TIME VALUE OF MONEY

-ONE OF THE LIMITATION OF PROFIT

MAXIMISATION IS IGNORING THE TIME
VALUE OF MONEY .
-AT THE SAME TIME IT DOES NOT CONSIDER
THE MAGNITUDE AND TIMING OF EARNINGS
- TO OVERCOME THE LIMITATIONS OF PROFIT
MAXIMISATION FIRMS CONSIDER THE
OBJECTIVE OF WEALTH MAXIMISATION.

MOST OF THE FINANCIAL DECISIONS SUCH AS

INVESTMENT DECISION FINANCING DECISION
AND DIVIDEND DECISION INVOLVES CASH
FLOWS (INFLOW AND OUTFLOW) OCCURRING IN
DIFFERENT TIME PERIODS.
FOR EXAMPLE INVESTMENT ON A PROJECT
REQUIRES AN IMMEDIATE CASH OUTFLOW AND
IT WILL GENERATE CASH INFLOWS DURING ITS
LIFE PERIOD.
IN SHORT COMPARISON OF CASH FLOWS
INVOLVES A LOGICAL WAY TO RECOGNISE THE
TIME VALUE OF MONEY.

 THE FIRM CAN MAXIMISE WEALTH ONLY

WHEN IT IS ABLE TO RECOGNISE THE TIME
VALUE OF MONEY AND RISK

Time value of money

Concept:
The time value of money received today is more than the
value of same amount of money received after a
certain period.
Time preference for money:
Options of time period for receivables.
(i) Immediate
(ii) Later
Reasons for time preference for money
(i) Uncertainty and loss
(ii) To satisfy present needs
(iii) Investment opportunities.

RATIONALE OF TIME PREFERENCE

FOR MONEY
UNCERTAINTY- FUTURE IS UNCERTAIN AND
IT INVOLES RISK. HENCE HE/SHE WOULD
LIKE TO PREFER TO RECEIVE CASH TODAY
INSTEAD IN THE FUTURE.
EXAMPLE- BIRD IN YOUR HAND AND THERE
ARE TWO BIRDS IN THE BUSH
WHICH ONE DO YOUR PREFER?

 CURRENT CONSUMPTION: MOST OF THE

PEOPLE GENERALLY PREFER TO USE THE
PRESENT MONEY FOR SATISFYING THE
PRESENT NEEDS.

 POSSIBILITY OF INVESTMENT
OPPORTUNITY
ANOTHER REASON WHY INDIVIDUALS
PREFER PRESENT MONEY IS DUE TO THE
POSSIBILITY OF INVESTMENT OPPORTUNITY
THROUGH WHICH THEY CAN EARN
ADDITIONAL CASH

Technique of time value of money

Compounding technique
The interest earned on the principal amount becomes a
part of principal at the end of the compounding period.
To determine the future value of money.
Formula Method Future Value (FV)= P(1+i)n
Lumpsum Method
P=Principal, i = interest, n = number of years
Table Value used when period of maturity is long.
Multiple compounding periods interest calculated
half-yearly, quarterly or every month. FV=P(1 +
i/m)mxn

m = Number of times per year

compounding is made
Ex: Mr.Kavin deposits Rs.20,000 for 3
years at 10% interest.
Series of payment
Annuity- series of equal annual payments
or investments made at the end of the
each year for a particular period.

 Discounting or present value technique

Money to be received in future date will be less because we
have lost the opportunity cost in the form of interest.
Computation of present value:
Lump sum
PV = Fv/ (1+i)n
Discount factor Tables
Series of payment
PV= F1 / (1+i) + F2 / (1+i)2 + .. Fn / (1+i)n
Annuity
At the end
PV= A / (1+i) + A / (1+i)2 + .. A / (1+i)n
At the beginning
PV= A+ A / (1+i) + A / (1+i)2 + .. A/ (1+i)n

INTRODUCTION TO THE CONCEPT OF RISK AND

RETURN

RISK- IS PRESENT IN EVERY DECISION

WHETHER IT IS CORPORATE
DECISION OR PERSONAL DECISION.
FOR EXAMPLE SELECTIN OF AN
ASSET FOR PRODUCTION
DEPARTMENT OR DEVELOPIN A NEW
PRODUCT OR FINANCIAL DECISION
LIKE

 DEVELOPING CAPITAL STRUCTURE

WORKING CAPITAL MANAGEMENT
AND DIVIDEND DECISION
THEREFORE THE DECISION MAKERS
HAVE TO ASSESS RISK AND RETURN
OF SECURITY BEFORE TAKING ANY
FINANCIAL DECISION

RISK IS THE CHANCE OF FINANCIAL

LOSS OR THE VARIABILITY OF
RETURNS ASSOCIATED WITH A GIVEN
ASSET.

Risk.
Variability of actual return from the expected returns associated with a
given asset.
= more risk in security more return-more variability.
= less variability-less risk.
measurement of risk.
1.
Behavioural.
- sensitivity analysis.
- probability ( distribution ).
1.
Quantitative/statistical.
- standard deviation.
- co-efficient of variation.

Behavioural Method
Sensitivity analysis.

Considered number of possible outcomes/return while assessing

risk.
Estimate worst ( pessimistic ) expected ( most likely ) and best
( optimistic ) return.
Level of outcome is related to state of economy recession,
normals, boom condition.
( optimistic-pessimistic outcome ) = range.
If Increase in range, increase in variability, increase in risk in asset.

Probability distribution

Likelihood/percentage chance of an event occurrence.

Ex: if outcome/return is 7 out of 10 then chance of occurrence is
70%.
n

Expected return R = Ri X Pri

i=1

Ri= return for the ith possible outcome.

Pri = probability associated with its return.
N= number of outcome considered.

Quantitative method
1.Standard deviation of return:
Square root of the average squared deviations of the individual
returns from the expected returns.
n

(Ri-R)2 X Pri
i=1

Greater the standard deviation of returns, greater the variability

of return and greater the risk of the asset /investment.
2. Co-efficient of variation:
Measure of risk per unit of expected return.
CV= r / R
= standard deviation
R= expected return
The lager the CV , larger the risk of the asset.

Objectives of measuring risk

The objective of measuring risk is not to
eliminate or avoid it because it is not
feasible to do so.
But it helps as in assessing and
determining whether the proposed
investment is worth or not
Risk is the chance of financial loss or the
variability of returns associated with a
given asset

Examples
For example government bond is less
risky because the principal amount and
return (interest) are guaranteed.
On the other hand investment on a
company stock is risky because of the
high variability (0 to above zero of returns)

Risk and Return of single asset.

Return:
Income received plus any change in market price of an asset.
R= Dt + ( Pt pt-1)/ Pt-1
D=annual income/ cash divided at the end of time t.
Pt= security price at time period t ( closing/ending ).
Pt-1= security price at t-1 ( opening/beginning ).
1.
Capital gain/ loss= ( ending price-beginning price )/beginning
price.
2.
Current field= annual income/beginning price.

Return
All the investors assess risk of an
investment on the basis of the variability of
returns expected form its over a maturity
period or life period or expected holding
period.
Return on an investment is an annual
income received during the period plus
change in value.

 For example and investor A invested

Rs.1000 on an firms share and received
Rs.100 as dividend at the end of the year,
and share is selling at the Rs.1200 here
the return is Rs.300
( dividend + inc in share price)
Return is expressed in terms of
percentage on the beginning of the
investment

Classification of risk
Diversifiable risk
Market risk
Diversifiable risk is company specific and
it can be completely eliminated through
diversification.
Market risk arises from market movement
and which cannot be eliminated through
diversification