Time Value of Money

Time value of money is central to the concept of finance. This concept recognizes that money has time value. Value of money is different at different points of time. A rupee today is more valuable than a rupee tomorrow. The difference in the value of money at present and the value of money in future is referred to as time value of money.

Reasons for the difference in the value of money at different points of time
o

Presence of inflation: Inflation is defined as the rise in the prices of goods, leading to a reduction in the value of money. The prices of goods & services increases with time. Hence, a lesser quantity of the same goods can be bought in the future than at present. The presence of inflation makes money more valuable today than tomorrow.

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o

o o

Preference of individual for current consumption over future consumption: The second reason for the change in the value of money is the preference of individuals to consume now than later. Each individual wants to fulfill all his needs today rather than in future. But consumption is postponed in the hope of having more in the future. This sacrifice of present consumption in favour of having more tomorrow must have some value.

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Investment opportunities money grow with time:

that

make

the

o o

Money has time value because capital can be put to productive use, if it is not consumed now. Like any other commodity, money is too scarce. The additional money with one company can be used by another who requires finance. Hence, the lending company can derive some benefit from that idle money by charging some interest on the borrower.

Uses of Time Value of Money

This concept is used in valuation of financial securities such as bonds, shares etc. It is used in corporate finance in the areas of valuation of firms, capital budgeting and mergers & acquisitions.

It is also used in personal finance such as determining installments of loans in leasing etc.

Suppose you invest Rs. 100 for 3 years in a savings account that pays 10% interest per year. If you reinvest your interest income, your investment will grow as follows: I Year: Principal = 100, Interest = 10% Principal at the end = 100 (1 + 10/100) = 100 (1 + .10) = 100 x 1.1 = 110

Future Value of a Single Amount

Contd
II Year: Principal = 110, Interest = 10% Principal at the end = 110 (1 + 10/100) = 110 (1 + .10) = 110 x 1.1 = 121 III Year: Principal = 121, Interest = 10% Principal at the end = 121 (1 + 10/100) = 121 (1 + .10) = 121 x 1.1 = 133.1

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The process of investing money as well as reinvesting the interest earned on it is called COMPOUNDING. FVn = PV (1+ r)n FVn = Future Value after n years or Compounded Value PV = Present Value (1+ r)n = Future Value Interest Factor or Future Value Factor

Present Value of a Single Amount

Suppose someone promises to give you Rs. 1000, 3 years later. What is the present value of this amount if the interest rate is 10%? Value 3 years later = 1000 Value 2 years later = 1000 / (1 + 10/100) = 1000 (1/1.10) Value 1 year later = 1000 (1/1.10) (1/1.10) Value now = 1000 (1/1.10) (1/1.10) (1/1.10)

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The process of DISCOUNTING, used for calculating the present value is simply the inverse of Compounding.
PV = FVn (1 + r)n

Future Value of an Annuity

An annuity is a stream of constant cash flows (Payments or Receipts) occurring at regular intervals of time. E.g. The premium payments of a life insurance policy are an annuity. When the cash flows occur at the end of each period, the annuity is called an ordinary annuity or a deferred annuity. When the cash flows occur at the beginning of each period, the annuity is called an annuity due. FVAn = A [ (1 + r)n - 1] r

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Ques. Suppose you deposit Rs. 1000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10%. What will be the value of this series of deposits at the end of 5 years? Ans. 6105.1

Present Value of an Annuity

PVAn = A [ 1 (1/(1 + r)n)] r

Concept of Risk and Return

The concept of risk & return needs to be understood simultaneously. They are the most critical factors in investment decisions.

The firms need to evaluate the returns that a particular project can offer and this process of evaluation must necessarily consider the risk associated with the project.

Return
Return on financial assets is the dividend / interest of holding the security and capital gains. Capital gain is the difference between the prices at the beginning and at the end of the holding period.

Return on investment is divided into two parts 1. The reward that the investor gets by owning the asset over the holding period, referred as Dividend Yield. 2. The gain that the investor makes upon selling the asset after the holding period, referred to as Capital Gain.

