Time Value of Money

& Capital Budgeting

By CA Sairaj Kasat
Time Value of Money

Time value of money means that a sum of money is worth more now than the same sum
of money in the future.
The value of a sum of money received today is more than its value received after some
time.
Conversely, a sum of money received in future is less valuable than it is today.

“So a Rupee in your wallet now is worth more today than the same rupee tomorrow”

Can you tell, Why?

• Investment Opportunities
• Inflation
• Risk
• Personal Consumption Preference

So this brings us to the concept of

 Compounding i.e. Future Value(FV) of Money
 Discounting i.e. Present Value(PV) of Money

2
Practical Application of Time Value of Money

• Sinking Fund-
To collect a specified sum on a periodic basis at a specified rate to reach a prescribed
amount.

• Amortization of Loan or Capital Recovery-

Loan is required to be paid in form of specified periodical instalments. In order to
determine the size of instalments, the above concept is used.

• Case of Deferred Payment-

Sometimes there is a gap of certain years between the date of borrowing and date of
commencement of repayment of interest. This is known as deferred payment. And to find
instalment above concept can be used.

• Determination of Implicit Rate of Return-

Sometimes various schemes are offered by finance companies under which a person is
required to deposit a specific sum in the beginning of a period and then return is available
to him in the form of annuity for a certain number of years.

3
Compounding Technique

 In compounding technique, interest is added (compounded) to the initial deposit

(principal) and becomes part of the principal at the end of each compounding period.
 Money grows over time, when it earns interest.
 Formula-

FV = PV (1 + k)n
Where, FV = Future Value
PV = Present Value
K = Discounted Rate
n = Number of Years

4
Discounting Technique

 Present value of a future cash flow is the current worth of a future sum of money or
stream of cash flow given a specified rate of return.
 Formula-

PV = FV
(1+k)n
Where, FV = Future Value
PV = Present Value
K = Discounted Rate
n = Number of Years

 Discounting can be yearly, semi-annually, quarterly, monthly, daily, etc.

5
Question

A Manager has to find out accumulated sum of money in future date to replace it with existing
assets. Company wants to replace existing assets after 10 years which will cost Rs.1,00,000.
Discounting Rate is 8% per year. Required investment will be as follows:

Answer: So ABC Ltd should invest Rs.46,319.35 now to get Rs.100,000 as replacement at 10
years.

6
Discounted Zero Growth Model

 The dividend discount model is a valuation method used to find the intrinsic value of a
company by discounting the predicted dividends that the company will be giving (to its
shareholders in future) to its present value.
 The zero-growth model assumes that the dividend always stays the same, i.e., there is
no growth in dividends. Therefore, the stock price would be equal to the annual
dividends divided by the required rate of return.
 Formula-

Value of stock = Dividend per share

Discount Rate

 A company pays dividend of Rs.1.20 annually. Mr.A wants to invest in company and his
expected return is 7%.So how much should he invest?
Answer-Rs.17.14

7
Capital Budgeting-Meaning

Capital budgeting is the process a business undertakes to evaluate potential major

projects or investments.
Capital budgeting is the process that a business uses to determine which propose
Investment it should accept, and which should be declined.
This process is used to create a quantitative view of each proposed fixed asset
investment, thereby giving a rational basis for making a judgment.
The benefit from an investment may be in the form of a reduction in cost or in the form
of increased revenue.

8
Capital Budgeting-Importance

9
Project Classification

• New Projects-
New manufacturing concerns require investing in fixed assets, without which there is no
manufacturing process.

• Expansion Projects-
Increase existing capacity, or addition of new features to the existing product or widen the
distribution network.

• Diversification Projects-
It is spreading of risk across number of assets of investments.

• Replacement and Modernization Projects-

Companies have to improve their operating efficiency and reduce costs, for which they are
required to go for either modernization of the existing machines or replacement of the
obsolete and inefficient machinery.

• Research and Development (R&D) Projects-

To find innovative and advanced ways to develop a product.
10
Capital Budgeting-Techniques

How do you decide - whether you should invest in Project A or Project B ?

Evaluation Criteria

• NPV- Net present Value

IRR- Internal Rate of Return

PI- Profitability Index

ARR- Accounting Rate of Return

Payback Period

11
Net Present Value(NPV)

NPV realistically predicts the future cash flows.

NPV discounts future cash flows at an appropriate industry discount rate, the
appropriate discount rate is the project’s opportunity cost of capital.
The greater the NPV, the better the project financial benefits.

NPV = “Present value of cash Inflows” – “Present value of cash Outflows”

 Concept Line-
If NPV > 0 (NPV is +ve, Accept the Project)
If NPV < 0 (NPV is –ve, Reject the Project)
If NPV = 0 (Accept the Project, considering other non tangible benefits)

“Greater the NPV, Better the Prospects”

12
Net Present Value(NPV)-Problem

1)A sum of Rs.400,000 invested today in an IT project may give a series of below cash
inflows in future:
Rs.70,000 in year 1,Rs.1,20,000 in year 2,Rs.1,40,000 in year 3,Rs.1,40,000 in year 4,
Rs.40,000 in year 5
If Opportunity cost of capital is 8% per annum, then should we accept or reject the
project?
.
Answer-
By calculating the present value of all cash inflows is Rs.4,08,959 & cash outflow is
Rs.4,00,000.
So, NPV is positive and project should be accepted

2) If Opportunity cost of capital is 15% per annum, then should we accept or reject the
project?
Answer-
By calculating the present value of all cash inflows is Rs.3,43,591 & cash outflow is
Rs.4,00,000.
So, NPV is negative and project should be rejected.

