UNIT 3

Time Value of Money

The basic idea of time value of money is that a dollar today is worth more than a dollar
tomorrow. This can be shown in many ways; many people find it easiest to understand if they
think in terms of something they already know: food. For example having the money today
allows you to buy some food immediately. Alternatively you may be willing to forgo current
consumption and wait until later to purchase your food. Thus you could lend your "food
money" to another with the promise of being paid back at some future time. Since you are
passing up food today you would demand a return sufficient to allow you to buy at least as
much food in the future that you are giving up now.
As we do not know the future this type of deal involves risks. For example the borrower may
decide to not pay you back. This is called default risk. Or the borrower may pay you back but
due to rising prices you can no longer purchase the same amount of food as you had expected
to be able to buy. As a result of these risks (you as a lender) would require a higher interest rate
to compensate for accepting the risks. However if you ask for too high of interest rates you will
not find any takers for your loan.

Present Value
The time value of money principle says that future Rupee is not worth as much as Rupee today.
You should be able to explain why! If you do not understand, please go back and reread the
above example. It is extremely important and influences almost everything we do from now
on.
We can compare present and future values with a rather simple equation.
PV = FV/(1+i)n
Example: What is the present value of Rs. 8,000 to be paid at the end of three years if the
correct interest rate is 11%?
PV = FV/(1+i)n
= 8,000/(1.11)3
= 8,000/1.36
=Rs. 5,849
For each single value we need to use the above formula. In case of annuity i.e. if an equal
amount is paid or received for the entire cash flow then another formula will be used.
PVa = A[(1+i)n 1] / i(1+i)n
Where A = annuity
Future Value
Future Value is largely the same as present value but in reverse. The basic idea is the same
except here instead of determining what something is worth today, we want to find out how
much something is worth in the future. For example how much will I have if I invest today.
The basic formula is
FV = PV(1+i)n
Example: you invest $1000 today at 10% in one year you will have 1000*(1.1)1=Rs.1,100. In
two years you will have 1,000*(1.1)2= 1,210. In three years you will have Rs.1,331, This is
based on the implicit assumption of compound interest. This means you earn interest on your
interest. This is a powerful concept and can lead to very large amounts when you have enough
time periods over which to accumulate more interest.
In case of annuity the basic formula is:
FVa = A[(1+i)n 1] / i

Simple and Compound Interest

The lending and borrowing of money has been happening since thousands of years. Any sum
of money, borrowed for a certain period, will invite an extra cost to be paid on the money
borrowed; this extra cost at a fixed rate is called interest. The money borrowed is called
principal. The sum of interest and principal is called the amount. The time for which money is
borrowed is called period.
Amount = Principal + Interest
The interest paid per hundred (or percent) for a year is called the rate percent per annum. The
rate of interest is almost always taken as per annum, in calculations we will always consider it
per annum unless indicated.
The interest is of two types, one is simple, and the other is compound:
Simple interest
It is the interest paid as it falls due, at the end of decided period (yearly, half yearly or
quarterly), the principal is said to be lent or borrowed at simple interest.
Simple Interest, SI = PRT / 100
Here P = principal, R = rate per annum, T = time in years
Therefore Amount, A = P + PRT/100 = P [1 + ( RT / 100 )]

If T is given in months, since rate is per annum, the time has to be converted in years, so the
period in months has to be divided by 12. if T = 2 months = 2/12 years)
Example 1: Find the amount on S.I. when Rs 4000 is lent at 5 % p.a. for 5 years.
By the formula, A = P (1 + RT/100) = 4000( 1 + 5 x 5/100 ) = Rs 5000
Compound Interest
The compound interest is essentially interest over interest. The interest due is added to the
principal and that becomes the new principal for the interest to be levied. This method of
interest calculation is called compound interest, this can be for any period (yearly, half yearly
or quarterly) and will be called Period compounded like Yearly compounded or quarterly
compounded and so on.
First periods principal + first periods interest = second periods principal
Compound interest = principal {1 + Rate/100}time - Principal
CI = P { 1 + R/100 } time P
Here Amount = principal {1 + Rate/100 } time
Example 2: Find the compound interest on Rs 4500 for 3 years at 6 % per annum
Using the formula, A = P (1 + R/100)time = 4500(1 + 6/100)3 = 4500 (1.06)3 = 5360
Compound interest = 5360 4500 = Rs 860

