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Time Value of Money

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Basics of Financial Management &

Time Value of Money


Suggested Readings

1. Financial Management- By I.M.Pandey – Vikas Publishing


2. Financial Management – Texts, Problem & Cases– By Khan & Jain –McGraw Hill
3. Financial Management – By Prasanna Chanadra –McGraw Hill
4. Principles of Corporate Finance – by Brealey, Myers, Allen & Mohanty- MC Graw Hill
Education
Nature of Financial Management
• Basic Finance Functions:
• Financing or Capital Mix Decision - Capital structure
• Investment or Long Term Asset Mix Decision - Capital budgeting
• Liquidity or Short Term Asset Mix Decision -Working capital management
• Profit Allocation Decision – Dividend Decision
Role of Finance Manager:
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
Financial Markets

Future Market Spot Market

Money Market
Capital Market

New issue / Primary Market Secondary Market

OTC Market Exchange Market


Capital Market Instruments (Pure, Hybrid and Derivatives)
• Equity shares - shareholder, as a fractional owner, undertakes the
maximum entrepreneurial risk associated with the company and has
voting rights.
• Preference shares - shareholder is entitled to a fixed dividend or
dividend calculated at a fixed rate to be paid regularly before dividend
can be paid in respect of equity shares.
• Debenture includes debenture stock, bonds and any other securities of
a company, whether constituting a charge on the assets of the
company or not; having a fixed coupon rate.
• Sweat equity share is an instrument permitted to be issued by
specified Indian companies, under Section 2(88) of Companies Act,
2013.
Capital Market Instruments (Pure, Hybrid and Derivatives)
• A Tracking stock is a type of common stock that “tracks” or depends
on the financial performance of a specific business unit or operating
division of a company, rather than the operations of the company as a
whole.
• Derivatives are contracts which derive their values from the value of
one or more of other assets (known as underlying assets).
• Future is a contract to buy or sell an underlying financial instrument
at a specified future date at a price when the contract is entered.
• An option contract conveys the right to buy or sell a specific security
or commodity at specified price within a specified period of time.
• Private equity fund is an unregistered investment vehicle in which
investors pool money to invest.
What should be the objective of Financial management?

• Profit maximization (profit after tax)


• Maximizing Earnings per Share
• Shareholders’ Wealth Maximization
Profit Maximization
• Maximizing the Rupee Income of Firm
• Resources are efficiently utilized
• Appropriate measure of firm performance
• Serves interest of society also
• Objections to Profit Maximization
• It is Vague – No precise connotation
• Ignores the Timing of Returns
• Periods Alt. A(Rs.) Alt. B(Rs.)
I 50 -
II 100 100
III 50 100
• Ignores Risk
• Assumes Perfect Competition
• In new business environment profit-maximization is regarded as Unrealistic / Difficult/
Inappropriate / Immoral
Maximizing EPS
• Ignores timing & risk of the expected benefit.

• Market value is not a function of EPS - hence maximizing EPS will not
result in highest price for company's shares

• Maximizing EPS implies that the firm should make no dividend payment so
long as funds can be invested at positive rate of return—such a policy may
not always work
Shareholders’ Wealth Maximization

• Maximizes the net present value of a course of action to shareholders


• Accounts for the timing and risk of the expected benefits
• Benefits are measured in terms of cash flows
• Fundamental objective—maximize the market value of the firm’s shares
Concept of Time Value of Money
Time Preference for Money
• Time preference for money is an individual’s preference for possession of
a given amount of money now, rather than the same amount at some future
time.
• Three reasons may be attributed to the individual’s time preference for money:
• risk
• preference for consumption
• investment opportunities
Time Value of Money
• Two most common methods of adjusting cash flows for time value of
money:
• Compounding —the process of calculating future values of
cash flows and
• Discounting —the process of calculating present values of cash
flows.

 Managers rely primarily on present value techniques as they are at


Zero time (t=0) when making decisions.
FV of a Cash Flow Stream
• X made an investment that will pay Rs.100 the first year, Rs.300 the
second year, Rs.500 the third year and Rs.1000 the fourth year. If the
interest rate is ten percent, what will be the worth at the end of fourth
year?
• FVt = CF0 * (1+r)t

Rs.100 300 500 1000

0 1 2 3 4
1000
i = 10% ?
?

?
Multi-Period Compounding
• If compounding is done more than once a year, the actual annualised rate of
interest would be higher than the nominal interest rate & it is called the
effective interest rate
𝑖 𝑛∗𝑚
• EIR = (1 + ) −1
𝑚

• If an investor deposits Rs.10,000 in a bank account for 5 years @ 8%


interest, what will be the amount in his account if interest is compounded
(a) Annually, (b) Semi-annually(6 monthly), (c) Quarterly and (d)
Continuously?
• Annual = (100 x 1.4693)=Rs.146.93
• Semi-Annual= (100 x 1.4802)=Rs.148.02
• Quarterly = (100 x 1.4859)=Rs.148.59
• Continuous = (100 x 1.4898)= Rs. 148.98
FV of an Annuity
• Annuity is a fixed payment (or receipt) each year for a specified
number of years - if one rents a flat and promise to make a series of
payments over an agreed period, the customer has created an
annuity