13
Internal Rate of Return(IRR)

IRR is the % of Return on investment.

How do we calculate IRR?
• If we increase the discount rate the NPV value decreases.
• We need to increase /decrease the discount rate to a level where NPV becomes zero.
• The discount rate at which NPV becomes zero is in fact the Internal rate of return.

“In other words, IRR is the opportunity cost at which the NPV becomes zero”

 Concept Line-
Accept the project when Internal rate of return > Discount rate or Opportunity cost of
capital.
Reject the project when Internal rate of return < Discount rate or Opportunity cost of
capital.
May accept the project when Internal rate of return = Discount rate or Opportunity cost

of capital.

14
Internal Rate of Return(IRR)-Problem

The cost of a project is Rs.1000. It has a time horizon of 5 years and the expected year
wise incremental cash flows are:
Year 1:Rs.200, Year 2:Rs.300, Year 3:Rs.300, Year 4:Rs.400, Year 5:Rs.500
Compute IRR of the project. If opportunity cost of Capital is 12%, should we accept the
project?

Answer-
At Discount Rate of 12%,NPV is 169
At Discount Rate of 20%,NPC is -57.55
So by using interpolation method at 17.70% ,NPV is zero and thus IRR is 17.70%.

15
Profitability Index(PI)

Present Value of all future cash inflows divided by Initial cash outflows.
Formula-

Profitability Index = Present Value of all future cash inflows

Initial cash outflows

 Concept Line-
Accept the project when PI > 1
Reject the project when PI < 1
May accept the project when PI = 1

“Higher the profitability Index of the project, the better.”

16
Profitability Index(PI)-Problem

A sum of Rs.25,000 invested today in a project may give a series of cash inflows in future
as described below:
Rs.5000 in year 1
Rs.9000 in year 2
Rs.10,000 in year 3
Rs.10,000 in year 4
Rs.3000 in year 5.
If the required rate of return is 12% pa, what is the Profitability Index?

Answer-
Present Value of future cash inflows is Rs.26.814.29
Initial cash outflow is Rs.25,000
So PI is 1.07 and since it is greater than 1,we can accept the project.

17
Accounting Rate of Return(ARR)

Percentage rate of return expected on an investment or asset, compared to the initial

investment's cost.
Formula-

ARR = Average Annual Profit

Average Investment

Where, Average Annual Profit=Total Profit over Investment Period

Number of Years

Average Investment=Book Value at Year1+Book Value at end of useful life

2

18
Accounting Rate of Return(ARR)-Problem

XYZ Company is considering investing in a project that requires an initial investment of

Rs.100,000 for some machinery. There will be net inflows of Rs.20,000 for the first two
years, Rs.10,000 in years three and four, and Rs.30,000 in year five. Finally, the machine
has a salvage value of Rs.25,000.

Answer-
By adding all the cash flows it comes to Rs.90,000.
Total Depreciation=Rs.1,00,000-Rs.25,000=Rs.75000
Profit=Rs.15,000
Average Profit per year=Rs.3000
Average Investment=(Rs.1,00,000+Rs.25,000)/2=Rs.62,500

So ARR=Rs.3,000/Rs.62,500=4.80%

19
Payback Period

Payback period is the number of years required to recover the cash outflow invested in
the project..
Payback period is a major consideration for every project, business or organization, it
tells us how soon we can recover our investment and this investment can be utilized for
other business needs/projects .
Formula-

Payback Period = Initial Investment

Cashflow per year

“Lower the payback period, the better.”

 Investment in a Project is Rs.100000 and annual payback is Rs.20000.What is

payback period?

Answer- 5 years

20
Capital Budgeting in Merger & Acquistion

• Merger and acquisition is one of the most important decisions in capital budgeting.
• Only after evaluating target company’s profitability, the acquiring company finalizes the
merger.
• Financial statement-This is considered to be the first step after deciding a merger.
Both company’s financials are shared with each other.
1. Major customers
2. Interviews
3. Competitive companies
• Income statement- Before a merger, both companies can measure their revenue lines
and compile their income statements to calculate their combined profitability. The
acquiring company may check the expenses of the merger company in order to see
whether they have used the resources in right way.
• Balance sheet- Balance sheet will provide information on lands, equipment, commonly
knownas assets and financial leverage, known as debts.
• Cash flow statement- After combining statements, necessary adjustments in tax rates,
interest rates and expenses are calculated to finally measure the cash flow of this
merger.
• After going through all these statements and capital budgeting techniques the acquiring
firm will decide whether to acquire the target firm or not.
21
Summary-

✔ Always choose projects with highest NPV.

✔ If NPV is same for the given projects, choose the project with highest IRR.
✔ If NPV, IRR remains the same for the given projects, choose the projects with early pay
back period.
✔ NPV = All Cash Inflows – Cash Outflows
✔ PI = All Cash Inflows / Cash Outflows
✔ IRR = Discount rate at which the NPV becomes zero, this tell us what is the percent of
return for the project.
✔ Payback period is a major consideration for every project, business or organization, it
tells us how soon we can recover our investment and this investment can be utilized for
other business needs/projects later on.

22
 THANK YOU
CA Sairaj Kasat
Mobile No-7058198909
E-mail id- sairaj.kasat@gmail.com
Linkedin-https://in.linkedin.com/in/sairaj-kasat

23