Contd

Total Return = Dividend Earned + Capital Gain

Total % Return = Dividend + Capital Gain x 100 Initial Investment = D1 + (P1 P0) x 100 P0 = [D1 + (P1 P0)] x 100 P0 P0

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Example Current Market Price of a share is Rs. 300. An investor buys 100 shares. After 1 year, he sells these shares at a price of Rs. 360 and also receives a dividend of Rs. 15 per share. Find out the dividend earned, capital gain, total return & total % return.

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Solution: Initial Investment = 300 x 100 = 30000 Dividend Earned = 15 x 100 = 1500 Capital Gain = (360 300) x 100 = 60 x 100 = 6000 Total Return = 1500 + 6000 = 7500 Total % Return = 1500 + 6000 x 100 30000 = 25%

Risk

Risk is the variability of actual return from the expected return associated with a given asset / investment.

The greater the variability, the riskier the security is said to be. E.g. Shares

Types of Risk

Systematic Risk: It refers to that portion of total risk which is caused by the factors affecting the prices of all securities. E.g. If the economy is moving towards a recession, stock prices may also decline across a broad point. Economic, Political & Sociological changes are sources of systematic risk.

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o

This risk is uncontrollable as it is external to the firm. Systematic Risk is of three types:

Market Risk 2. Interest Rate Risk 3. Purchasing Power Risk / Inflation Risk
1.

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Unsystematic Risk: o It is that portion of total risk which is unique to a firm or industry. o Unsystematic factors are largely independent of factors affecting securities market. o It is controllable in nature as it is internal to the firm. o Unsystematic risk is of two types:
1. 2.

Business Risk Financial Risk

Cost of Capital
The term Cost of Capital is defined as the minimum rate of return that a firm must earn on its investments so that the market value of the firm remains unchanged. Hence, it is a yardstick or basis of approval or rejection of an investment. In this way, it becomes a target rate of return, cut off rate, borrowing rate, hurdle rate or the financial standard of assessment of performance of a project.

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According to Solomon Ezra, Cost of Capital is the minimum required rate of earnings or the cut off rate for capital expenditure. According to James C. Van Horne, The cost of capital represents a cut off rate for the allocation of capital to investment of profits. It is the rate of return on a project, that will leave unchanged the market price of the stock. This concept can also be expressed in terms of opportunity cost of capital.

Importance of Cost of Capital Designing an optimal Capital Structure:

This concept is very helpful in designing a sound, optimal and economical capital structure of the firm. o Capital structure of a company consists of different sources of capital such as preference share capital, equity capital, debentures, retained earnings etc. and these sources differ from each other in terms of their respective costs.
o

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Helpful in taking Investment Decisions:

This concept is very helpful in making investment decisions because cost of capital is the minimum required rate of return on an investment project.
A firm must not invest in those projects which generate a return less than the cost of capital incurred for its financing.

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For evaluating the financial information:

This concept is used to evaluate the financial performance of the top management of an organization. o This evaluation involves the comparison of actual profitability of the investment project with the project overall cost of capital of funds. o If actual profitability is more than the projected cost of capital, then the financial performance may said to be satisfactory.
o

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Deciding about the method of financing:

A capable finance manager must have the knowledge of fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, the finance manager may have a better choice of the source of finance which bears the minimum cost of capital.

Explicit & Implicit Cost

The cost of capital can be either Explicit or Implicit. Explicit Cost is the rate of return that the firm pays to procure financing. It is thus, the cost of raising funds. Implicit Cost of capital is the rate of return associated with the best investment opportunity for the firm and its shareholders. It is, thus, the cost of using the funds.

Measurement of Cost of Capital or Components of Cost of Capital

Measurement of Cost of Capital involves two steps: Calculation of the Cost of Individual Sources of Funds, that is, Specific Costs and
Calculation of Weighted Average Cost of Capital

1.

2.

Calculation of the Cost of Individual Sources

It includes: Cost of Debentures (Debt) Cost of Preference Share Capital

1.

2.

3.

Cost of Equity Share Capital

Cost of Retained Earnings

4.

Cost of Debt

Debentures can be issued (a) at par (b) at premium and (c) at discount.

Debt Capital is of two types: 1. Perpetual Debt / Irredeemable debt o These are the debts which are repayable only on the liquidation of the company.

