TIME VALUE OF MONEY

Money has time-value because value of money changes over time:

• Due to inflation, money has higher purchasing power today than tomorrow
• We can employ a Rupee today to earn interest
• We prefer current to future consumption
Understanding Annuities
 An annuity is a series of equal payments made at the end of equidistant points in time
such as annually, over a finite period of time
 If payments are made at the end of each period, the annuity is referred to as ordinary
annuity.
Effective Annual Rate
• EAR is the actual rate on a deposit after taking into account the number of times
interest is paid during a year
• More frequent the compounding periods, higher the EAR
EAR = (1+r%/n)n - 1
Eg: EAR of 12% paid semiannually: (1+12%/2)2 - 1 = 12.36%
• Compounding an investment n times a year for t years gives a future value of: FV =
PV (1+r%/n)nt
• For example, if you invest Rs.500 for 3 years at 12% compounded semi-annually, it
will grow to: 500 (1+6%)6 = 709
• Compounded annually, Rs.500 would have grown to:
500 (1+12%)3 = 702
Annuity Due
• In annuity-due, payments are made at the beginning of the periods
• Hence the PV (FV) of each payment of annuity-due is (1 + i) times the PV (FV) of the
corresponding payment in an ordinary annuity
• PV of an annuity due is hence (1+i%) x PVIFAi%,y
• FV of an annuity due is hence (1+i%) x FVIFAi%,y
Financial Management
 Involves acquisition and use of funds by a firm
 Goals of Financial Management
• Profit Maximization (PAT)
• Maximizing EPS (shareholder wealth)
 Financial Management decisions concern:
 • Capital Budgeting: Investment in long term projects
• Capital Structure: Funding of projects
• Working Capital: Investment in short term projects
• Dividend: How much dividends to declare

CAPITAL BUDGETING
What is the cost of capital?
 Firm’s overall cost of financing
 WACC: average post-tax cost of debt, equity, preferred stock
 It is the discount rate used to analyze an investment
 Helps determine required return for projects
Capital budgeting
 Process by which a business evaluates investments or projects
 An initial expenditure (cost) is involved
 Evaluation involves comparing future benefits with initial costs
 Future benefits = Cash Flow (PAT + Depr)
 Economic life of the equipment is considered
Capital budgeting tools
 Discounted Payback Period (DPP)
 Net Present Value (NPV)
 Internal Rate of Return (IRR)

All of the above compare discounted Cash Flows (PAT + Depr) with Initial Investment
Discounting Payback Period
 Time taken to cover the initial expenditure
 Future Cash Flows are discounted to time 0 
 Let’s take an example with cash flows for 5 years, assuming a 10% cost of capital and
Rs.5,000 initial expenditure
Problem with DPP
 DPP ignores the post payback period cash flows
 Cannot determine whether the investment will increase the firm's value or not
Net present value
 NPV is calculated as the difference between PV of cash inflows & PV of cash
outflows
 An investment with a positive NPV will be  profitable, while one with a negative NPV
will result in a loss 
 Hence, only investments with positive NPV should be undertaken
Ranking of Projects: Profitability Index
 PI is a relative measure of a project, unlike NPV which is an absolute measure
 PI is used to rank mutually exclusive projects

PI =     PV of expected cash inflows

 Initial cost of project

 PI indicates profit per Rupee of initial cost

 PI higher than 1.0 implies positive NPV
 PI lower than 1.0 implies negative NPV
 Project with the highest PI is desirable
Internal Rate of Return
 IRR is the rate generated by a project (compounding or discounting rate)

 It is the percentage earned on each rupee invested in a project

 IRR assumes that a project’s cash flows are reinvested at the IRR itself

 A project with an IRR greater than its cost of capital (ie the hurdle rate) is a profitable
one
To calculate IRR, set NPV equal to zero and solve for the discount rate r, which is the IRR
Problems with IRR
 A project with a higher IRR can sometimes result in lower NPV
 Impractical assumption of reinvesting in the project
 IRR cannot distinguish between borrowing and lending
 Unconventional project cash flows can result in multiple IRRs
 Cannot compare projects of different size using IRR

