TIME VALUE OF MONEY

TIME VALUE OF MONEY

-ONE OF THE LIMITATION OF PROFIT MAXIMISATION IS IGNORING THE TIME VALUE OF MONEY .

-AT THE SAME TIME IT DOES NOT CONSIDER THE MAGNITUDE AND TIMING OF EARNINGS

- TO OVERCOME THE LIMITATIONS OF PROFIT MAXIMISATION FIRMS CONSIDER THE OBJECTIVE OF WEALTH MAXIMISATION.

MOST OF THE FINANCIAL DECISIONS SUCH AS INVESTMENT DECISION FINANCING DECISION AND DIVIDEND DECISION INVOLVES CASH FLOWS (INFLOW AND OUTFLOW) OCCURRING IN DIFFERENT TIME PERIODS.

FOR EXAMPLE INVESTMENT ON A PROJECT REQUIRES AN IMMEDIATE CASH OUTFLOW AND IT WILL GENERATE CASH INFLOWS DURING ITS LIFE PERIOD.

IN SHORT COMPARISON OF CASH FLOWS INVOLVES A LOGICAL WAY TO RECOGNISE THE TIME VALUE OF MONEY.

• “ THE FIRM CAN MAXIMISE WEALTH ONLY WHEN IT IS ABLE TO RECOGNISE THE TIME VALUE OF MONEY AND RISK”

Time value of money

Concept:

The time value of money received today is more than the value of same amount of money received after a certain period.

Time preference for money:

Options of time period for receivables.

(i) Immediate

(ii) Later

Reasons for time preference for money

(i) Uncertainty and loss

(ii) To satisfy present needs

(iii) Investment opportunities.

RATIONALE OF TIME PREFERENCE FOR MONEY

• UNCERTAINTY- FUTURE IS UNCERTAIN AND IT INVOLES RISK. HENCE HE/SHE WOULD LIKE TO PREFER TO RECEIVE CASH TODAY INSTEAD IN THE FUTURE.

• EXAMPLE- BIRD IN YOUR HAND AND THERE ARE TWO BIRDS IN THE BUSH

• WHICH ONE DO YOUR PREFER?

• CURRENT CONSUMPTION: MOST OF THE PEOPLE GENERALLY PREFER TO USE THE PRESENT MONEY FOR SATISFYING THE PRESENT NEEDS.

• POSSIBILITY OF INVESTMENT OPPORTUNITY

ANOTHER REASON WHY INDIVIDUALS PREFER PRESENT MONEY IS DUE TO THE POSSIBILITY OF INVESTMENT OPPORTUNITY THROUGH WHICH THEY CAN EARN ADDITIONAL CASH

Technique of time value of money

• Compounding technique

The interest earned on the principal amount becomes a part of principal at the end of the compounding period.

To determine the future value of money. Formula Method Future Value (FV)= P(1+i)n

Lumpsum Method P=Principal, i = interest, n = number of years Table Value – used when period of maturity is long. Multiple compounding periods – interest calculated

half-yearly, quarterly or every month. FV=P(1 + i/m)mxn

m = Number of times per year compounding is made

Ex: Mr.Kavin deposits Rs.20,000 for 3 years at 10% interest.

Series of paymentAnnuity- series of equal annual payments

or investments made at the end of the each year for a particular period.

• Discounting or present value technique

Money to be received in future date will be less because we have lost the opportunity cost in the form of interest.

Computation of present value: Lump sum

PV = Fv/ (1+i)n

Discount factor Tables Series of payment

PV= F1 / (1+i) + F2 / (1+i)2 + ….. Fn / (1+i)n

Annuity

At the end

PV= A / (1+i) + A / (1+i)2 + ….. A / (1+i)n

At the beginning

PV= A+ A / (1+i) + A / (1+i)2 + ….. A/ (1+i)n

INTRODUCTION TO THE CONCEPT OF RISK AND RETURN

• RISK- IS PRESENT IN EVERY DECISION WHETHER IT IS CORPORATE DECISION OR PERSONAL DECISION.

• FOR EXAMPLE SELECTIN OF AN ASSET FOR PRODUCTION DEPARTMENT OR DEVELOPIN A NEW PRODUCT OR FINANCIAL DECISION LIKE

• DEVELOPING CAPITAL STRUCTURE

• WORKING CAPITAL MANAGEMENT AND DIVIDEND DECISION

• THEREFORE THE DECISION MAKERS HAVE TO ASSESS RISK AND RETURN OF SECURITY BEFORE TAKING ANY FINANCIAL DECISION

RISK IS THE CHANCE OF FINANCIAL LOSS OR THE VARIABILITY OF RETURNS ASSOCIATED WITH A GIVEN ASSET.

Risk.

Variability of actual return from the expected returns associated with a given asset.

= more risk in security more return-more variability.

= less variability-less risk.

measurement of risk.

1. Behavioural.

- sensitivity analysis.

- probability ( distribution ).

1. Quantitative/statistical.

- standard deviation.

- co-efficient of variation.

Behavioural Method

Sensitivity analysis. • Considered number of possible outcomes/return while assessing

risk.• Estimate worst ( pessimistic ) expected ( most likely ) and best

( optimistic ) return.• Level of outcome is related to state of economy – recession,

normals, boom condition.• ( optimistic-pessimistic outcome ) = range.• If Increase in range, increase in variability, increase in risk in asset.

Probability distribution

• Likelihood/percentage chance of an event occurrence.

Ex: if outcome/return is 7 out of 10 then chance of occurrence is 70%. n

Expected return R = Σ Ri X Pri

i=1

Ri= return for the ith possible outcome.

Pri = probability associated with its return.

N= number of outcome considered.

Quantitative method

1.Standard deviation of return:Square root of the average squared deviations of the

individual returns from the expected returns. n

σ = Σ (Ri-R)2 X Pri i=1

Greater the standard deviation of returns, greater the variability of return and greater the risk of the asset /investment.

2. Co-efficient of variation:Measure of risk per unit of expected return. CV= σr / Rσ= standard deviationR= expected return

The lager the CV , larger the risk of the asset.

Objectives of measuring risk

• The objective of measuring risk is not to eliminate or avoid it because it is not feasible to do so.

• But it helps as in assessing and determining whether the proposed investment is worth or not

Risk is the chance of financial loss or the variability of returns associated with a given asset

Examples

• For example government bond is less risky because the principal amount and return (interest) are guaranteed.

• On the other hand investment on a company stock is risky because of the high variability (0 to above zero of returns)

Risk and Return of single asset.

Return:

Income received plus any change in market price of an asset.

R= Dt + ( Pt – pt-1)/ Pt-1

D=annual income/ cash divided at the end of time t.

Pt= security price at time period t ( closing/ending ).

Pt-1= security price at t-1 ( opening/beginning ).

1. Capital gain/ loss= ( ending price-beginning price )/beginning price.

2. Current field= annual income/beginning price.

Return

• All the investors assess risk of an investment on the basis of the variability of returns expected form its over a maturity period or life period or expected holding period.

• Return on an investment is an annual income received during the period plus change in value.

• For example and investor A invested Rs.1000 on an firm’s share and received Rs.100 as dividend at the end of the year, and share is selling at the Rs.1200 here the return is Rs.300

( dividend + inc in share price)• Return is expressed in terms of

percentage on the beginning of the investment

Classification of risk

• Diversifiable risk

• Market risk

• Diversifiable risk is company specific and it can be completely eliminated through diversification.

• Market risk arises from market movement and which cannot be eliminated through diversification