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Financial Management - Chapter 2
Financial Management - Chapter 2
Is there a situation in which the prices decrease over a period of time and
opposite of inflation takes place?
Usually in a developing country, such a situation does not arise, as the demand is always greater than
supply. However currently Japan is experiencing deflation in which current prices would be less than
the past prices. This is harmful to a developing economy, as units that save money would get very low
interest or no interest. Hence there will be no incentive for the units to invest money in bonds, fixed
deposits etc.
The bank does the business of lending. For this, it requires funds through deposits. It earns
interest on loans and pays interest on deposits;
With the passage of time, the purchasing power of money reduces. The same thing will happen
to your deposit with the bank. The bank gives compensation to you for this loss in value of
money;
In case the bank does not pay interest, it will not get funds for lending. You will not keep
deposits with it. You will choose other willing banks or avenues of investment.
While all of them are correct, we are more interested in the second reason. Value of money erodes due
to inflation as we have seen in the earlier paragraph. The rates of inflation would be different for
different countries. Further, it could be different for the same country at different times. Sometimes it
could be high while at some other times, it could be low.
Note:1
Rate of inflation coming down - What does it mean? Does it mean that the prices of commodities are coming
down or the increase in prices of commodities is coming down? Answer is: The increase in prices of commodities
is coming down; in actual terms, the prices of commodities are not reducing.
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The duration of the deposit the longer the duration, the higher the premium and vice-versa.
That is why the longer duration deposits would attract higher rates of interest and shorter
duration deposits would have a lower rate of interest.
The need for deposits by the banking company for a specific period. The bank would offer a
higher rate for that period. Suppose a bank wants more deposits for six months rather than
one year. It will attract deposits for six months by offering higher rate of interest than the
market.
Tier 3 What does the bank do with the deposits that it accepts? It gives loans. The rate of interest on
loans becomes the next tier, Tier 3.
What are the factors that a bank would consider to determine its lending rate?
Average interest paid out on deposits and expenses
Minimum expected profit from lending operations
Degree of risk in lending specific to a borrower, depending upon his business
Continuing discussion on Tier 3,
+ 1% = 11%. This is the lowest
name for this rate. It is referred
rate depending upon risk etc.,
borrower to borrower.
This is the reason that for different activities, the same bank charges different rates of interest at the
same time. Similarly for different borrowers pursuing the same activity, the rates of interest would be
different as per perception of risk associated with them.
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The project owners investment does not have the backing of assets. A lender, on the contrary,
has backing of assets for his loan.
The enterprise pays the lender interest periodically. The owners on the contrary, get return in
the form of dividend. This is not certain.
Besides interest, the enterprise should also have sufficient surplus after paying interest to
repay the loan amount
Risk of project failure affects the owners more than the lenders for the same reason as
mentioned in the first bullet point
Example No. 2
Let us summarise the above as under:
Rate of inflation = Tier no. 1 = 3% p.a.
Rate of interest on investment = Tier no. 2 = 7% p.a.
Rate of interest on loans = Tier no. 3 = 11% p.a.
Rate of return from investment in projects = Tier no. 4 = 15% p.a. (This is just an example. The rate of
return expected from a project would actually depend upon the degree of risk associated with the
project in the perception of the project owners primarily and project lenders secondarily)
n
(1 + r/100) is known as compounding factor.
Let us apply this formula to another investment example and determine the future value.
Example no. 3
You have a fixed deposit for Rs.10,000/- in a bank. Terms of deposit are:
Period Two years
Does the future value alter with the change in the frequency of compounding?
In the above example, we have assumed that the bank pays interest at the frequency of one year.
Suppose the bank pays interest at a higher frequency, would the future value turn out to be different?
Let us see the following example.
Example no. 4
Suppose the bank increases the frequency of compounding from yearly to half-yearly. What will be the
future value? We can use the same formula with an amendment. The amended formula would be:
Future value = Present investment x (1 + r/200)
nx2
As interest gets compounded twice as frequently, r is divided by 200. Similarly the number of periods
for compounding also gets doubled and hence it is 2 x n instead of n. Accordingly, in our formula,
what would be the values of r and n?
r = 5% and n = 4
With these values, the future value FV at T2 works out to 10,000 x (1.05)
= Rs.12,155/-.
Similarly we can see that in case the frequency of compounding increases to quarterly from halfyearly, the future value works out to Rs. 12,184/-.
Let us summarise what we have learnt so far on compounding and future value:
The amount that you get back at the end is called future value
Frequency of compounding
Doubling period
A frequent question posed by an investor is: How much time it will take for my investment to double
in value? This question can be answered by a rule known as Rule of 72. It is an approximate way of
finding out the doubling period. Suppose the rate of interest is 12%. The doubling period is 6 years.
A more accurate answer can be had by a better formula like:
0.35 + 69/interest rate in % terms. Employing the same rate of 12%, we find that the doubling period
is 6.10 years instead of 6 years. This is more accurate than the Rule of 72 formula.
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Example no. 5
We want to get Rs.108/- at the end of T 1. The desired rate of interest is 8% per annum. What is the
amount that we should invest at T0?
