Time Value Money
The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity
Why Time Value of Money Exists- Reasons
- Risk and uncertainity
- Inflation
- Consumption
- Investment
Application
- Investment decisions
- Capital Budgeting decisions
- Applied in present and future value calculation
- Bond Evaluation
- Stock Evaluation
- Accept/Reject decisions for Project Management
- Financial Analysis of Firms
Capital Budgeting
- Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization’s long term investments.
- It is the process of allocating resources for major capital, or investment, expenditures
- It is process of deciding whether to invest or not to invest in a particular asset, the benefit of which will be available over a period of time.
- Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment
Types of Projects or Long term Investment Decision
- New projects
- Expansion projects
- Diversification Projects
- Replacement and Modernisation Projects
- Research and Development Projects
Significance of Capital Budgeting
- Long term Decision
- Irreversible Decision
- Huge Investments
- Growth
- Selecting profitable projects
- Capital expenditure control
- Finding the right sources for funds
Types of Capital Budgeting Decision
- Accept-Reject Investment Decisions - accept or reject the project
- Mutually Exclusive Investments Decisions - projects that compete with each other
- Capital Rationing Investment Decisions - projects fight for funding due to limited funds
Process of Capital Budgeting
- Searching of Investment Opportunities
- Evaluation or Analysis
- Selection of Project
- Financing the Project
- Execution or Implementation
- Review of the Project
Methods of Capital Budgeting or Evaluation Criteria
- Traditional Methods or Non Discounted Cash flow
- Payback Period - initial investment / annual cash flow
- Accounting rate or return method
- Discounted Cash Flow Method or Modern Method
- Net Present Value Method
- Profitability Index Method
- Internal Rate of Return Method
Merits of Payback period
- Easy and Simple Method
- Liquidity is emphasized
- Useful in Case of Uncertainty.
Limitation of Payback period
- Ignores the returns generated after the payback period
- Ignores the Time Value of Money
- It overlook cost of capital or interest factor
- It Ignore the risk of future cash flows
Investment Evaluation Criteria
- Estimation of cash flows
- Estimation of the required rate of return
- Application of a decision rule for making the choice
Discounted Cash Flow Techniques
- Considered to be the best method to evaluate the investment The cash inflows and outflows are calculated proposals
- The cash inflows and outflows are calculated
- These cash inflows and outflows are then discounted at an appropriate discount rate
- The difference between the discounted cash inflow and discounted cash outflow is calculated
Net Present Value (NPV)
- In NPV technique the profitability of investment proposal is measured through the difference between the cash inflows generated out of the cash outflows or the investments made in the project.
- Net Present Value = PVCI (inflow)– PVCO (outflow)
- Decision Criteria
- If the net present value is greater than zero, the proposal has to be accepted.
- If the net present value is less than zero, the proposal has to be rejected.
Profitability Index or Benefit- Cost ratio
Profitability Index measures the present value of returns derived from per rupee invested. It shows the relationship between the benefits and cost of the project and therefore it is called as Benefit-cost ratio PI = present value of cash flow / present value of cash outflow PI = (NPV + initial investment) / initial investment
Merits of NPV
- Consider time value of money.
- Consider all cash flows over the entire project life
- It helps to make a comparative assessment of different projects
Limitation of NPV
- The application or usage of this method requires the knowledge of rate of cost of capital. If cost of capital is unknown, this method cannot be used.
- Determining an appropriate discount rate is difficult in this method.
- This method does not indicate the rate of return which is expected to be earned.
- This method may fail to give satisfactory answers when the projects are requiring different level of amount of investment and with different economic life of the project.
Merits of PI
- It consider time value of money.
- It considers all cash inflows
- It is recommended for use particularly when there is shortage of funds, because it correctly ranks the proposals.
- It makes right decision in the case of different amount of cash outflow of different project.
Limitations of PI
- May lead to incorrect decisions in comparisons of mutually exclusive investments.
- Cost of capital is required to calculate PI.
Accounting rate of return
The Accounting Rate of Return (ARR) is a financial metric used to evaluate the profitability of an investment or project. It measures the expected annual return as a percentage of the initial investment or average investment cost, based on accounting profits (net income) rather than cash flows.
