2nd Assignment

Time Value of Money Affects Investments and Financial Decisions

ALLAMA IQBAL OPEN UNIVERSITY

(Department of Business Administration)

Assignment # 2

Financial Management (5535)

TOPIC: TIME VALUE OF MONEY AFFECTS INVESTMENTS

AND FINANCIAL DECISIONS

Submitted to: Sir Waqar Akbar

Submitted by: Ishtiaq Ahmed (0333-6824303)
AH-526270

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Time Value of Money Affects Investments and Financial Decisions

ACKNOWLEDGEMENT

All praises to Almighty Allah, the most Gracious, the most Beneficent and the most Merciful,
who enabled me to complete this assignment.
I feel great pleasure in expressing my since gratitude to my teacher, for his guidance and
support for providing me an opportunity to complete my Project.
My special thanks and acknowledgments to Mr. Ishtiaq for providing me all relative
information, guidance and support to compile the Project.
I will keep my hopes alive for the success of given task to submit this report to my
honorable teacher Sir Waqar Akbar, whose guidance; support and encouragement enable
me to complete this assignment.

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Time Value of Money Affects Investments and Financial Decisions

EXECUTIVE SUMMARY

“The today’s world moves at neck breaking speed & it calls for a decisive action”
“Quantum Leap thinking”
The topic which was assign was “How Time Value of Money Affects Investments and
Financial Decisions in Financial Management“
The time value of money is the value of money figuring in a given amount of interest earned
over a given amount of time. The time value of money is the central concept in finance
theory. Some standard calculations based on the time value of money are Present value,
Present value of an annuity, Present value of a perpetuity, Future value and Future value of
an annuity.
Where finance investment is putting money into something with the expectation of gain
that upon thorough analysis has a high degree of security for the principal amount, as well
as security of return, within an expected period of time.
So, any organization of having any type of business can calculate its future worth of
investments by Time value of money and can make its operations more efficient and
effective.
So, by using Time value of Money concepts, any organization can make good and accurate
decisions.

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Table of Contents Page No

Title page 01
Acknowledgement 02
Abstract 03
Table of contents 04
Introduction to the issue 05
Practical study of the Topic 15
Conclusion 25
Recommendations 26
References 27

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Introduction to Topic
Time value of money:
The time value of money is the value of money figuring in a given amount of interest earned
over a given amount of time. The time value of money is the central concept in finance
theory.

For example, $100 of today's money invested for one year and earning 5% interest will be
worth $105 after one year. Therefore, $100 paid now or $105 paid exactly one year from
now both have the same value to the recipient who assumes 5% interest; using time value
of money terminology, $100 invested for one year at 5% interest has a future value of $105.

The method also allows the valuation of a likely stream of income in the future, in such a
way that the annual incomes are discounted and then added together, thus providing a
lump-sum "present value" of the entire income stream.

All of the standard calculations for time value of money derive from the most basic algebraic
expression for the present value of a future sum, "discounted" to the present by an amount
equal to the time value of money. For example, a sum of FV to be received in one year is
discounted (at the rate of interest r) to give a sum of PV at present: PV = FV − r·PV = FV/
(1+r).

Some standard calculations based on the time value of money are:

Present value
The current worth of a future sum of money or stream of cash flows given a specified rate of
return. Future cash flows are discounted at the discount rate, and the higher the discount
rate, the lower the present value of the future cash flows. Determining the appropriate
discount rate is the key to properly valuing future cash flows, whether they be earnings or
obligations.

Present value of an annuity

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals.
Leases and rental payments are examples. The payments or receipts occur at the end of
each period for an ordinary annuity while they occur at the beginning of each period for an
annuity due.
Present value of a perpetuity
Is an infinite and constant stream of identical cash flows.

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Future value
Is the value of an asset or cash at a specified date in the future that is equivalent in value to
a specified sum today?

Future value of an annuity

(FVA) is the future value of a stream of payments (annuity), assuming the payments are
invested at a given rate of interest.