Mutually Exclusive Projects is the term which is used generally in the capital budgeting
process where the companies choose a single project on the basis of certain parameters out of
the set of the projects where acceptance of one project will lead to rejection of the other
projects.
What is the difference between independent and mutually exclusive projects?
Independent projects: if the cash flows of one are unaffected by the acceptance of the other.
Mutually exclusive projects: if the cash flows of one can be adversely impacted by the
acceptance of the other.
Whenever an NPV and IRR conflict arises, always accept the project with higher NPV.
It is because IRR inherently assumes that any cash flows can be reinvested at the internal rate
of return. This assumption is problematic because there is no guarantee that equally profitable
opportunities will be available as soon as cash flows occur. The risk of receiving cash flows
and not having good enough opportunities for reinvestment is called reinvestment risk. NPV,
on the other hand, does not suffer from such a problematic assumption because it assumes
that reinvestment occurs at the cost of capital, which is conservative and realistic.
Salvage value is the estimated book value of an asset after depreciation is complete, based on
what a company expects to receive in exchange for the asset at the end of its useful life. As
such, an asset's estimated salvage value is an important component in the calculation of a
depreciation schedule.
TVM MCQ
1. Finding the present value is simply the reverse of compounding. T
2. The present value interest factor (PVIF) is the reciprocal of the future value interest factor
(FVIF). T
3. If the discount rate decreases, the present value of a given future amount decreases. F
4. If you would like to double your money in 8 years, the approximate compound annual
return you need is 9 percent (Rule of 72). T
5. A saving account at Bank A pays 6 percent interest, compounded annually. Bank B's
savings account pays 6 percent compounded semiannually. Bank B is paying twice as much
interest. F
6. All other things being equal, I'd rather have $1,000 today than to receive $1,000 in 10
years. T
7. For a given nominal interest rate, the more numerous the compounding periods, the less the
effective annual interest rate. F
8. If money has a time value, then the future value will always be more than the original
amount invested. T
9. All other things remaining the same, an annuity received at the beginning of each period
has more present value than does one received at the end of each period. T
10. You want to buy an ordinary annuity that will pay you 4,000 a year for the next 20 years.
You expect annual interest rates will be 8 percent over that time period. The maximum price
you would be willing to pay for the annuity is closest to
32,000; 39,272; 40,000; 80,000
11. With continuous compounding at 10 percent for 30 years, the future value of an initial
investment of 2,000 is closest to
34,898; 40,171; 164,500; 328,282
12. In 3 years you are to receive 5,000. If the interest rate were to suddenly increase, the
present value of that future amount to you would
fall; rise; remain unchanged; requires more information
13. You are considering investing in a zero-coupon bond that sells for 250. At maturity in 16
years it will be redeemed for 1,000. What approximate annual rate of growth does this
represent?
8 %; 9%; 12%; 25%
14. To increase a given present value, the discount rate should be adjusted
upward; downward; True; False
15. For 1,000 you can purchase a 5-year ordinary annuity that will pay you a yearly payment
of 263.80 for 5 years. The compound annual interest rate implied by this arrangement is
closest to
8%; 9%; 10%; 11%
16. (1 + i)n
PVIF; FVIF; PVIFA; FVIFA
17. You can use          to roughly estimate how many years a given sum of money must earn
at a given compound annual interest rate in order to double that initial amount.
Rule 415; Rule of 72; the Rule of 78; Rule 144
Capital Budgeting MCQ
1. Capital Budgeting is a part of:
(a) Investment Decision
(b) Working Capital Management
(c) Marketing Management
(d) Capital Structure
2. Capital Budgeting deals with:
(a) Long-term Decisions
