Unit-II A

UNIT-II
INVESTMENT COSTS AND COST ESTIMATION 8

Time Value of money; capital costs and depreciation, estimation of
capital cost, manufacturing costs and working capital, invested capital
and profitability.
VALUATION CONCEPTS
The time value of money establishes that there is a preference of having

money at present than a future point of time. It means
(a) That a person will have to pay in future more, for a rupee received
today.
For example :
Suppose your father gave you Rs. 100 on your tenth birthday. You
deposited this amount in a bank at 10% rate of interest for one year.
How much future sum would you receive after one year? You
would receive Rs. 110
Future sum = Principal + Interest
= 100 + 0.10 × 100
= Rs. 110
What would be the future sum if you deposited Rs. 100 for two
years? You would now receive interest on interest earned after one
year.
Future sum = 100 × 1.102

= Rs. 121
This procedure of calculating as Compound Value or Future

Value of a sum.

(b) A person may accept less today, for a rupee to be received in the
future. Thus, the inverse of compounding process is termed as
discounting.
TECHNIQUES OF TIME VALUE OF MONEY

There are two techniques for adjusting time value of money. They
are:
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques
The value of money at a future date with a given interest rate is

called future value. Similarly, the worth of money today that is
receivable or payable at a future date is called Present Value.
Compounding Techniques/Future Value Techniques
Suppose you invest Rs. 1000 for three years in a saving account that
pays 10 per cent interest per year. If you let your interest income be
reinvested, your investment will grow as follows:

A generalized procedure for calculating the future value of a
single amount compounded annually is as follows:
Formula: FVn = PV(1 + r)n
In this equation:
(1 + r)n is called the future value interest factor (FVIF).

where,FVn = Future value of the initial flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
n
FVn = PV (1 + r)
= 1,000 (1.10)3
FVn = 1331
The formula for calculating the Future Value of a single amount is

as follows:
FV = PV (1 + r) n

If you deposit Rs. 55,650 in a bank which is paying a 12 per cent
rate of interest on a ten-year time deposit, how much would the
deposit grow at the end of ten years?
SOLUTION:
FV = PV(1 + r)n
If you deposit Rs. 55,650 in a bank which is paying a 12 per cent
rate of interest on a ten-year time deposit, how much would the
deposit grow at the end of ten years?
SOLUTION:
FV = PV(1 + r)n
MULTIPLE COMPOUNDING PERIODS
Interest can be compounded monthly, quarterly and half-yearly.
If compounding is quarterly, annual interest rate is to be divided by 4

and the number of years is to be multiplied by 4.
If monthly compounding is to be made, annual interest rate is to be

divided by 12 and number of years is to be multiplied by 12.
The formula to calculate the compound value is given above.
where,
FVn = Future value after ‘n’ years

PV = Cash flow today
r = Interest rate per annum
m = Number of times compounding is done during a year
n = Number of years for which compounding is done.
Calculate the compound value when Rs. 1000 is invested for 3 years
and the interest on it is compounded at 10% p.a. semi-annually.
SOLUTION: The formulae is

Mr. Ravi Prasad and Sons invests Rs. 500, Rs. 1,000, Rs. 1,500, Rs
2,000 and Rs. 2,500 at the end of each year. Calculate the compound
value at the end of the 5th year, compounded annually, when the
interest charged is 5% per annum.
SOLUTION: Statement of the compound value

Mr. Ravi Prasad and Sons invests Rs. 500, Rs. 1,000, Rs. 1,500, Rs
2,000 and Rs. 2,500 at the end of each year. Calculate the compound
value at the end of the 5th year, compounded annually, when the
interest charged is 5% per annum.
SOLUTION: Statement of the compound value

FUTURE VALUE OF MULTIPLE CASH FLOWS
The above illustration is an example of multiple cash flows.

The transactions in real life are not limited to one. An investor
investing money in installments may wish to know the value of his
savings after ‘n’ years. The formulae is
DISCOUNTING OR PRESENT VALUE CONCEPT
 Present value is the exact opposite of future value.
 The present value of a future cash inflow or outflow is the amount

of current cash that is of equivalent value to the decision maker.
The process of determining present value of a future payment or

receipts or a series of future payments or receipts is called
discounting.
 The compound interest rate used for discounting cash flows is also
called the discount rate.
SIMPLE AND COMPOUND INTEREST
In compound interest, each interest payment is reinvested to earn

further interest in future periods. However, if no interest is earned
on interest, the investment earns only simple interest. In such a
case, the investment grows as follows:
Future value = Present value [1 + Number of years × Interest

rate]
For example, if Rs. 1,000 is invested @ 12% simple interest, in 5
years
it will become
1,000 [ 1 + 5 × 0.12] = Rs. 1,600
Value of Rs. 1,000 invested at 10% simple and compound interest
Year Simple Interest Compound Interest
Starting Balance + Starting Balance + Interest