Formula
[ ARR = \frac{\text{Average Annual Accounting Profit}}{\text{Initial Investment (or Average Investment)}} \times 100 ]
- Average Annual Accounting Profit: Total profit over the project’s life divided by the number of years.
- Initial Investment: The total cost of the investment.
- Average Investment: (Initial Investment + Salvage Value) / 2, if used instead of initial investment.
Merits of ARR
- Simplicity:
- Focus on Profitability:
- Useful for Comparisons:
- Incorporates Entire Project Life:
- Familiar to Managers:
Demerits of ARR
- Ignores Time Value of Money:
- Based on Accounting Profits, Not Cash Flows:
- Inconsistent Definitions:
- Ignores Risk and Uncertainty:
- No Clear Acceptance Criterion:
- May Encourage Short-Term Focus:
The image lists three Modern Methods of Discounted Cash Flow (DCF) used for investment appraisal: Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI). Below is an explanation of each method, along with their merits and demerits in points.
Net Present Value (NPV) Method
Explanation: NPV calculates the present value of a project’s cash inflows minus the present value of cash outflows, discounted at a specific rate (usually the cost of capital). A positive NPV indicates the project adds value.
Merits:
- Accounts for Time Value of Money: Discounts future cash flows to reflect their present value.
- Focuses on Absolute Value: Measures the actual value added by the project in monetary terms.
- Considers All Cash Flows: Incorporates cash flows over the entire project life.
- Clear Decision Rule: Accept if NPV > 0; reject if NPV < 0.
- Risk Adjustment: Discount rate can be adjusted to account for project risk.
Demerits:
- Requires Discount Rate: Needs an accurate cost of capital, which can be hard to estimate.
- Complexity: Involves detailed cash flow projections and discounting, which can be time-consuming.
- Ignores Scale: Does not consider the relative size of the investment (e.g., a smaller project may have a lower NPV but higher return rate).
- Assumes Reinvestment at Discount Rate: Assumes cash flows are reinvested at the discount rate, which may not be realistic.
Internal Rate of Return (IRR) Method
Explanation: IRR is the discount rate that makes the NPV of a project zero. It represents the project’s expected rate of return. If IRR exceeds the cost of capital, the project is accepted.
Merits:
- Time Value of Money: Like NPV, it accounts for the time value of cash flows.
- Percentage-Based: Provides a rate of return, making it easy to compare with the cost of capital or other projects.
- No Need for Discount Rate Upfront: Calculates the break-even rate internally.
- Considers All Cash Flows: Includes cash flows over the project’s entire life.
Demerits:
- Multiple IRRs: Can produce multiple IRRs for projects with unconventional cash flows (e.g., alternating inflows and outflows).
- Assumes Reinvestment at IRR: Assumes cash flows are reinvested at the IRR, which may be unrealistically high.
- Conflicts with NPV: May rank projects differently from NPV, especially for mutually exclusive projects.
- Complex Calculation: Requires trial-and-error or software to compute, as it’s not a direct formula.
Profitability Index (PI) Method
Explanation: PI (also called the benefit-cost ratio) is the ratio of the present value of cash inflows to the initial investment. A PI greater than 1 indicates the project is profitable.
Formula: [ PI = \frac{\text{Present Value of Cash Inflows}}{\text{Initial Investment}} ]
Merits:
- Time Value of Money: Discounts cash flows to their present value.
- Relative Measure: Useful for comparing projects of different sizes, as it measures return per unit of investment.
- Complements NPV: A PI > 1 aligns with a positive NPV, reinforcing decision-making.
- Useful for Capital Rationing: Helps prioritize projects when funds are limited.
Demerits:
- Requires Discount Rate: Like NPV, it depends on an accurate cost of capital.
- Ignores Absolute Value: A high PI doesn’t show the total value added (e.g., a small project may have a high PI but low overall benefit).
- Less Intuitive: Not as widely understood as NPV or IRR for decision-making.
- May Conflict with NPV: For mutually exclusive projects, PI may rank projects differently from NPV.