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| TIME VALUE OF MONEY |
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Today’s rupee is not equal to tomorrow’s rupee. This is what we find in first lesson of any financial management book and this is where the financial management subject revolves.
So let me also start from the same good old story.
So why today’s rupee is not equal to that of tomorrow ?? This is due to the following three factors:-
So what do you mean by above three factors now???
Okk then let me explain them using some silly examples:- Your friend offered you 1 rupee today or one rupee after one year .Now what will you prefer ??? It depends on the following components. Inflation:- Due to inflation the purchasing power of our money will decrease.
For example we used to get 2 pani puries for 1 rupee a couple of
years back but now we only get 1 and in future may be none …….
We can term this as inflation effect and due to this u prefer to
have the rupee now. Risk:- If u take the rupee today you will have cash in your hand now but if you will not take it today u have risk of not getting it in future.
Say if you have preferred to have the rupee next year and at
that time your friend gone on a date with his girl friend where
he utilized the rupee
Opportunity:-
If you can get the rupee now then you will have an opportunity
to invest it somewhere and get some return on it. You may even
earn corers of rupees from it like that of Rajanikanth in the
movie sivaji. So you should prefer the rupee now.
So duo to these things (not the examples but the 3 factors This premium is called the return. Return may be in the name of Interest, Dividend or else Capital Gains. So whenever you are investing a particular rupee some where you will expect some rate of return. This is the called the expected rate of return on the point of view of investor and cost of capital on the point of view of the borrower of our investment.
Now the rate of return again depends of three factors which is as follows:-
Risk free rate is generally the rate of interest/return you can earn by depositing/investing your money in secured government securities or deposits where you are fully guaranteed of your investment. Inflation premium is the premium you expect to compensate the depreciation in rupee value due to inflation which we had discussed previously. Risk premium refers to the premium you want to earn by taking the risk of investing the rupee. Means by investing it on non secured investment or project you will have risk of losing your money/investment due to many reasons like failure of project, Insolvency, Political or regional disturbances natural calamities etc.. or even the situation I mentioned earlier.. So now rate of return = Risk free rate (Rf) + Inflation premium + Risk premium Now let us move towards the word rate (or else interest) There are two types of interest rates:
Simple rate:-This is computed on the principal/investment for entire period of borrowing/investment i.e principal or investment is same for any number of years. This is calculated by:- S.I = pnr and A=p(1+nr) p-Principal A-amount n-number of years r-rate of return Compound rate:-In this type interest/return earned by an investment is reinvested so that the reinvested amount also yields some return. C.I=p[(1=r)n -1] A=p(1=r)n Remember the above two methods assumes amount of return is even i.e we get same rate of return at any period and there will be no uneven cash flows.
Effective Rate:- Effective rate represents the rate of return actually being earned means equivalent annual rate of interest at which an investment grows in value when interest is actually being compounded. We can also term this as the flat rate … For example if the interest is 10% payable quarterly then the effective interest rate will be (1+0.1/4)4-1= 10.38% nominal interest So the formula can be given by: E=(1+periodic rate)m-1 (periodic rate = interest rate/m). Now we came to know that due to the first stated 3 reasons the rupee today is defiantly not equal to the rupee tomorrow and we expect certain rate of return on it if we want to take it in future and we have also studied that on which factors the rate of return will depend. Now let us proceed further and study how to calculate the present value or the future value of the given amount Future Value of single amount:- You have deposited some amount in bank say PV or you have lended it to your friend for n years at an interest rate of i% now at the nth year what would be the value of your amount? It is given by Future value = PV(1+i)n Present value of a single amount:- Your friend said you that he will give you an amount FV after n number of years, and presently the expected rate of return or interest is i% . Now what amount will compensate the FV if it had to be given now??? It is like this Present value(PV)= FV/(1+i)n ANNUITY An annuity is a series of regular & equal periodic payment made or received for a specified period of time. Loan installments, recurring deposit with the bank, Lic premium etc are typical examples of an annuity.
Annuity vs Annuity due:- Let me take another common example to explain this thing. All of must have got a mobile phone right ??? Then Ordinary annuity or simply annuity is a post paid mobile Where as the annuity due is a prepaid mobile.. Mean in annuity payment is made @ end of period where as in annuity due payment are made at the beginning of period. But remember unlike my mobile bill example the payments made at every period in an annuity should b equal . Calculation of a present amount of annuity :- Amount (A) = P x [(1+i)n-1/i] n-number of years, i-interest, p-periodic payments Calculation of present amount of an annuity due :- Amount of annuity due = amount of ordinary annuity + interest thereon for 1year.
Perpetuity:- An unending series of annuity. Means they never stop. Its given by:- PVp=Annual cash flow/r r-rate of interest.
WILL BE CONTINUED IN NEXT ARTICLE -CAPITAL BUDGETING.. |
…..and
you are given with a hand.
That is why it is better to have the rupee now._32x32.png){kind=small}
THANKS FOR READING
------------------------PAVAN KUMAR
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