Interest = Ending Balance
= Ending Balance
1 1,000 + 100 = 1,100 1,000 + 100 = 1,100

5 1,000 + 500 = 1,500 1,464 + 146 = 1,610
10 1,000 + 1000 = 2,000 2,358 + 236 = 2,594
20 1000 + 2000 = 3,000 6,116 + 612 = 6,728
50 1000 + 5000 = 6,000 1,06,718 + 10672 = 11,7,390
100 1000 + 10000 = 11,000 1,25,27,829 + 12,52,783 = 1,37,80,612
Mr. Rahul has deposited Rs. 1,00,000 in a saving bank account at 6
per cent simple interest and wishes to keep the same, for a period of
5 years. Calculate the accumulated Interest.
SOLUTION:
SI = P0 (I) (n)
where SI = Simple interest

P0 = Initial amount invested
I = Interest rate
n = Number of years
SI = Rs. 1,00,000 × 0.06 × 5 years
SI = Rs. 30,000
If the investor wants to know his total future value at the end of ‘n’
years. Future value is the sum of accumulated interest and the principal
amount. Symbolically
FVn = P0 + P0(I) (n)
= P0 + SI
Mr. Krishna’s annual savings is Rs. 1,000 which is invested in a bank

saving fund account that pays a 5 per cent simple interest. Krishna
wants to know his total future value or the terminal value at the end of
a 8 years time period.

SOLUTION: FVn = P0 + P0 (I) (n)
= Rs. 1000 + Rs. 1000 (0.05) (8)
= Rs. 14,000
Compound Interest:
Suppose Mr. Jai Singh Yadav deposited Rs. 10,00,000 in a financial

institute which pays him 8 percent compound interest annually for a
period of 5 years. Show how the deposit would grow.
SOLUTION: FV5 = P0 (1 + I)n
FV5 = 10,00,000 ( 1 + 0.08)5

= 10,00,000 (1.469)
FV5 = Rs. 14,69,000
Variable Compounding Periods/Semi-annual Compounding
How much does a deposit of Rs. 40,000 grow in 10 years at the

rate of 6% interest and compounding is done semi-annually.
Determine the amount at the end of 10 years.
Quarterly compounding:
Suppose a firm deposits Rs. 50 lakhs for 4 years at the rate of 6 per
cent interest and compounding is done on a quarterly basis. What is
the compound value at the end of the 4th year?
Quarterly compounding:
Suppose a firm deposits Rs. 50 lakhs for 4 years at the rate of 6 per
cent interest and compounding is done on a quarterly basis. What is
the compound value at the end of the 4th year?

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UNIT-II

INVESTMENT COSTS AND COST ESTIMATION 8

The time value of money establishes that there is a preference of having

Future sum = 100 × 1.102

This procedure of calculating as Compound Value or Future

TECHNIQUES OF TIME VALUE OF MONEY

The value of money at a future date with a given interest rate is

Formula: FVn = PV(1 + r)n

(1 + r)n is called the future value interest factor (FVIF).

The formula for calculating the Future Value of a single amount is

Interest can be compounded monthly, quarterly and half-yearly.

If compounding is quarterly, annual interest rate is to be divided by 4

If monthly compounding is to be made, annual interest rate is to be

FVn = Future value after ‘n’ years

SOLUTION: The formulae is

SOLUTION: Statement of the compound value

SOLUTION: Statement of the compound value

The above illustration is an example of multiple cash flows.

 Present value is the exact opposite of future value.

 The present value of a future cash inflow or outflow is the amount

The process of determining present value of a future payment or

In compound interest, each interest payment is reinvested to earn

Future value = Present value [1 + Number of years × Interest

Starting Balance + Starting Balance + Interest

1 1,000 + 100 = 1,100 1,000 + 100 = 1,100

where SI = Simple interest

Mr. Krishna’s annual savings is Rs. 1,000 which is invested in a bank

Suppose Mr. Jai Singh Yadav deposited Rs. 10,00,000 in a financial

SOLUTION: FV5 = P0 (1 + I)n

FV5 = 10,00,000 ( 1 + 0.08)5

How much does a deposit of Rs. 40,000 grow in 10 years at the

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