Five Factors of a TVM Calculation:

1. Number of time periods involved (months, years)

2. Annual interest rate (or discount rate, depending on the calculation)

3. Present value (what do you have right now in your pocket)

4. Payments (if any exist. If not, payments equal zero)

5. Future value (the dollar amount you will receive in the future. A standard mortgage will
have a zero future value, because it is paid off at the end of the term)

Calculations:
There are several basic equations that represent the equalities listed above. The solutions
may be found using (in most cases) the formulas, a financial calculator or a spreadsheet.
The formulas are programmed into most financial calculators and several spreadsheet
functions (such as PV, FV, RATE, NPER, and PMT).

For any of the equations below, the formula may also be rearranged to determine one of
the other unknowns. In the case of the standard annuity formula, however, there is no
closed-form algebraic solution for the interest rate (although financial calculators and
spreadsheet programs can readily determine solutions through rapid trial and error
algorithms).

These equations are frequently combined for particular uses. For example, bonds can be
readily priced using these equations. A typical coupon bond is composed of two types of
payments: a stream of coupon payments similar to an annuity, and a lump-sum return of

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capital at the end of the bond's maturity - that is, a future payment. The two formulas can be
combined to determine the present value of the bond.

An important note is that the interest rate i is the interest rate for the relevant period. For
an annuity that makes one payment per year, i will be the annual interest rate. For an
income or payment stream with a different payment schedule, the interest rate must be
converted into the relevant periodic interest rate. For example, a monthly rate for a
mortgage with monthly payments requires that the interest rate be divided by 12 (see the
example below). See compound interest for details on converting between different periodic
interest rates.

The rate of return in the calculations can be either the variable solved for, or a predefined
variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost
of debt or any number of other analogous concepts. The choice of the appropriate rate is
critical to the exercise, and the use of an incorrect discount rate will make the results
meaningless.

For calculations involving annuities, you must decide whether the payments are made at
the end of each period (known as an ordinary annuity), or at the beginning of each period
(known as an annuity due). If you are using a financial calculator or a spreadsheet, you can
usually set it for either calculation. The following formulas are for an ordinary annuity. If you
want the answers for the Present Value of an annuity due simply multiply the PV of an
ordinary annuity by (1 + i).

Formulas:
1) Present value of a future sum

The present value formula is the core formula for the time value of money; each of the
other formulae is derived from this formula. For example, the annuity formula is the sum of
a series of present value calculations. The present value (PV) formula has four variables,
each of which can be solved for:

1. PV is the value at time=0

2. FV is the value at time=n

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3. i is the discount rate, or the interest rate at which the amount will be
compounded each period
4. n is the number of periods (not necessarily an integer)

The cumulative present value of future cash flows can be calculated by summing the
contributions of FVt, the value of cash flow at time=t

Note that this series can be summed for a given value of n, or when n is . This is a very
general formula, which leads to several important special cases given below.

2) Present value of an annuity for n payment periods

In this case the cash flow values remain the same throughout the n periods. The present
value of an annuity (PVA) formula has four variables, each of which can be solved for:

 PV(A) is the value of the annuity at time=0

 A is the value of the individual payments in each compounding period
 i equals the interest rate that would be compounded for each period of time
 n is the number of payment periods.

To get the PV of an annuity due, multiply the above equation by (1 + i).

3) Present value of a growing annuity

In this case each cash flow grows by a factor of (1+g). Similar to the formula for an annuity,
the present value of a growing annuity (PVGA) uses the same variables with the addition of
g as the rate of growth of the annuity (A is the annuity payment in the first period). This is a
calculation that is rarely provided for on financial calculators.

Where i ≠ g:

To get the PV of a growing annuity due, multiply the above equation by (1 + i).

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Where i = g:

4) Present value of a perpetuity

When , the PV of a perpetuity (a perpetual annuity) formula becomes simple

division.

5) Present value of a growing perpetuity

When the perpetual annuity payment grows at a fixed rate (g) the value is theoretically
determined according to the following formula. In practice, there are few securities with
precise characteristics, and the application of this valuation approach is subject to various
qualifications and modifications. Most importantly, it is rare to find a growing perpetual
annuity with fixed rates of growth and true perpetual cash flow generation. Despite these
qualifications, the general approach may be used in valuations of real estate, equities, and
other assets.

This is the well known Gordon Growth model used for stock valuation.

6) Future value of a present sum

The future value (FV) formula is similar and uses the same variables.

