09 Time Value of Money and Investment Decision

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Capital Budgeting and InvestmentDecision

King’s College

King's College, MBA - 2015 1


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Capital budgeting decision

Capital budgeting desc!ibesdecisions "#e!e e$penditu!es and!eceipts %o! a pa!ticula! unde!ta&ing "illcontinue ove! a pe!iod o% time

In ot#e! "o!ds, it is t#e p!ocess in"#ic# a business dete!mines "#et#e!p!o(ects suc# as building a ne" plant o!investing in a long-te!m ventu!e a!e"o!t# pu!suing


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King's College, MBA - 2015 )

Capital budgeting decision

*+pes o% capital budgeting decisionse$pansion o% %acilities because o%g!o"ing demandne" o! imp!oved p!oducts

eplacement - o% plant o! mac#ineslease o! bu+ma&e o! bu+.t#e! i% mandated b+ la"


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/#at is *ime alue/e sa+ t#at mone+ #as a time value becauset#at mone+ can be invested "it# t#ee$pectation o% ea!ning a positive !ate o% !etu!n

In ot#e! "o!ds, a upee !eceived toda+ is"o!t# mo!e t#an a upee to be !eceivedtomo!!o"3 *#at is because toda+4s upee can be invested

so t#at "e #ave mo!e t#an one upeetomo!!o"

King's College, MBA - 2015


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*#e *e!minolog+ o% *ime aluePresent Value - An amount o% mone+ toda+,o! t#e cu!!ent value o% a %utu!e cas# %lo"Future Value - An amount o% mone+ at some

%utu!e time pe!iodPeriod - A lengt# o% time 6o%ten a +ea!, but canbe a mont#, "ee&, da+, #ou!, etc 7

nterest !ate - *#e compensation paid to a

lende! 6o! save!7 %o! t#e use o% %undse$p!essed as a pe!centage %o! a pe!iod6no!mall+ e$p!essed as an annual !ate7

5King's College, MBA - 2015


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*imelines

0 1 2 ) 5

8 9

*oda+

A timeline is a g!ap#ical device used to cla!i%+t#e timing o% t#e cas# %lo"s %o! an investment

:ac# numbe! !ep!esents one time pe!iod

;King's College, MBA - 2015


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Calculating t#e 9utu!e alue


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Cal"ulating t#e Future Value $"ont%&


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ene!ali ing t#e 9utu!e alueecogni ing t#e patte!n t#at is developing, "e can gene!ali e t#e

%utu!e value calculations as %ollo"sFV PV$1 ( r& n

also

I% +ou e$tended t#e investment %o! at#i!d +ea!, +ou "ould #ave

King's College, MBA - 2015


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Compound Inte!est

ote %!om t#e e$ample t#at t#e %utu!e valueis inc!easing at an inc!easing !ateIn ot#e! "o!ds, t#e amount o% interest

ea!ned eac# +ea! is inc!easingEea! 1 s 10Eea! 2 s 11Eea! ) s 12 10

*#e !eason %o! t#e inc!ease is t#at eac# +ea!+ou a!e ea!ning inte!est on t#e inte!est t#at"as ea!ned in p!evious +ea!s in addition tot#e inte!est on t#e o!iginal p!inciple amount



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Calculating t#e 8!esent alue


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8!esent alue An :$ample


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on-annual Compounding


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on-annual Compounding 6cont 7

*o solve t#is p!oblem, +ou need to dete!mine"#ic# ban& "ill pa+ +ou t#e most inte!estIn ot#e! "o!ds, at "#ic# ban& "ill +ou #avet#e #ig#est %utu!e value*o %ind out, let4s c#ange ou! basic 9 eFuationslig#tl+

In t#is ve!sion o% t#e eFuation Gm4 is t#e numbe! o%compounding pe!iods pe! +ea!



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on-annual Compounding 6cont 7

/e can %ind t#e 9 %o! eac# ban& as %ollo"s

9i!st ational Ban&


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*#e p!esent value o% a st!eamo% cas# %lo"s


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*#e p!esent value contd

9o! e$ample8 o% t#e %i!st s1 million

s1 million

8 o% t#e second s1 million

= Rs 925,926

In t#e #and+ table on t#e ne$t page, t#e 8 s o%all t#e 25 pa+ments, at @= discount !ate a!ep!esented

King's College, MBA - 2015 1>


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*#e p!esent value contd

King's College, MBA - 2015 1@


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*#e !esult*#e dude4s o%%e! o% s15 million loo&s a"%ull+good, compa!ed to t#e 8 o% t#e 25 pa+mentsH s 11 5 millionJ