Can we use the future value formula here?
Yes with necessary modification as under:
Future value = Present investment x (1 + r/100)
Future value
-------------------(1 + r/100)
The reciprocal of compounding factor is referred to as discounting factor. We need to multiply the
n
future value by this discounting factor and not divide. In the above formula, 1/(1+r/100) is referred
to as discounting factor.
Example no. 6
We want to get Rs.10,000/- after two years. The desired rate of interest is 12% p.a. The frequency of is
yearly.
What is the present value of this future sum of Rs.10,000/-?
Present value = Rs. 7,971/The two-step process in determining present value is:
Step 1 = determine the discounting factor = 1/[1 + 12/200] 4 = 0.7924
Step 2 = multiply the future value by this factor to get the present value
We have already seen under future value that higher frequency of compounding increases the future
value. Conversely, higher frequency of discounting decreases the present value. The students are
advised to take the following exercise and verify for themselves.
Exercise No. 1
After three years we are likely to get a windfall of Rs.1,00,000/-. What will be the present value of this
windfall, in case the expected rate of return is 15% p.a.?
Answer Rs.65,751/Let us summarise what you have learnt so far on discounting and present value:
It is used when you want to determine the present value of a future sum
In case you determine the discounting factor, you should multiply the future value by this
factor to get the present value
The more the frequency the of discounting, the less will be the value of present value
Present value will always be less than future value by the same token of inflation.
We want to evaluate our investment decision in the project. How do we do this? By applying
discounting factor for 20% to the future earnings.
Present value of T1 = Value at T0 = Rs. 30lacs/1.20 = Rs.25 lacs
Present value of T2 = Value at T0 = Rs.35 lacs/(1.20) 2 = Rs.24.30 lacs
Discount the future earnings by a suitable rate of discount. This depends upon the market rate
for borrowing and our perception of risk in the project. This gives the present value of all future
earnings.
Compare this with the present value of investment. We invest in the project if the present
value of the future earnings is more than present value of investment.
In the above example, suppose the present value is greater than Rs.100 lacs. Then we would
select the project for investment.
Exercise No. 2
We are investing in a project Rs. 1000 lacs. The rate of return that we expect from the project is 18%
p.a. The estimated future earnings for three years are:
T1 = Rs.450 lacs
T2 = Rs.500 lacs
T3 = Rs.550 lacs
The above are also referred to as cash flows 3(in this case cash inflows)
Examine as to whether it is worthwhile investing in the project. Find out the Net Present Value of the
project.
Answer:
Present value of future earnings = Rs.1071 lacs
Net Present Value = Rs.71 lacs
We can invest in the project
Cash flow could either be cash inflow or cash outflow. When an investment is made at T 0 it is called cash out
flow. Similarly when returns are received they are called cash in flows. Cash out flow is denoted by mentioning
the figure within bracket like (50 lacs)
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Rs.100/-
Rs.100/-
Rs.100/-
Rs.100/-
Rs.1100/-
Step 2 = discounting the payment expected by the rate of return, i.e., 8% p.a., we can determine the
present value of the future cash flows. It is Rs.1080.30. This means that an investor will be willing to
purchase this bond now from the market provided the market price of this bond is less than
Rs.1080.30.
Exercise No. 3
We have a bond with the face value of Rs.5,000/-. The interest on the bond is Rs.600/- per year. We are
supposed to get a premium on the bond of Rs.250/- at the end of the maturity period. Expected rate of
return by us = 10% p.a. Suppose the maturity is after 5 years, what is the price at which an investor
would be willing to purchase it from us?
(Note please add the premium amount to the face value. You will get Rs.5,250/- on maturity)
Answer: Present value of future returns = Rs.5534/-. An investor will be willing to pay
anything less than this value for purchasing the bond from you.
Unit Rate
2000
Rs.250/-
Rs.5 lacs
2200
Rs.250/-
Rs.5.5 lacs
2500
Rs.250/-
Rs.6.25 lacs
This is similar to finding out the net present value in the case of projects. We discount the expected
sales by the expected rate of return of 15% p.a. This determines the present value of the expected
sales. Let us compare this with the total product development expenses.
Exercise No. 4
Find out the net present value in the above example. Also confirm that the total product development
costs stand fully recovered at T3.
Answer The product development costs stand fully recovered at T3.
Let us summarise what we have learnt on application of Time value of money to business
Compounding has greater application to personal investment while discounting has greater
application to business.
Let us look at one more example for reinforcing our learning. Let us select the
best project out of the three projects proposed.
Consider the following 3 alternative projects. Assumptions are also given below:
Investment at T0 for all the projects is Rs.500 lacs.
Future cash flows are considered for T1 to T5.
Although the scale of operations for all the projects is the same, the projects have different future
earnings or returns.
The promoters expect a rate of return of 15% p.a. hence; this is the rate by which the future returns
are discounted.
(Rupees in Lacs)
Project 1
Year
No.
Project 2
Future
Earnings
Disc. Value
Project 3
Future
Earnings
Disc.