Cost Benefit Analysis

Identify & evaluate all costs & benefits
Discount
Assess project(s) by calculating
Benefit/Cost Ratio (B/C)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Evaluation
Identification (what are they?)
Evaluation (what are they worth?)
Measurement issues:
Direct & indirect (i.e. externalities) effects
Tangible & intangible effects
Pecuniary effects
Discounting
Policies & projects last a long time
Frequently costs & benefits occur at different times
 Money has a time value, i.e. ceteris paribus, current dollars are more valuable than
future dollars
Thus, we need to place current & future costs & benefits on an equal basis for
comparison
This is done by discounting, that is by reducing future dollars to present value by
applying a discount (or a negative interest) rate
Discount Rate Vs Interest Rate
Rs.100,000 invested at a 3% interest rate today will be worth roughly Rs.115,927 in
five years
Rs.100,000 in anticipated benefits five years from now is worth roughly Rs.86,260
today, when discounted by 3%
Discount Rate Matters
Rs.100,000 in anticipated benefits five years from now is worth roughly Rs.86,260
today, when discounted by 3%
Rs.100,000 in anticipated benefits five years from now is worth roughly Rs.78,352
today, when discounted by 5%
The difference grows larger as
Multiple years are accounted for
Benefits accrue further into the future
What to use as a Discount Rate?
There are various approaches to selecting one
o Givens (i.e. some authority imposes one)
o Bank interest rates
o Rates of return on certain investments (e.g. government bonds)
o Social discount rates
Net Present Value
The difference between total discounted benefits and total discounted costs
NPV = (PVB - PVC)
NPV: decision criteria
o For a single project, a positive NPV indicates acceptability
o For multiple (competing) projects, the project(s) with the highest NPVs should
receive highest priority
Benefit/Cost Ratio
B/C = (PVB / PVC)
 Benefit/Cost ratio: decision criteria
o For a single project, a B/C ratio which is greater than 1 indicates acceptability
o For multiple (competing) projects, the project(s) with the highest B/C ratios
(greater than 1) should receive highest priority
Internal Rate of Return
The discount rate at which the present value of benefits is equal to the present value of
costs
Internal Rate of Return: decision criteria
o For a single project, an IRR which is greater than the selected (for B/C and/or
NPV analysis) discount rate indicates acceptability
o For multiple (competing) projects, the one with the largest IRR is the most
desirable
NPV and B/C Comparison
NPV measures totals, indicates the amount by which benefits exceed (or do not exceed)
costs (total benefit or loss)
B/C measures the ratio (or rate) by which benefits do or do not exceed costs (efficiency)
They are clearly similar, but not identical
With multiple projects, some may do better under NPV analysis, others under B/C

Problems with IRR (Internal Rate of Return)

It has a certain attraction, but also has some problems
o The argument that an IRR which is greater than the selected discount rate is
desirable can be questioned - discount rates can be arbitrary!
o Calculation (by hand) is tedious & prone to error (but modern spreadsheets are a
help)
o Under certain conditions there may be more than one correct solution to an IRR
problem

Risk Analysis
Risk analysis is a technique used to identify and assess factors that may jeopardize the success
of a project or achieving a goal. This technique also helps to define preventive measures to
reduce the probability of these factors from occurring and identify countermeasures to
successfully deal with these constraints when they develop to avert possible negative effects on
the competitiveness of the company.
 Risk analysis can be qualitative or quantitative. Quantitative Risk Analysis seeks to
numerically assess probabilities for the potential consequences of risk, and is often called
probabilistic risk analysis or probabilistic risk assessment (PRA). Qualitative risk analysis uses
words or colors to identify and evaluate risks or presents a written description of the risk

Depreciation

Depreciation is the systematic reduction in the recorded cost of a fixed asset. It may be defined
as:

1. A method of allocating the cost of a tangible asset over its useful life. Businesses
depreciate long-term assets for both tax and accounting purposes.

2. A decrease in an asset's value caused by unfavorable market conditions.

Causes of Depreciation: Wear and tear, effusion of time, exhaustion, obsolescence etc-

Examples of fixed assets that can be depreciated are buildings, furniture, leasehold
improvements, and office equipment. The only exception is land, which is not depreciated
(since land is not depleted over time, with the exception of natural resources). The reason for
using depreciation is to match a portion of the cost of a fixed asset to the revenue that it
generates; this is mandated under the matching principle, where you record revenues with their
associated expenses in the same reporting period in order to give a complete picture of the
results of a revenue-generating transaction. The net effect of depreciation is a gradual decline
in the reported carrying amount of fixed assets on the balance sheet.

It is very difficult to directly link a fixed asset with a revenue-generating activity, so we do not
try - instead, we incur a steady amount of depreciation over the useful life of each fixed asset,
so that the remaining cost of the asset on the company's records at the end of its useful life is
only its salvage value.

Inputs to Depreciation Accounting

There are three factors to consider when you calculate depreciation, which are:

Useful life. This is the time period over which the company expects that the asset will be
productive. Past its useful life, it is no longer cost-effective to continue operating the asset, so it
is expected that the company will dispose of it. Depreciation is recognized over the useful life
of an asset.
 Book value. It represents the amount of capital that remains invested in the company and must
be recovered in the future through the accounting process. It may not be the accurate measure
of market value.
Salvage value. When a company eventually disposes of an asset, it may be able to sell it for
some reduced amount, which is the salvage value. Depreciation is calculated based on the asset
cost, less any estimated salvage value. If salvage value is expected to be quite small, then it is
generally ignored for the purpose of calculating depreciation.
Depreciation method. You can calculate depreciation expense using an accelerated
depreciation method, or evenly over the useful life of the asset. The advantage of using an
accelerated method is that you can recognize more depreciation early in the life of a fixed asset,
which defers some income tax expense recognition into a later period. The advantage of using
a steady depreciation rate is the ease of calculation. Examples of accelerated depreciation
methods are the declining balance and sum-of-the-years digits methods. The primary
method for steady depreciation is the straight-line method. The production method is also
available if you want to depreciate an asset based on its actual usage level, as is commonly
done with airplane engines that have specific life spans tied to their usage levels.

If, midway through the useful life of an asset, you expect its useful life or the salvage value to
change, you should incorporate the alteration into the calculation of depreciation over the
remaining life of the asset; do not retrospectively change any depreciation that has already been
recorded.

Other Depreciation Issues

Depreciation has nothing to do with the market value of a fixed asset, which may vary
considerably from the net cost of the asset at any given time.

Depreciation is a major issue in the calculation of a company's cash flows, because it is

included in the calculation of net income, but does not involve any cash flow. Thus, a cash
flow analysis calls for the inclusion of net income, with an add-back for any depreciation
recognized as expense during the period.