate of interest is 12% p.a. The frequency of is yearly. What is the present value of this future sum of Rs.10,000/-? Present value = Rs. 7,971/The two-step process in determining present value is: Step 1 = determine the discounting factor = 1/[1 + 12/200]4 = 0.7924 Step 2 = multiply the future value by this factor to get the present value Present value of Rs.10,000/- = Rs.7,924/-

We have already seen under future value that higher frequency of compounding increases the future value. Conversely, higher frequency of discounting decreases the present value. The students are advised to take the following exercise and verify for themselves.

Exercise No. 1 After three years we are likely to get a windfall of Rs.1,00,000/-. What will be the present value of this windfall, in case the expected rate of return is 15% p.a.? Answer Rs.65,751/Let us summarise what you have learnt so far on discounting and present value: Discounting is the converse of compounding It is used when you want to determine the present value of a future sum Just as there is a compounding factor, there is a discounting factor In case you determine the discounting factor, you should multiply the future value by this factor to get the present value

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 The more the frequency the of discounting, the less will be the value of present value Present value will always be less than future value by the same token of inflation.

Application of concepts of future value and present value in business

Where does one apply the future value and present value in business? As discussed earlier, future value is helpful in determining the compounded return of an investment and hence is more useful in the case of personal investment. However, in the case of discounted value, the relevance is more to business. The following example illustrates this.

Example no. 6 - Application 1 We want to start an Industrial project at T0 with an investment of Rs.100 lacs. We expect to get a return of 20% from the project. The estimated future earnings are: T1 Rs.30 lacs T2 Rs.35 lacs T3 Rs.40 lacs T4 Rs.45 lacs

We want to evaluate our investment decision in the project. How do we do this? By applying discounting factor for 20% to the future earnings. Present value of T1 = Value at T0 = Rs. 30lacs/1.20 = Rs.25 lacs Present value of T2 = Value at T0 = Rs.35 lacs/(1.20)2 = Rs.24.30 lacs Present value of T3 = Value at T0 = Rs.40 lacs/(1.20)3 = Rs.23.14 lacs And Present value of T4 = Value atT0 = Rs.45 lacs/(1.20)4 = Rs.21.69 lacs

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The sum total of all the T0 values = Rs.94.13 lacs = Present value of future earnings for a period of four years. What does this mean? It means that at 20% expected return the project has given back only Rs.94.13 lacs. This is against Rs.100 lacs that have been invested in it. That is, the present value of future earnings is less than original investment. Hence we will not invest in the project. The difference between the present value of future earnings and the investment at T0 is called the Net present value or NPV. This is one of the fundamental methods of selecting a project.

Here is how we can use it for selecting a project: Determine the amount we need to invest in a project. Estimate future earnings from the project on certain working assumptions. Discount the future earnings by a suitable rate of discount. This depends upon the market rate for borrowing and our perception of risk in the project. This gives the present value of all future earnings. Compare this with the present value of investment. We invest in the project if the present value of the future earnings is more than present value of investment. In the above example, suppose the present value is greater than Rs.100 lacs. Then we would select the project for investment.

Exercise No. 2 We are investing in a project Rs. 1000 lacs. The rate of return that we expect from the project is 18% p.a. The estimated future earnings for three years are: T1 = Rs.450 lacs T2 = Rs.500 lacs T3 = Rs.550 lacs The above are also referred to as cash flows 2(in this case cash inflows)

Cash flow could either be cash inflow or cash outflow. When an investment is made at T 0 it is called cash out flow. Similarly when returns are received they are called cash in flows. Cash out flow is denoted by mentioning the figure within bracket like (50 lacs)

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Examine as to whether it is worthwhile investing in the project. Find out the Net Present Value of the project.