7) Future value of an annuity

The future value of an annuity (FVA) formula has four variables, each of which can be solved
for:

 FV(A) is the value of the annuity at time = n

 A is the value of the individual payments in each compounding period
 i is the interest rate that would be compounded for each period of time
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 n is the number of payment periods

8) Future value of a growing annuity

The future value of a growing annuity (FVA) formula has five variables, each of which can be
solved for:

Where i ≠ g:

Where i = g:

 FV(A) is the value of the annuity at time = n

 A is the value of initial payment paid at time 1
 i is the interest rate that would be compounded for each period of time
 g is the growing rate that would be compounded for each period of time
 n is the number of payment periods

What is Investment?
Investment has different meanings in finance and economics. Finance investment is putting
money into something with the expectation of gain that upon thorough analysis has a high
degree of security for the principal amount, as well as security of return, within an expected
period of time. In contrast putting money into something with an expectation of gain
without thorough analysis, without security of principal, and without security of return is
speculation or gambling.

Investment is related to saving or deferring consumption. Investment is involved in many

areas of the economy, such as business management and finance whether for households,
firms, or governments.

To avoid speculation an investment must be either directly backed by the pledge of

sufficient collateral or insured by sufficient assets pledged by a third party. [original research?] A
thoroughly analyzed loan of money backed by collateral with greater immediate value than
the loan amount may be considered an investment. A financial instrument that is insured by

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the pledge of assets from a third party, such as a deposit in a financial institution insured by
a government agency may be considered an investment. Examples of these agencies
include, in the United States, the Securities Investor Protection Corporation, Federal Deposit
Insurance Corporation, or National Credit Union Administration, or in Canada, the Canada
Deposit Insurance Corporation.

Promoters of and news sources that report on speculative financial transactions such as
stocks, mutual funds, real estate, oil and gas leases, commodities, and futures often
inaccurately or misleadingly describe speculative schemes as investment.

Investment In finance:
In finance, investment is the commitment of funds through collateralized lending, or making
a deposit into a secured institution. In contrast to investment; dollar cost averaging, market
timing, and diversification are phrases associated with speculation.

Investments are often made indirectly through intermediaries, such as banks, Credit Unions,
Brokers, Lenders, and insurance companies. Though their legal and procedural details differ,
an intermediary generally makes an investment using money from many individuals, each of
whom receives a claim on the intermediary.

Types of Investments:
1. Deposits/Fixed Term Deposits

This type of investment is used by a large proportion of the population e.g. Bank accounts.
The appeal is easy access and the very unlikely event of losing your capital. Unfortunately
very little income or capital growth takes place simply because of the low interest rates.
Another important point to bear in mind is the devaluation of your particular currency
which will eat away at any gains made especially if cash is held on deposit in the long term.
For this reason alone it is not good practice to leave large deposits in this type of
investment.

2. Bonds

The term bond includes any security that involves debt. When you purchase a bond you are
actually lending money to a company or the government. In return you will receive interest
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and eventually your capital sum. Bonds are generally safe, however for this reason returns
are small. Bonds are for people who want a higher return than a cash deposit would bring
but still want a low risk investment.

3. Stocks

Stocks, sometimes called shares or equities represent part ownership of a company. Unlike
bonds, when you purchase a share in a company you are not guaranteed your money back.
Shares fluctuate in value on a daily basis and therefore it is best to invest longer term (say 5
years and above) However the potential returns are far greater than bonds and for this
reason stocks must be considered a medium risk in general.

Some companies elect to pay profits direct to their shareholders in the form of a dividend
rather than investing the profits back into the company. These dividends can be a tax
efficient way of receiving income. If you would like to invest in stocks but don’t have the
necessary experience, time or inclination, here are some trading services which I have found
to be very good.

4. Managed Funds

When you buy units in a managed fund you are pooling your money with other investors
which enable you to buy into a large number of different asset classes, eg. Fixed interest
deposits, bonds, property, equity etc.

Each fund is managed by a fund manager who decides what percentage of the fund should
be invested into which asset class. Managed funds are popular because of the low cost and
risk diversification. They are suitable for new investors, people with small initial deposits
and anyone who wants to spread risk over a number of asset classes.