(1+𝑖)𝑛 −1
• FV = A [ ] Or FV = A * FVIFA ( Future Value Factor of an
𝑖
Annuity)
Sinking Fund
• Allows businesses that have floated bonds to prevent a large lump-
sum payment at maturity - some bonds are issued with a sinking fund
feature attached to them
• A bond sinking fund is an escrow account (the third party account which holds
the asset until the conclusion of a specific event or time - an independent
trustee) into which a company places cash that it will eventually use to retire a
bond liability that it had previously issued

(1+𝑖)𝑛 −1 𝑖
• FV = A [ ] & A = FV [ 𝑛 ]
𝑖 (1+𝑖) −1
• The factor used to calculate the annuity for a given future sum is called the
sinking fund factor (SFF)
Sinking Fund………
• RLB ltd. desires to create a BSF to retire a bond of Rs.10 million at
the end of 5 years with an effective rate of interest of 12%pa. What
will be the annuity for this BSF?

• FV of an annuity of Re 1 after 5 years = {(1/0.12) [(1+0.12)5 – 1]} = 8.3333


(1.7623 – 1) = 6.3525
• If the amount of annuity is ‘x’, then
• 6.3525x = 100,00,000
• or x = 15,74,183
Present Value
• Present value of a future cash flow (inflow or outflow) is the
amount of current cash that is of equivalent value to the decision-
maker.
• Discounting is the process of determining present value of a series
of future cash flows.
• The interest rate used for discounting cash flows is also called the
discount rate.
Example
PV of a Cash Flow Stream
• X made an investment that will pay Rs.100 the first year, Rs.300
the second year, Rs.500 the third year and Rs.1000 the fourth year.
If the interest rate is ten percent, what is the present value of this
cash flow stream?

Rs100 300 500 1000

0 1 2 3 4

?
? i = 10%
?
?
Present Value of an Annuity
• Computation of the PV of an Annuity can be written in the following
form:
1 1 (1+𝑖)𝑛 −1
• P =A [ − 𝑛 ] or A [ 𝑛 ]
𝑖 𝑖(1+𝑖) 𝑖(1+𝑖)

• The term within parentheses is the PV factor of an annuity of Re 1, which we


would call PVFA, and it is a sum of single-payment present value factors
• An executive is about to retire at the age of 60. His employer has offered him
two post-retirement options- (a) Rs.20,00,000 lump sum, (b) Rs.2,50,000 for
10 years. Assuming 5% rate of interest, which one is a better option?
• Present Value of annuity= Rs.2,50,000 X 7.722 =Rs.19,30,500. Since lump
sum of Rs.20,00,000 is more now, the executive should opt for it
Capital Recovery and Loan Amortisation
• Capital recovery is the annuity of an investment made today for a
specified period of time at a given rate of interest - Capital recovery
factor helps in preparing a loan amortisation (loan repayment) schedule

𝑖(1+𝑖)𝑛
• A= P [ 𝑛 ]
(1+𝑖) −1

• Assume that you have borrowed Rs. 10 lakh from a financial institution in the
form of an educational loan at an interest of 14% p.a. The loan is to be cleared in
five equal installments. Prepare a loan amortization schedule.
• Annual Installment = Rs.10,00,000 ÷ PVAF (5, 0.14);
• Rs.10,00,000 ÷ 3.433 = Rs.2,91,290
Example……(Schedule)

Year Annual Interest Principal Loan Due


Installments Component Component
1 2,91,290 1,40,000 1,51,290 10,00,000
2 2,91,290 1,18,819 1,72,470 8,48,710
3 2,91,290 94,673 1,96,616 6,76,239
4 2,91,290 67,147 2,24,142 4,79,622
5 2,91,290 35,767 2,55,500 2,55,480
Rounding off Rounding off
Error Error
PV of an Uneven Periodic Sum
• Investments made by of a firm do not frequently yield constant
periodic cash flows (annuity)
• In most instances the firm receives a stream of uneven cash flows.
Thus the present value factors for an annuity cannot be used
• The procedure is to calculate the present value of each cash flow and
aggregate all present values
PV of Perpetuity
• Perpetuity is an annuity that occurs indefinitely - fixed coupon
payments on permanently invested (irredeemable) sums of
money - e.g. scholarships paid perpetually from an endowment -
not very common in financial decision-making:

• PV of a perpetuity = [Perpetuity / Interest rate]


PV of Growing Annuities
• The present value of a constantly growing annuity is given below:
𝐴 1+𝑔 𝑛
•P= [1 − ( ) ]
𝑖 −𝑔 1+𝑖
• Present value of a constantly growing perpetuity is given by a simple formula
as follows:
𝐴
•P=
𝑖 −𝑔
• A company paid a dividend of Rs.60 last year. The dividend stream
commencing one year is expected to grow at 10% p.a. for 15 years and then
ends. If the discount rate is 21%, what is the present value of the expected
series?
• Rs.50.7 X 7.606 = Rs.385.62
Value of an Annuity Due
• Annuity due is a series of fixed receipts or payments starting at
the beginning of each period for a specified number of periods ( e.g.
Insurance premium payable on a life insurance policy)

(1+𝑖)𝑛 −1
• Future Value of an Annuity Due = CF [ ] * (1+i)
𝑖

(1+𝑖)𝑛 −1
• Present Value of an Annuity Due = CF [ 𝑛 ] * (1+i)
𝑖(1+𝑖)

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