(b) Short-term Decisions
(c) Both (a) and (b)
(d) Neither (a) nor (b)
3. Which of the following is not used in Capital Budgeting?
(a) Time Value of Money
(b) Sensitivity Analysis
(c) Net Assets Method
(d) Cash Flows
4. Capital Budgeting Decisions are:
(a) Reversible
(b) Irreversible
(c) Unimportant
(d) All of the above
5. Which of the following is not incorporated in Capital Budgeting?
(a) Tax-Effect
(b) Time Value of Money
(c) Required Rate of Return
(d) Rate of Cash Discount
6. Which of the following is not a capital budgeting decision?
(a) Expansion Programme
(b) Merger
(c) Replacement of an Asset
(d) Inventory Level
7. A sound Capital Budgeting technique is based on:
(a) Cash Flows
(b) Accounting Profit
(c) Interest Rate on Borrowings
(d) Last Dividend Paid
8. In capital budgeting, the term Capital Rationing implies:
(a) That no retained earnings available
(b) That limited funds are available for investment
(c) That no external funds can be raised
(d) That no fresh investment is required in current year
9. Which of the following does not affect cash flows proposal?
(a) Salvage Value
(b) Depreciation Amount
(c) Tax Rate Change
(d) Method of Project Financing
10. Cash Inflows from a project include:
(a) Tax Shield of Depreciation
(b) After-tax Operating Profits
(c) Raising of Funds
(d) Both (a) and (b)
11. Depreciation is incorporated in cash flows because it:
(a) Is unavoidable cost
(b) Is a cash flow
(c) Reduces Tax liability
(d) Involves an outflow
12. Which of the following is not applied in capital budgeting?
(a) Cash flows be calculated in incremental terms
(b) All costs and benefits are measured on cash basis
(c) All accrued costs and revenues be incorporated
(d) All benefits are measured on after-tax basis
13. Capital Budgeting Proposals is based on Cash Flows because:
(a) Cash Flows are easy to calculate
(b) Cash Flows are suggested by SEBI
(c) Cash is more important than profit
(d) None of the above
14. A proposal is not a Capital Budgeting proposal if it:
(a) is related to Fixed Assets
(b) brings long-term benefits
(c) brings short-term benefits only
(d) has very large investment
15. Savings in respect of a cost is treated in capital budgeting as:
(a) An Inflow
(b) An Outflow
(c) Nil
(d) None of the above
16. Internal rate of return is …
a) Rate at which discounted cash inflow is more than discounted cash outflow
b) Rate at which discounted cash inflow is less than discounted cash outflow
c) Rate at which discounted cash inflow equals the discounted cash outflow
d) Either a or b
17. A profitability index (PI) of 0.92 for a project means that __________.
a) project's costs are less than the present value of the project's benefits
b) project's NPV is greater than zero
c) project's NPV is greater than 1
d) project returns 92 paisa in present value for each current rupee invested
18. Which is incorrect regarding a normal project?
a) If the NPV of a project is greater than 0, then its PI will exceed 1
b) If project IRR is 8%, NPV at discount rate more than 8%, will be less than 0
c) If project PI is 0, initial cash outflow equals the PV of its cash flows
d) If project IRR is greater than the discount rate, PI will be greater than 1
19. A project whose acceptance does not prevent or require the acceptance of one or
more alternative projects is referred to as __________.
a) a mutually exclusive project
b) an independent project
c) a dependent project
d) a contingent project
20. Assume that a firm has accurately calculated the net cash flows relating to two
mutually exclusive investment proposals. If the net present value of both proposals
exceed zero and the firm is not under the constraint of capital rationing, then the firm
should __________.
a) calculate the IRRs of these investments to be certain that the IRRs are greater than the cost
of capital
b) compare the profitability index of these investments to those of other possible investments
c) calculate the payback periods to make certain that the initial cash outlays can be recovered
within a appropriate period of time
d) accept the proposal that has the largest NPV since the goal of the firm is to maximize
shareholder wealth and, since the projects are mutually exclusive, we can only take one.