Multi millionaire Steven Sutherland is the UK's leading authority in ISA Trend Investing. With
ISA Trend Investing you trade investment funds (not stocks) using an ISA, a SIPP or both, to
achieve tax-free index beating returns. By simply copying what Steven does you can very
quickly build up a very profitable portfolio. I have negotiated a reduced price for Stephen's
book, 'liquid millionaire', if you are interested in this type of investing. It will also introduce
you to his services (highly recommended reading)

5. The Foreign Exchange Market (also called currency, forex or FX)

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The Forex market is the largest market in the world, frequently trading $3trillion per day. It
is an extremely liquid market that trades 24hours, 5 days per week. A currency trade is the
simultaneous buying of one currency and selling of another one. An investor's goal in Forex
trading is to profit from foreign currency movements. The most commonly traded
currencies are the EUR/USD, USD/JPY, USD/CHF and GBP/USD.
Very large profits can be made using forex. Depending on the type of trades forex can be a
low, medium or high risk investment.

6. Property

Every well rounded portfolio should contain property, even if it's just your own residential
home. Property is an excellent asset class since it increases in value over time. It does
however fluctuate in value in the short to medium term and therefore it is best seen as a
long term investment. You can also earn rental income from your tenants as an added
bonus and indeed if you buy the right property you may never have to make a mortgage
payment from your own funds. An excellent resource I use is The Property Tycoon Forum.
Sign up for your Free Trial here. You can also get more information about property from my
buying rental property page.

7. Gold

Gold that is physical gold should be thought of as an insurance policy against poor economic
conditions rather than an investment vehicle. Having said that we are in a bull market at
present (2009) and it is highly likely you will make money if you invest in physical gold today.
In my opinion you should have 5-15% of your total assets in physical gold. A good source of
physical gold is Bullionvault. If you want further information about gold including ETFs,
please go to my gold page.

8. Options/futures

Options and futures are generally at the high risk end of investments with a corresponding
possibility of a high-reward. They are much more speculative in nature and as such new
investors should focus on building a sound investment strategy before speculating. However
there is nothing to stop you using a good quality paid service which uses the knowledge of
an industry expert. Again, I highly recommend Moneymappress.

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Practical Study with respect to the Issue

TIME VALUE OF MONEY AND INVESTMENT ANALYSIS

INVESTMENT ANALYSIS AND CAPITAL BUDGETING:
The two basic issues associated with an investment decision are its feasibility and its desirability.
Feasibility refers to the ability to actually access the necessary capital and complete the project.
Clearly an investment could promise highly desirable levels of returns, but simply be infeasible in
terms of the initial cash flow requirements -- the simplest illustration of a budget constraint.
Alternatively, an investment may be affordable and completely feasible, but the returns could be so
low as to make the investment alternative unattractive. There are a variety of ways by which one
can evaluate returns on investment options. Five of the most common are: (1) net present value
method, (2) internal rate of return methods, (3) profitability index or Q methods, (4) payback or
breakeven period methods, (5) the average rate of return on investment. A study in Financial
Management indicated that the capital budgeting practices employed most by large firms to
make decisions were internal rate of return methods (88%) and net present value methods (63%).
Both the payback and the average rate of return approaches fail to account for the time value of
money. And, the profitability index simply a variant of the NPV approach that is used to control for
size effects. Consequently, the following discussion focuses on net present value and internal rate of
return methods of evaluating investments. These two methods are the most commonly employed
in practice, both account for the time value of money, and together they provide the most

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meaningful decision making information in investment analysis and capital budgeting situations.

Information Needs:
The following information is needed to evaluate investments using time value of money concepts:
1. The expected net after-tax cash flows (NATCF, or ATNCF) for the investment by period
including a salvage value, if any,
2. An appropriate interest rate or discount rate,
3. The length of planning horizon,
4. Terms of financing if borrowed funds are used,
5. The marginal tax bracket of the borrower, and the taxability status for each cash flow.

A. Net Present Value Approach

The following example provided in Table illustrates the appropriate procedures for solving simple
investment-type problems. Consider an investment that costs $6,000 initially. It is expected to yield
net cash inflow of $1,500 per year for 5 years and have an expected salvage value of $1,500 at the
end of 5 years. Assume an 8 percent after-tax discount rate.