2. Redeemable Debt o It is a debt which is redeemed after a certain period of time.

Cost of Preference Share Capital

Preference Shares are also fixed cost bearing securities like debentures. The rate of dividend payable on these shares is fixed. Preference Shares can also be issued (a) at par (b) at premium and (c) at discount.
1. 2.

Preference Shares are of two types: Perpetual / Irredeemable Preference Shares Redeemable Preference Shares

Cost of Equity Share Capital

Cost of Equity Share Capital is the rate of return on investment that is required by the companys ordinary shareholders. It can be calculated in the following ways: Dividend Yield Method Dividend Yield + Growth in Dividend Method Earning Yield Method

1. 2. 3.

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Dividend Yield Method: This method is based on the assumptions that when an investor invests in the equity shares of a company, he expects to get payment equivalent to the rate of return prevailing in the market. Dividend Yield + Growth in Dividend Method: When the dividends of the firm are expected to grow at a constant rate, this method is used to compute the cost of equity capital. Earning Yield Method: This method gives a relationship between Earning Per Share & Current Market Price of the share.

Cost of Retained Earnings

Retained Earnings involve opportunity cost. A firm is required to earn on the retained earnings at least equal to the rate that would have been earned by the shareholders if they were distributed to them.

Calculation of WACC

Weighted Average Cost of Capital (WACC) is the rate that a company expects to pay to finance the assets. WACC is calculated taking into account the relative weights of each component of the capital structure. A firms WACC is the overall required rate of return on the firm as a whole.

Steps involved in computation of WACC

1.

2.

3.
4.

5.

Determination of the type of funds to be raised and their individual share in the total capitalization of the firm. Computation of cost of specific sources of funds. Assignment of weight to specific costs. Multiply the cost of each source by the appropriate assigned weights to get the weighted cost. Finally, weighted cost of all sources of capital as calculated in Step 4 are added together to get an overall WACC.

Assignment of Weights

Weights are assigned to specific sources of funds on the basis of following weights
Book Value Weights: Book Value is the accounting value of a firm. It is the total value of the companys assets that shareholders would theoretically receive if a company was liquidated. Book Value Weights are based on the values found on the balance sheet. Market Value Weights: Market Value is the current quoted price at which investors but or sell a common share or a debenture at a given time. Marginal Weights: According to this approach, each specific costs are assigned weights in proportion of funds to be raised from each source to the total funds to be raised.

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2.

3.

Valuation of Stocks and Bonds

BOND
A bond is a long term debt instrument which is treated as a fixed income security having a fixed rate of interest and a defined maturity period. If a bond is issued by a private firm / corporate, it is known as debenture. The par value of the bond indicates the face value of the bond i.e. the value stated on the bond paper.

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Generally the face value of bonds are Rs. 1,000, 2,000, 5,000 and so on. Bonds make fixed interest payment till the maturity period. This specific rate of interest is known as coupon rate. Valuation of a bond means to find out the Yield of the bond as per the time value of money.

 Interest Default

Risks associated with a Bond

Rate Risk Risk Risk

Marketability Callability

Risk

Bond Return

Holding Period Return An investor buys and sells it after holding for a period. The rate of return in that holding period is:

Holding Period Return =

Price Gain or Loss during the holding period + Coupon Interest Rate (if any) Price at the beginning of the holding period

The holding period rate of return is also called the one period rate of return.

Yield to Maturity (YTM)

Yield to Maturity (YTM) is the most widely used measure of return on bonds. YTM is the rate of return an investor earns on a bond held till maturity. It may be defined as the compounded rate of return an investor is expected to receive from a bond purchased at the current market price and held to maturity. It is really the internal rate of return earned from holding a bond till maturity.

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YTM depends upon the cash outflow for purchasing the bond, that is, the cost or current market price of the bond as well as the cash inflows from the bond, namely the future interest payments and the end principal repayment. t MP = Ct + TV i = 1 (1 + YTM)t (1 + YTM)n

Where,

Contd
YTM = C + (P or D / years to maturity) (P0 + F) / 2 where, YTM = Yield to Maturity C = Coupon Rate P or D = Premium or Discount P0 = Present Value F = Face Value