Value
Future
Earnings
Disc. Value
10
100
86.96
150
130.44
175
152.18
120
90.73
150
113.42
150
113.42
200
131.5
150
98.63
180
118.35
250
142.95
200
114.36
225
128.66
250
124.3
200
99.44
250
124.3
Total
576.4
556.29
636.91
As Project 3 has the highest NPV it would be selected. NPV = PV of future earnings (-) original
investment. Accordingly, the net present values for the three projects would be:
Project 1
76.44 lacs
Project 2
56.29 lacs
Project 3
136.91 lacs
Concept of annuity
So far we have seen the following in respect of application of time value of money:
Investment lump sum at T0 and get lump sum at Tn
called future value of a single stream.
Suppose we are given a future value and want to know how much should be invested at present. We
use the process that is converse of compounding and this is called discounting. In order to get lump
sum after a given period, we should invest the present value at the beginning, again a lump sum. This
is called the present value of a single stream.
Invest lump sum at T0 in a project and get annual returns. The returns will not be equal to each other.
To determine the present value of the future returns to determine Net Present Value = Present value;
process is discounting. This is the example of present value of multiple streams.
Annuity refers to multiple stream of cash flows but which are equal to each other and
occurring annually. The cash flows could either be in flows or out flows. This means that the following
alternatives are available to us when we are talking of annuity.
We invest at the beginning one lump sum amount and get returns over a period of time
that are equal to each other. The cash in flows that are equal to each other are called
annuity. Herein we use what is known as Present Value Interest Factor Annuity
(PVIFA). We multiply the Annuity by this factor and get the present value of the future
cash flows in one shot. Then we compare this present value with our proposed investment
at T0 taking decision on investment. We invest provided the Present value of future
annuities is at least equal to our investment at T0.
We invest in equal instalments over a period of time and get one lump sum at the end of
the period. The cash outflows that are equal to each other are called annuity. Herein
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At T0
T1
T2
T3
T4
T5
Investment = zero
1,000/-
1,000/-
1,000/-
1,000/-
1,000/-
Can we use the future value formula, find out the future value of each stream of Rs.1000/- and add
them up? Thus T1 investment would earn interest for 4 years, the 2 nd year investment would earn
interest for 3 years, the 3 rd year investment would earn interest for 2 years, the 4 th year investment
would earn interest for 1 year and the last year investment would not earn any interest. Instead of
doing such an elaborate exercise, we use the alternative FVIFA.
Practical applications of Annuity4 for future value
Example no. 11
Similar in concept to Example no. 10, we can think of investment lump sum at T 0 and getting returns
over a period of time, the returns being equal in value. Example is investment in bank deposit floated
by competitive banking industry at present. Each return will be partly principal amount and partly
interest amount. Our aim is to determine the present value of the future returns by discounting them
and comparing the present value with our investment value.
Can we use PVIF and find out the present value of future cash flows? Yes. The cash flow at T 1 is
discounted for one year, the cash flow at the end of the second year is discounted for two years, the
cash flow at the end of the third year is discounted for three years and so on and so forth. Instead of
repeating the discounting process so many times, we have the easy alternative of Present Value
Interest Factor Annuity.
It is okay for discussion. However the students will be interested in knowing as to where he will get the
PVIFA and FVIFA values. These will be available as annexure with any standard textbook on Financial
Management and multiply with the annuity to arrive at the Present Value or Future value as the case
may be.
Concept of perpetuity
This is the concept applicable in the case of pension. Pension is taken to be perpetual. Can we find out
the lump sum amount in case the pension amount is given?
Example no. 12
Suppose the pension amount is Rs. 1000/-. The expected rate of return is 10% p.a. What is the core
amount out of which interest is paid? The annual payment is Rs.12,000/-. Hence the lump sum amount
is Annual payment/rate of interest expressed in decimals.
4
Annuity could be at a frequency more than one year. In fact in the case of recurring deposit, the annuity is
monthly.
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Why should return from a project be the highest in the 4-tier interest rate structure?
2.
3.
Can you find out the present value of a stream of annuity without using PVIFA? Explain the process.
4.
Find out the present value of a sum of Rs. 10 lacs at the end of five years in case the expected rate
of return is 12% and the compounding is done on half-yearly basis.
5.
Suppose you open a recurring deposit account with annual interest of 6%. You open it for a period
of 12 months. The annuity is Rs.500/-. What will be the value at the end of one year?
6.
Mr. George is about to retire. The employer places before him two alternatives. Mr. George has to
choose between them. Lump sum Rs. 12 lacs or half-yearly pension of Rs. 79,000/-. Which one
should he choose in case the annual expected return is 10%?
7.
What is the present value of an income stream that provides Rs. 2,000/- at the end of year one, Rs.
5000/- at the end of year two and Rs.10,000/- for the next 5 years? Assume the rate of interest to
be 8% p.a.
8.
What is the present value of Rs. 5,000/- receivable annually for 30 years if the first receipt occurs
after 5 years and the rate of interest is 10% p.a?
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