Table: Net Present Value Calculations

Period Net After-Tax Cash 8% Present Present Value
Flow Value Factor (Rounded)
0 -$6,000 1.0 -$6,000
1-4 +$1,500 3.31213 +$4,968
5 +$3,000 .68058 +$2,042
Net Present Value $1,010

A negative cash flow reflects the outflow (in this example, the initial payment for the
purchase) while the positive signs indicate net inflows. A common criterion for acceptance
or rejection of a given project, abstracting from risk considerations and budget constraints,
is to accept projects with positive NPV values and reject those with NPV values less than
zero. At NPV = 0, the return is equal to the cost of capital, and the investor would be
indifferent to making the investment or not. In the example above, note the technique used
to discount the equal $1,500 flow per year for four years. The USPV factor can be used to
discount an entire stream of income with one calculation. In year five, there is a salvage
value of $1,500 plus the $1,500 net operating inflow, for a total of $3,000. For amounts
different than the uniform flow, the SPPV factor must be applied. A positive NPV of $1,010
for the sample problem suggests the investment should be made. It is important to

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recognize that the NPV of $1,010 is not the amount of profit made by undertaking this
investment. Rather, it is the amount by which this investment exceeds the return from the
next best investment. The next best investment generates an 8% after-tax return as
reflected by the discount rate. Remember, net present value is a measure of net cash
returns expressed in today's dollars, and is not a measure of profit made on an investment.

Special Problems in Measuring Cash Flows:

In discounting after-tax cash flows, it is important to include all cash flow items that belong
in the analysis and exclude those that do not belong. As a general rule, all incremental cash
flows should be included, i.e., all cash flows which result from making the investment. In
cases where two competing projects are made, many of the incremental cash flows or
benefits are equivalent between the two options and can be canceled by evaluating the
NPV of one project minus the other. But in most cases, all flow values that differ with or
without the project should be included. Sometimes these incremental cash flows are
complicated to isolate, or appear to exist when they really do not. Below, some of the
common pitfalls in measuring cash flows are provided along with guidance on how they
should be treated.

1. Working Capital Requirements:

Most investment opportunities for agricultural businesses or other businesses require some
capital expenditure including the purchases of land, buildings or machinery. For example, a
hog producer may build new confinement facilities to expand the size of the hog operation,
or a meat packer might build and equip a new slaughter house. In doing a net present value
calculation of these investment alternatives, it is important to remember that working
capital requirements will also likely increase as a result of the expansion. For example, the
hog producer will likely have more feed and livestock inventory as a result of the expansion.
Likewise, the packer will have a larger inventory of slaughtered hogs. These increases in
working capital must be accounted for as a cash outflow to do a proper net present value
calculation of the expansion option. If this working capital is sold or returned at the end of
investment period, an inflow of cash occurs from the sale of inventories or other items that
return working capital at the end of the investment, much like a salvage value. In any case,
the investment of additional working capital should be treated in terms of its incremental
cash flows.

2. Sunk Costs:

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Suppose a farmer spends $1,000 over a 6 month period searching for a property to expand
the size of the operation. A parcel is now found and the farmer wants to do a net present
value analysis of the purchase. However, the $1,000 spends searching for the property
should not be included as a cash outflow in this calculation. The reason is that it is now a
sunk cost and will exist whether the farmer does or does not buy the current property
under consideration. Thus, it has no bearing on the financial rewards from the decision at
hand. Although it is a real expense, it is not an incremental cash flow associated with the
investment because it is not affected by the acceptance or rejection decision about the
project.

3. Opportunity Costs:
Suppose an agribusiness firm is considering a new product line that will use up existing
excess capacity in the firm's manufacturing plant. As a result, the firm will need to expand
the size of their plant at the end of the second year rather than at the end of the fourth
year. Should a net present value analysis of the new product line include a charge for using
up existing excess capacity? The answer here is yes, because it causes the firm to rebuild in
year two versus the current plans which call for expansion in the fourth year.
As another example, suppose a farmer is doing a net present value analysis of a slurry store
handling system versus a lagoon system. To construct the lagoon, the farmer will need to
take 2 acres of land out of production. In doing the net present value analysis, one should
account for the opportunity cost of using the land for something other than a lagoon.
Perhaps more importantly in this case, there is an important contingency cost that can be
thought about as the cost of insuring against liability created by the lagoon. Many
companies explicitly budget to fund a legal reserve associated with new projects.