Answer: Present value of future earnings = Rs.1071 lacs Net Present Value = Rs.71 lacs We can invest in the project

Example No. 7 - Application 2 Suppose there is a bond that has been floated in the market with face value of Rs.1000/-. The interest per year is Rs.100/-. The period is 5 years. The expected rate of return is 8% p.a. What is the price at which an investor will be willing to purchase the bond from the market now?

Step 1 = to construct the future returns including the principal amount Year from now 1 2 3 4 5 Rs.100/Rs.100/Rs.100/Rs.100/Rs.1100/Payment expected (cash inflow)

Step 2 = discounting the payment expected by the rate of return, i.e., 8% p.a., we can determine the present value of the future cash flows. It is Rs.1080.30. This means that an investor will be willing to purchase this bond now from the market provided the market price of this bond is less than Rs.1080.30.

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Exercise No. 3 We have a bond with the face value of Rs.5,000/-. The interest on the bond is Rs.600/- per year. We are supposed to get a premium on the bond of Rs.250/- at the end of the maturity period. Expected rate of return by us = 10% p.a. Suppose the maturity is after 5 years, what is the price at which an investor would be willing to purchase it from us? (Note please add the premium amount to the face value. You will get Rs.5,250/- on maturity) Answer: Present value of future returns = Rs.5534/-. An investor will be willing to pay anything less than this value for purchasing the bond from you.

Example no. 8 - Application 3 Evaluation of opening of a branch office by discounting the expected future returns at a suitable rate of discount and comparing the present value with the investment required in capital assets to open a branch office. As you will have realised by now, the investment in a branch office is very similar to investment in a project. You are investing in a project to get returns from it. Similarly, you invest in a branch office based on expectation of additional returns. As it is very similar to a project, separate example or exercise is not given here.

Example No. 9 - Application 4 Suppose we develop a product by spending say Rs.10 lacs. This amount will be recovered along with profit through sales of a number of units over a period of time. Suppose we project sales in unit terms as well as value terms over a period of time. Let us assume this period to be three years. Suppose the expected rate of return is 15% p.a. Further, assume projected sales for the next three years to be as under: No. of units expected to be sold 2000 2200 2500 Unit Rate Expected sales in lacs of Rupees Rs.5 lacs Rs.5.5 lacs Rs.6.25 lacs

Rs.250/Rs.250/Rs.250/-

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This is similar to finding out the net present value in the case of projects. We discount the expected sales by the expected rate of return of 15% p.a. This determines the present value of the expected sales. Let us compare this with the total product development expenses.

Exercise No. 4 Find out the net present value in the above example. Also confirm that the total product development costs stand fully recovered at T3. Answer The product development costs stand fully recovered at T3. Let us summarise what we have learnt on application of Time value of money to business Compounding and discounting have a number of applications to Finance decisions. Compounding has greater application to personal investment while discounting has greater application to business. Discounting is useful in a number of decisions like project, product development, opening a branch office etc. Bond valuation is also done through discounting. Let us look at one more example for reinforcing our learning. Let us select the best project out of the three projects proposed. Consider the following 3 alternative projects. Assumptions are also given below: Investment at T0 for all the projects is Rs.500 lacs. Future cash flows are considered for T1 to T5. Although the scale of operations for all the projects is the same, the projects have different future earnings or returns. The promoters expect a rate of return of 15% p.a. hence; this is the rate by which the future returns are discounted.

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(Rupees in Lacs) Project 1 Year No. Future Earnings Project 2 Future Earnings Project 3 Disc. Value Future Earnings

Disc. Value

Disc. Value

100

86.96

150

130.44

175

152.18

120

90.73

150

113.42

150

113.42

200

131.5

150

98.63

180

118.35

250

142.95

200

114.36

225

128.66

250

124.3

200

99.44

250

124.3

Total

576.4

556.29

636.91

As Project 3 has the highest NPV it would be selected. NPV = PV of future earnings (-) original investment. Accordingly, the net present values for the three projects would be: Project 1 Project 2 Project 3 76.44 lacs 56.29 lacs 136.91 lacs

On the basis of net present value, project 3 would get selected.

