IT 4th semester

Code- HSMC- 02
Economics notes

Module-2
Time Value of Money (TVM)
Meaning -- The time value of money (TVM) is the concept that money you
have now is worth more than sum received in the future due to its
potential earning capacity.

The time value of money is a basic financial concept that holds that money
in the present is worth more than the same sum of money to be received in
the future. This is true because money that you have right now can be
invested and earn a return, thus creating a larger amount of money in the
future.

In simple sense it is said that today’s money is not equal to tomorrow’s

money.TVM is also sometimes referred to as present discounted value.

According to this concept –

Today’s money not = Tomorrow’s Money

Today’s money + Interest = Tomorrow’s Money

Time Value of Money Formula

● FV = Future value of money

● PV = Present value of money
● i = interest rate
● n = number of compounding periods per year
● t = number of years

Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (i / n) ] (n x t)
Application of Time Value of Money-
Assume a sum of $10,000 is invested for one year at 10% interest. The future
value of that money is:

FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000

let’s look at an example where you have $5,000 and can expect to earn 5%
interest on that sum each year for the next two years. Assuming the
interest is only compounded annually, the future value of your $5,000 today
can be calculated as follows:

FV = $5,000 x (1 + (5% / 1) ^ (1 x 2) = $5,512.50

The formula can also be rearranged to find the value of the future sum in
present day dollars. For example, the value of $5,000 one year from today,
compounded at 7% interest, is:

PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673

Capital Budgeting
Meaning - Capital budgeting is the process a business undertakes to
evaluate potential major projects or investments. Construction of a new
plant or a big investment in an outside venture are examples of projects that
would require capital budgeting before they are approved or rejected. Simply,
it is used for long term investment purposes.

Capital budgeting is related to investment decisions of a firm. These decisions

are related to allocation of funds to different long term assets. We want to
invest in those projects from which we get higher returns.

Capital Budgeting is also known as investment decision making,

planning of capital acquisition, planning and analysis of capital
expenditure etc.

Purpose of Capital Budgeting

 1. Substantial Expenditure
2. Long term period
3. Irreversibility
4. Complex Decisions

Features of Capital Budgeting

1. Capital budgeting involves the investment of funds currently for
getting benefits in the future.
2. Generally, the future benefits are spread over several years.
3. The long term investment is fixed.
4. The investments made in the project is determining the financial
condition of business organization in future.
5. Each project involves a huge amount of funds.
6. Capital expenditure decisions are irreversible.
7. The profitability of the business concern is based on the quantum
of investments made in the project.
Techniques of Capital Budgeting
There are mainly two types of capital budgeting techniques ---

● Discounted techniques are also called Modern Techniques. It

includes the time value of Money.
● Non-Discounted Techniques are also known as Traditional
techniques. It doesn’t include the time value of Money.
● Both are classified as below-
 Non-Discounted(Traditional technique) –
⮚ Pay Back Period (PBP)
⮚ Accounting Rate of Return (ARR)

1. Payback Period:
This is a traditional method which is based on how quickly the investment is
recovered. As per PBP criteria the shorter the recovery period for the investment
is to be ranked 1st. It is simple and easy to calculate. It favors those projects that
generate high cash flows in the early stage of the project. It is a good criteria
when a business is facing the problem of liquidity of cash. This method measures
the capital recovery not the profitability of the project. It reflects project
liquidity and not the business liquidity as a whole.
It is calculated by the mathematical formula as shown below

Payback period = Cash outlay (investment) / Annual

cash inflow
Project Project
A B
 Cost 1,00,000 1,00,000
Expected
future cash
flow
Year 1 50,000 1,00,000
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Payback period of project B is shorter than A, but project A
provides higher returns. Hence, project A is superior to B.

2. Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback
period method. The rate of return is expressed as a percentage of the
earnings of the investment in a particular project.
The selection criterion is high ARR. It is simple in calculation and the
information is readily available. It has shortcomings like it is based on accounting
profit and not on cash flows; it does not consider Time Value of Money. It is
calculated by the mathematical formula as shown below

ARR = Average Return * 100

Average Investment
Discounted (Modern techniques)- These are
classified as follows-
⮚ Net Present Value (NPV)
⮚ Benefit Cost Ratio (PI)
⮚ Internal Rate of Return (IRR)
1. Net Present Value:
It is one of the most important concept in finance when it comes to evaluating
investments, making financial decisions involving cash flows in multiple periods.
It is the sum of the present values of all the cash flows over the life of the project.
The NPV represents the net benefit with respect to time and risk associated.
Therefore the criteria for accepting a project is that cash flow should be
positive, while reject if the cash flow is negative.
NPV > 0, Accept ( +NPV means return is higher that cost of capital )
NPV > 0, Reject ( -NPV means cost of capital is higher that returns )
NPV can be mathematical represented as

NPV = Ʃ Ct - Initial Investment

(1+r)

Where A1, A2…. represent cash inflows,

K is the firm’s cost of capital,
C is the cost of the investment proposal and
n is the expected life of the proposal.
 or
NPV can also be calculated by finding the difference between
the Present Value(PV) after the competition of time duration of
investment and the initial amount invested where the Present
Value "PV" after time "t" for a rate of return "r" can be
calculated as:
Present value, PV = cash value at time period
(1+rate of return)^time period

It should be noted that the cost of capital, K, is assumed to be

known, otherwise the net present value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs
NPV= Present value of cash inflows -
. Present value of cash outflows

Examples on Net Present Value Formula

Example 1: An investor made an investment of $500 in property and gets back $570
the next year. If the rate of return is 10%. Calculate the net present value.
Solution:
Given:
Amount invested = $500
Money received after a year = $570
Rate of return = 10% = 0.1
Using net present value formula,
Present value, PV = cash value at time period
(1+rate of return)^time period
 Limitations of NPV -
∙ NPV is expressed in absolute terms and not in relative terms and doesn’t take
into account the investment required for the project.
∙ NPV doesn’t consider the life of the project.

2. Profitability Index/Benefit cost Ratio (PI):

It is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the
investment. It may be gross or net, net being simply gross
minus one. The formula to calculate profitability index (PI) or
benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.
PI < 1, Rejected.

3. Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the
investment is zero. The discounted cash inflow is equal to the
discounted cash outflow. This method also considers the time
value of money. It tries to arrive at a rate of interest at which
funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay
and proceeds associated with the project and not any rate
determined outside the investment.
It can be determined by solving the following equation:
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IRR < k = reject
WACC= Weighted Average Cost of Capital
k = cost of Capital

Relationship Between IRR and NPV and Cost of Capital

If NPV < 0, then IRR < K - Reject
If NPV = 0, then IRR = 0 - Reject ( Profit is not sufficient)
If NPV > 0, Then IRR > K - Accept