4. Synergies:
Suppose you were considering the addition of a new project that utilized products produced
elsewhere in your operation, or otherwise contributed to the profitability of your operation.
For example, suppose you run a “pick your own orchard” and are considering the addition
of pony rides and Halloween hayrides. In addition to measuring the direct cash flows from
the additional projects, the potential increase in apple sales while the new customers are on
site should be included.

5. Diversions and cannibalism

Suppose you now running a “pick your own” orchard and are considering the addition of a
cider press to expand your product line. Clearly the value of the apples used in production
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should be accounted for in the NPV calculation, but so should any reduction in fresh apple
sales that might occur if the availability of cider reduces the demand for fresh apples. (The
example might be more obvious if prunes were replaced by apples, except that the authors
know of no prune orchards). Cannibalism effects have been frequently noted in food
manufacturing businesses. For example, when Post introduced Dino Pebbles to compete
with Kellogg’s Marshmallow Krispies, the main effect was in the reduction of sales of Post’s
other similar line -- Fruity Pebbles. This case illustrates the importance of including any lost
revenues associated with other projects owned by the same person or firm as a cost of the
project being evaluated.

B. Internal Rate of Return (IRR)

NPV analysis results in a dollar-valued answer based on discounting cash inflows and cash
outflows. Given no capital constraints, all projects generating positive NPV values would be
accepted. However, because the NPV is simply a dollar value, it does not provide a measure
of the rate of return generated by the project. And, NPV results are not always sufficient to
evaluate the desirability of two very different sized projects. For example, suppose project A
has NPVA = $100, and project B has NPVB = $105. If they were otherwise equal, project B
would be more desired. However, if project B had twice as large an initial cost, and its
acceptance prohibited other positive NPV projects, then project A may be more desirable.
Thus, complementary information about the effective yield provided per dollar of cash flow
in the project is also useful to know. That measure is the internal rate of return or IRR. Its
solution uses the same principles that are employed in NPV calculations except that the
discount rate being solved for is the one that results in the project having an NPV of zero. In
this sense, it is simply the highest costs of capital that would make the project exactly break
even in terms of the NPV. If the actual discount rate or cost of capital is less than the IRR,
then the project is viewed as a desirable project because it generates more than it costs. If
the IRR is lower than the costs of capital or negative, then the project is not desirable and
should be rejected. To illustrate, the example problem used above to illustrate the basic NPV
approach is solved for its IRR. The IRR is the discount rate that results in the present value of
the inflows and the present value of the outflows being exactly equal and thus resulting in
NPV equal 0. Because the discount rate in the time value of money formulas is inside an
equation that often has an exponent greater than one, it often cannot be algebraically
isolated and analytically solved. Fortunately, most financial calculators can be used to
compute an IRR for the basic types of problems. Moreover, trial and error approaches

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converge fairly rapidly toward a solution, and simple interpolation methods are easily used
at any stage of a trial and error process. Finally, the spreadsheet supplied with this booklet
also contains a simple facility to calculate the IRR for most analyses.
In attempting to solve for the IRR by hand, a trial and error process can be used to bracket
the answer fairly quickly. Depending on the precision needed, the search can then be
stopped and any two answers used to interpolate (or extrapolate) an approximate answer.
To do so, the common steps are: (1) guess a discount rate and solve for the NPV. If the NPV
is positive, then increase the discount rate and try again. (2) If the trial NPV is negative,
decrease the trial discount rate and recalculate. (3) Repeat this search until you have two
trial discount rates that “bracket the answer” (one negative NPV and one positive NPV).
Then, (4) a manual method of bisection search can be used to locate the exact solution. The
bisection involves the following approach. First take the average of the two rates that are
known to bracket the IRR and recomputed the NPV at the average rate. If the NPV is
positive, use the average and the higher rate for the next bracket. If the NPV at the average
rate is negative, then use the average and the lower rate for the next bracket. Then, re-
average the rates from the new “bracket” and repeat the process until the NPV is suitably
close to zero. At any time, the two rates that bracket the IRR can also be used in a process
known as interpolation to approximate the answer. The interpolation process is illustrated
below using the same example that was used to demonstrate the NPV technique above.