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Concept of annuity So far we have seen the following in respect of application of time value of money: Investment lump sum at T0 and get lump sum at Tn = Future value; process is compounding. This is called future value of a single stream. Suppose we are given a future value and want to know how much should be invested at present. We use the process that is converse of compounding and this is called discounting. In order to get lump sum after a given period, we should invest the present value at the beginning, again a lump sum. This is called the present value of a single stream. Invest lump sum at T0 in a project and get annual returns. The returns will not be equal to each other. To determine the present value of the future returns to determine Net Present Value = Present value; process is discounting. This is the example of present value of multiple streams. Annuity refers to multiple stream of cash flows but which are equal to each other and occurring annually. The cash flows could either be in flows or out flows. This means that the following alternatives are available to us when we are talking of annuity. We invest at the beginning one lump sum amount and get returns over a period of time that are equal to each other. The cash in flows that are equal to each other are called annuity. Herein we use what is known as Present Value Interest Factor Annuity (PVIFA). We multiply the Annuity by this factor and get the present value of the future cash flows in one shot. Then we compare this present value with our proposed investment at T0 taking decision on investment. We invest provided the Present value of future annuities is at least equal to our investment at T0. We invest in equal instalments over a period of time and get one lump sum at the end of the period. The cash outflows that are equal to each other are called annuity. Herein we use what is known as Future Value Interest Factor Annuity (FVIFA) .We multiply the Annuity by this factor and get the future value of the cash out flows in one shot. Let us study the following examples to understand the concept of annuity. Example no. 10 We are able to invest every year Rs.1000/- for a period of 5 years. We expect a return of 10% p.a. What will be the value of this investment at the end of 5 years? Let us represent this by way of a timeline

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At T0 Investment = zero

T1

T2 1,000/-

T3 1,000/1,000/-

T4

T5

1,000/- 1,000/-

Can we use the future value formula, find out the future value of each stream of Rs.1000/- and add them up? Thus T1 investment would earn interest for 4 years, the 2nd year investment would earn interest for 3 years, the 3rd year investment would earn interest for 2 years, the 4th year investment would earn interest for 1 year and the last year investment would not earn any interest. Instead of doing such an elaborate exercise, we use the alternative FVIFA. Practical applications of Annuity3 for future value Life Insurance policy premium Recurring deposit account with a bank

Example no. 11 Similar in concept to Example no. 10, we can think of investment lump sum at T0 and getting returns over a period of time, the returns being equal in value. Example is investment in bank deposit floated by competitive banking industry at present. Each return will be partly principal amount and partly interest amount. Our aim is to determine the present value of the future returns by discounting them and comparing the present value with our investment value. Can we use PVIF and find out the present value of future cash flows? Yes. The cash flow at T1 is discounted for one year, the cash flow at the end of the second year is discounted for two years, the cash flow at the end of the third year is discounted for three years and so on and so forth. Instead of repeating the discounting process so many times, we have the easy alternative of Present Value Interest Factor Annuity. It is okay for discussion. However the students will be interested in knowing as to where he will get the PVIFA and FVIFA values. These will be available as annexure with any standard textbook on Financial Management and multiply with the annuity to arrive at the Present Value or Future value as the case may be.

Annuity could be at a frequency more than one year. In fact in the case of recurring deposit, the annuity is monthly.

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Concept of perpetuity
This is the concept applicable in the case of pension. Pension is taken to be perpetual. Can we find out the lump sum amount in case the pension amount is given? Example no. 12 Suppose the pension amount is Rs. 1000/-. The expected rate of return is 10% p.a. What is the core amount out of which interest is paid? The annual payment is Rs.12,000/-. Hence the lump sum amount is Annual payment/rate of interest expressed in decimals. Accordingly the lump sum amount is Rs. 12,000/0.1 = Rs. 1,20,000/-.

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These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.

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