In ot#e! "o!ds, i% +ou ta&e t#e dude4s o%%e! o%s 15 million and +ou ea!n an @= !etu!n "it# it

t#en +ou "ill do muc# bette! t#an &eeping t#e

lotto tic&etHa!ound s ) 5 million bette! intoda+4s dolla!s



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et 8!esent alue Investment Decision

o" suppose t#at +ou a!e a %i!m t#in&ing o% ma&ing aninvestment it "ill cost mone+ toda+, and "ill !esult in#ig#e! !evenue in t#e %utu!e *#e!e "ill be a cas# out%lo"toda+, and cas# in%lo"s in t#e %utu!e

Eou "ould li&e to evaluate t#e me!its o% t#is investment,!elative to alte!nate investments t#at +ou could ma&e /#enet present value of the investment is the presentvalue of all of the cash outflows and in)lo s t#atresult )ro t#e in*est ent%I% an investment4s net p!esent value is positive, t#en it is asupe!io! investment !elative to t#e ave!age investment int#e econom+ *#e #ig#e! an investment4s net p!esent value,t#e mo!e supe!io! it is !elative to t#e ave!age investment



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8 contd:$ampleA mac#ine costs s 1000 to bu+ It "ill !esult in s )00 o%!evenue at t#e end o% eac# +ea!, %o! +ea!s At t#e endo% t#e %ou! +ea!s it can be sold %o! sc!ap %o! s 100 *#is

investment #as %ive cas# %lo"s

Let us use t#e p!esent value %o!mula to calculate t#e 8o% eac# o% t#ese cas# %lo"s *#en "e4ll add up t#e 8 s toget t#e et 8!esent alue 6 8 7



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8 contd.ne impo!tant Fuestion "#at discount !ate touse 9o! no", let4s (ust sa+ t#at it is 11=

*#e negative 8 tells us t#at "e could do bette!

"it# an ave!age investment else"#e!e in t#eeconom+, so t#is one doesn4t loo& ve!+ good



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King's College, MBA - 2015 2)

Inte!nal ate o% etu!n 6I 7 Met#od

*#e internal rate o) return o% a p!o(ectis t#e discount !ate t#at causes 8 toeFual e!o 9o!mula

/#e!e, t time pe!iod, n last pe!iod o%p!o(ect, t cas# in%lo" in t#e pe!iod o% t,

. t cas# out%lo" in t#e pe!iod o% t, ! I

Also #ere, C 0 in*est ent

∑∑== +

=+

n

t t

t

n

t t

t

r O

r R

01 )1()1(

0)1(1

C r

Rn

t t

t =+

∑=


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I contd

*#e inte!nal !ate o% !etu!n on an investment o!p!o(ect is t#e annuali ed e%%ectivecompounded !etu!n !ate o! !ate o% !etu!n

t#at ma&es t#e net p!esent value 6 8 7 o% allcas# %lo"s 6bot# positive and negative7 %!om apa!ticula! investment eFual to e!o

It can also be de%ined as t#e discount !ate at"#ic# t#e p!esent value o% all %utu!e cas# %lo"is eFual to t#e initial investment



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I contd

I% t#e I is la!ge! t#an t#e cost o%capital it signals acceptance I% t#eI is less t#an t#e cost o% capital t#ep!oposed p!o(ect s#ould be !e(ected

n ot#er ords,I% t#e I is g!eate! t#an t#e cost o%capital, accept t#e p!o(ectI% t#e I is less t#an t#e cost o% capital,!e(ect t#e p!o(ect



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King's College, MBA - 2015 2;

As+mmet!ic in%o!mation

As etri" in)or ation ma!&etsituation in "#ic# one pa!t+ in at!ansaction #as mo!e in%o!mationt#an t#e ot#e! pa!t+ Leads to man+p!oblems in ma!&ets

too muc# o! too little p!oduction

cont!acting can be di%%icult:conomic imbalances


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King's College, MBA - 2015 2>

As+mmet!ic in%o!mationAd*erse sele"tion it occu!s be%o!e at!ansaction ta&es place, one pa!t+ma+ &no" mo!e about t#e value o% agood being o%%e!ed t#an t#e ot#e!s

:$ample Glemons4 6bad usedca!s7N selle! &no"s t#e ve#icle "ell,

but bu+e! does not, +et ma!&et doesnot divide in t"o It causes good ca!to be sold at lo"e! p!ices


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King's College, MBA - 2015 2@

As+mmet!ic in%o!mation

Moral 3a4ard t#is p!oblem ma+a!ise a%te! t#e t!ansaction #asoccu!!ed

:$ample it is common isinsu!ance because t#e %i!m can notcompletel+ monito! t#e activities o!conditions o% t#e insu!ed

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09 Time Value of Money and Investment Decision