Table: Interpolation Calculation Inputs

Present Value Factors Present Value Factors
Net After
Period Tax Cash 12% 14% at 12% at 14%
Flow
0 -$6,000 1.0 1.0 -$6,000 -$6,000
1-4 +1,500 3.03735 2.91371 +$4,556 +$4,371
5 +3,000 .56743 .51937 +$1,702 +$1,558
Net Present Value (NPV) = +$258 - $71

The Table above shows that at a 12 percent discount rate, the NPV is still positive, but at 14
percent it is negative, and thus the IRR is bracketed between 12 and 14 percent.

Problems with IRR:

Addition to problems associated with calculating an IRR; there are several other issues with
which the user should be aware. First, if the series of cash flows has more than one sign

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reversal (changes from a positive to negative cash flow, or vice versa) then there are
multiple solutions. For example, there are two sign changes in the following series of cash
flows (Table 4 below) and thus we have two IRRs, in this case equal to 25% and 400%.

Table: Multiple IRRs Illustrated

Time Cash Flow
0 -4,000
1 +25,000
2 +25,000

In fact, according to Descartes rule of signs, there are as many roots (solutions) as there are
changes in signs, so a problem with 4 sign reversals would have 4 different solutions. To deal
with this issue, a modified internal rate of return, or MIRR, is often used. Under this
approach, all negative cash flows are first treated as a single problem and placed into an
equivalent negative single present value.
Then, all positive cash flows are treated as a single problem and represented as a single
positive future value. Finally, NPV methods are applied to the two values – the negative
single initial value and the positive single future value as though these were the only two
cash flows and therefore having only one solution. Note that to use the MIRR approach, a
discount rate is needed in the first stage to compute the single positive and negative values.
It is suggested that the firm’s cost of capital be used for this stage to compute both the
present value of the cash outflows and the future value of the positive cash flows. Denoting
the present value of the cash outflows as P0 - and the future value of the positive cash flows
as Pn +, the MIRR is the discount rate, r, that solves: Po-(1+r)n = Pn+
The MIRR is also used in cases where the IRR is unrealistically influenced by the assumption
that the cash flows can be reinvested in the project at the same long-run rate of return. In
this case, using the MIRR approach is useful because a lower, often more realistic cost of
capital is used to first convert cash flows to a future value that is then used to solve for an
MIRR assuming that cash flows are taken out of the project and employed elsewhere in the
firm at a return equal to the discount rate. In fact, according to Descartes rule of signs, there
are as many roots (solutions) as there are changes in signs, so a problem with 4 sign
reversals would have 4 different solutions. To deal with this issue, a modified internal rate of
return, or MIRR, is often used. Under this approach, all negative cash flows are first treated
as a single problem and placed into an equivalent negative single present value. Then, all
positive cash flows are treated as a single problem and represented as a single positive
future value. Finally, NPV methods are applied to the two values – the negative single initial

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Time Value of Money Affects Investments and Financial Decisions
value and the positive single future value as though these were the only two cash flows and
therefore having only one solution. Note that to use the MIRR approach, a discount rate is
needed in the first stage to compute the single positive and negative values. It is suggested
that the firm’s cost of capital be used for this stage to compute both the present value of
the cash outflows and the future value of the positive cash flows. Denoting the present
value of the cash outflows as P0 - and the future value of the positive cash flows as Pn+, the
MIRR is the discount rate, r that solves:
P0-(1+r)n = Pn +
The MIRR is also used in cases where the IRR is unrealistically influenced by the assumption
that the cash flows can be reinvested in the project at the same long-run rate of return. In
this case, using the MIRR approach is useful because a lower, often more realistic cost of
capital is used to first convert cash flows to a future value that is then used to solve for an
MIRR assuming that cash flows are taken out of the project and employed elsewhere in the
firm at a return equal to the discount rate.
Table: Illustration of Non Existent IRR
Time Cash Flow 10% Present Value Present Value
Factor
1 1000 .90909 909.09
2 3000 .82645 2,479.35
3 3000 .75131 2,253.93
Net Present Value 5,642.37
IRR NA

A third issue in interpreting IRR is that of borrowing versus lending or investing. Consider
the following projects A and B, with cash flows as shown in Table.
Table: IRRs under Lending versus Borrowing
Cash Flows at: NPV at:

Project t=0 t=1 IRR 10 percent

A -2,000 +2,400 +20% $181.82
B +2,000 -2,400 +20% -181.82

Notice each project has an IRR of 20%, but A has a positive NPV while B has a negative NPV.
Project A represents an investment which is, in essence, lending money at a rate of 20%.
When lending 32 money, the highest IRR is preferred. For Project B is in essence a case of
borrowing with a positive cash flow today followed by the repayment at time 1. In this case,

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Time Value of Money Affects Investments and Financial Decisions
the IRR indicates an interest rate on borrowed money of 20%. When borrowing, the lowest
IRR is preferred. The point is that the IRR alone does not indicate whether the project is a
“borrowing” or “lending” style investment, a fact which can lead to confusion on how to
interpret the IRR number.

TIME VALUE OF MONEY AND CAPITAL BUDGITING

Capital Expenditures:
Whenever we make an expenditure that generates a cash flow benefit for more than one
year, this is a capital expenditure. Examples include the purchase of new equipment,
expansion of production facilities, buying another company, acquiring new technologies,
launching a research & development program, etc., etc., etc. Capital expenditures often
involve large cash outlays with major implications on the future values of the company.
Additionally, once we commit to making a capital expenditure it is sometimes difficult to
back-out. Therefore, we need to carefully analyze and evaluate proposed capital
expenditures.

Stages of Capital Budgeting Analysis:

Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets
that provide cash flow benefits for more than one year. We are trying to answer the following
question:

Will the future benefits of this project be large enough to justify the investment given the risk
involved?

It has been said that how we spend our money today determines what our value will be
tomorrow. Therefore, we will focus much of our attention on present values so that we can
understand how expenditures today influence values in the future. A very popular approach to
looking at present values of projects is discounted cash flows or DCF. However, we will learn that
this approach is too narrow for properly evaluating a project. We will include three stages within
Capital Budgeting Analysis:

 Decision Analysis for Knowledge Building

 Option Pricing to Establish Position

 Discounted Cash Flow (DCF) for making the Investment Decision

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Time Value of Money Affects Investments and Financial Decisions
KEY POINT  Do not force decisions to fit into Discounted Cash Flows! You need to go
through a three-stage process: Decision Analysis, Option Pricing, and Discounted Cash
Flow. This is one of the biggest mistakes made in financial management.

Conclusion
The topic which was assign was “How Time Value of Money Affects Investments and
Financial Decisions in Financial Management“

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Time Value of Money Affects Investments and Financial Decisions
The time value of money is the value of money figuring in a given amount of interest earned
over a given amount of time. The time value of money is the central concept in finance
theory. Some standard calculations based on the time value of money are Present value,
Present value of an annuity, Present value of a perpetuity, Future value and Future value of
an annuity.
Where finance investment is putting money into something with the expectation of gain
that upon thorough analysis has a high degree of security for the principal amount, as well
as security of return, within an expected period of time.
So, any organization of having any type of business can calculate its future worth of
investments by Time value of money and can make its operations more efficient and
effective.
So, by using Time value of Money concepts, any organization can make good and accurate
decisions.

Recommendation

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Time Value of Money Affects Investments and Financial Decisions

I recommend some things for all type of organizations,

 Every organization should have to calculate its investment worth before investing
by using different formulas of Time value of Money
 Every organization should have to analyze its capital budgeting by using Time value
of money techniques.
 Should have to take steps for cost saving by using Time value of Money.
 Should have to apply Time value of money concept in segments in the whole
organization.

Reference
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Time Value of Money Affects Investments and Financial Decisions

www.slideshare.com

http://www.googler.com.pk/

http://www.business.com.pk/

http://en.wikipedia.org/wiki/

http://www.scribd.com/doc/24651033/

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