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How Time Value of Money Affects Investments and Financial Decisions in Financial Minagement?

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(Department of Business Administration) Assignment # 2

Financial Management (5535)

Submitted to: Sir Waqar Akbar Submitted by: Ishtiaq Ahmed (0333-6824303) AH-526270

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ACKNOWLEDGEMENT

All praises to Almighty Allah, the most Gracious, the most Beneficent and the most Merciful, who enabled me to complete this assignment. I feel great pleasure in expressing my since gratitude to my teacher, for his guidance and support for providing me an opportunity to complete my Project. My special thanks and acknowledgments to Mr. Ishtiaq for providing me all relative information, guidance and support to compile the Project. I will keep my hopes alive for the success of given task to submit this report to my honorable teacher Sir Waqar Akbar, whose guidance; support and encouragement enable me to complete this assignment.

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EXECUTIVE SUMMARY

The todays world moves at neck breaking speed & it calls for a decisive action Quantum Leap thinking The topic which was assign was How Time Value of Money Affects Investments and Financial Decisions in Financial Management The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory. Some standard calculations based on the time value of money are Present value, Present value of an annuity, Present value of a perpetuity, Future value and Future value of an annuity. Where finance investment is putting money into something with the expectation of gain that upon thorough analysis has a high degree of security for the principal amount, as well as security of return, within an expected period of time. So, any organization of having any type of business can calculate its future worth of investments by Time value of money and can make its operations more efficient and effective. So, by using Time value of Money concepts, any organization can make good and accurate decisions.

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Table of Contents

Title page Acknowledgement Abstract Table of contents Introduction to the issue Practical study of the Topic Conclusion Recommendations References

Page No

01 02 03 04 05 15 25 26 27

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Introduction to Topic

Time value of money:

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory. For example, $100 of today's money invested for one year and earning 5% interest will be worth $105 after one year. Therefore, $100 paid now or $105 paid exactly one year from now both have the same value to the recipient who assumes 5% interest; using time value of money terminology, $100 invested for one year at 5% interest has a future value of $105. The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum "present value" of the entire income stream. All of the standard calculations for time value of money derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV rPV = FV/(1+r). Some standard calculations based on the time value of money are:

Present value

The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary

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annuity while they occur at the beginning of each period for an annuity due.

Is an infinite and constant stream of identical cash flows. Is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today?

(FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

1. Number of time periods involved (months, years) 2. Annual interest rate (or discount rate, depending on the calculation) 3. Present value (what do you have right now in your pocket) 4. Payments (if any exist. If not, payments equal zero) 5. Future value (the dollar amount you will receive in the future. A standard mortgage will have a zero future value, because it is paid off at the end of the term)

Calculations:

There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator or a spreadsheet. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT). For any of the equations below, the formula may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms).

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These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond. An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). See compound interest for details on converting between different periodic interest rates. The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless. For calculations involving annuities, you must decide whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation. The following formulas are for an ordinary annuity. If you want the answers for the Present Value of an annuity due simply multiply the PV of an ordinary annuity by (1 + i).

Formulas:

1) Present value of a future sum

The present value formula is the core formula for the time value of money; each of the other formulae is derived from this formula. For example, the annuity formula is the sum of a series of present value

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calculations. The present value (PV) formula has four variables, each of which can be solved for:

1. PV is the value at time=0 2. FV is the value at time=n 3. i is the discount rate, or the interest rate at which the amount

will be compounded each period 4. n is the number of periods (not necessarily an integer) The cumulative present value of future cash flows can be calculated by summing the contributions of FVt, the value of cash flow at time=t

Note that this series can be summed for a given value of n, or when n is . This is a very general formula, which leads to several important special cases given below.

In this case the cash flow values remain the same throughout the n periods. The present value of an annuity (PVA) formula has four variables, each of which can be solved for:

PV(A) is the value of the annuity at time=0 A is the value of the individual payments in each compounding

period i equals the interest rate that would be compounded for each period of time n is the number of payment periods.

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3)

In this case each cash flow grows by a factor of (1+g). Similar to the formula for an annuity, the present value of a growing annuity (PVGA) uses the same variables with the addition of g as the rate of growth of the annuity (A is the annuity payment in the first period). This is a calculation that is rarely provided for on financial calculators. Where i g:

To get the PV of a growing annuity due, multiply the above equation by (1 + i). Where i = g:

4)

5)

When the perpetual annuity payment grows at a fixed rate (g) the value is theoretically determined according to the following formula. In practice, there are few securities with precise characteristics, and the application of this valuation approach is subject to various qualifications and modifications. Most importantly, it is rare to find a growing perpetual annuity with fixed rates of growth and true perpetual cash flow generation. Despite these qualifications, the general approach may be used in valuations of real estate, equities, and other assets.

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This is the well known Gordon Growth model used for stock valuation.

6)

The future value (FV) formula is similar and uses the same variables.

7)

The future value of an annuity (FVA) formula has four variables, each of which can be solved for:

FV(A) is the value of the annuity at time = n A is the value of the individual payments in each compounding

period i is the interest rate that would be compounded for each period of time n is the number of payment periods

8)

The future value of a growing annuity (FVA) formula has five variables, each of which can be solved for: Where i g:

Where i = g:

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FV(A) is the value of the annuity at time = n A is the value of initial payment paid at time 1 i is the interest rate that would be compounded for each period of

time g is the growing rate that would be compounded for each period of time n is the number of payment periods

What is Investment?

Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain that upon thorough analysis has a high degree of security for the principal amount, as well as security of return, within an expected period of time. In contrast putting money into something with an expectation of gain without thorough analysis, without security of principal, and without security of return is speculation or gambling. Investment is related to saving or deferring consumption. Investment is involved in many areas of the economy, such as business management and finance whether for households, firms, or governments. To avoid speculation an investment must be either directly backed by the pledge of sufficient collateral or insured by sufficient assets pledged by a third party.[original research?] A thoroughly analyzed loan of money backed by collateral with greater immediate value than the loan amount may be considered an investment. A financial instrument that is insured by the pledge of assets from a third party, such as a deposit in a financial institution insured by a government agency may be considered an investment. Examples of these agencies include, in the United States, the Securities Investor Protection Corporation, Federal Deposit Insurance Corporation, or National Credit Union Administration, or in Canada, the Canada Deposit Insurance Corporation. Promoters of and news sources that report on speculative financial transactions such as stocks, mutual funds, real estate, oil and gas leases,

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commodities, and futures often inaccurately or misleadingly describe speculative schemes as investment.

Investment In finance:

In finance, investment is the commitment of funds through collateralized lending, or making a deposit into a secured institution. In contrast to investment; dollar cost averaging, market timing, and diversification are phrases associated with speculation. Investments are often made indirectly through intermediaries, such as banks, Credit Unions, Brokers, Lenders, and insurance companies. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.

Types of Investments:

1. Deposits/Fixed Term Deposits

This type of investment is used by a large proportion of the population e.g. Bank accounts. The appeal is easy access and the very unlikely event of losing your capital. Unfortunately very little income or capital growth takes place simply because of the low interest rates. Another important point to bear in mind is the devaluation of your particular currency which will eat away at any gains made especially if cash is held on deposit in the long term. For this reason alone it is not good practice to leave large deposits in this type of investment.

2. Bonds

The term bond includes any security that involves debt. When you purchase a bond you are actually lending money to a company or the government. In return you will receive interest and eventually your capital sum. Bonds are generally safe, however for this reason returns are small. Bonds are for people who want a higher return than a cash deposit would bring but still want a low risk investment.

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3. Stocks

Stocks, sometimes called shares or equities represent part ownership of a company. Unlike bonds, when you purchase a share in a company you are not guaranteed your money back. Shares fluctuate in value on a daily basis and therefore it is best to invest longer term (say 5 years and above) However the potential returns are far greater than bonds and for this reason stocks must be considered a medium risk in general. Some companies elect to pay profits direct to their shareholders in the form of a dividend rather than investing the profits back into the company. These dividends can be a tax efficient way of receiving income. If you would like to invest in stocks but dont have the necessary experience, time or inclination, here are some trading services which I have found to be very good.

4. Managed Funds

When you buy units in a managed fund you are pooling your money with other investors which enable you to buy into a large number of different asset classes, eg. Fixed interest deposits, bonds, property, equity etc. Each fund is managed by a fund manager who decides what percentage of the fund should be invested into which asset class. Managed funds are popular because of the low cost and risk diversification. They are suitable for new investors, people with small initial deposits and anyone who wants to spread risk over a number of asset classes. Multi millionaire Steven Sutherland is the UK's leading authority in ISA Trend Investing. With ISA Trend Investing you trade investment funds (not stocks) using an ISA, a SIPP or both, to achieve tax-free index beating returns. By simply copying what Steven does you can very quickly build up a very profitable portfolio. I have negotiated a reduced price for Stephen's book, 'liquid millionaire', if you are interested in this type of investing. It will also introduce you to his services (highly recommended reading)

5.

or FX)

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The Forex market is the largest market in the world, frequently trading $3trillion per day. It is an extremely liquid market that trades 24hours, 5 days per week. A currency trade is the simultaneous buying of one currency and selling of another one. An investor's goal in Forex trading is to profit from foreign currency movements. The most commonly traded currencies are the EUR/USD, USD/JPY, USD/CHF and GBP/USD. Very large profits can be made using forex. Depending on the type of trades forex can be a low, medium or high risk investment.

6. Property

Every well rounded portfolio should contain property, even if it's just your own residential home. Property is an excellent asset class since it increases in value over time. It does however fluctuate in value in the short to medium term and therefore it is best seen as a long term investment. You can also earn rental income from your tenants as an added bonus and indeed if you buy the right property you may never have to make a mortgage payment from your own funds. An excellent resource I use is The Property Tycoon Forum. Sign up for your Free Trial here. You can also get more information about property from my buying rental property page.

7. Gold

Gold that is physical gold should be thought of as an insurance policy against poor economic conditions rather than an investment vehicle. Having said that we are in a bull market at present (2009) and it is highly likely you will make money if you invest in physical gold today. In my opinion you should have 5-15% of your total assets in physical gold. A good source of physical gold is Bullionvault. If you want further information about gold including ETFs, please go to my gold page.

8. Options/futures

Options and futures are generally at the high risk end of investments with a corresponding possibility of a high-reward. They are much more speculative in nature and as such new investors should focus on building a sound investment strategy before speculating. However there is nothing to stop you using a good quality paid service which uses the

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INVESTMENT ANALYSIS AND CAPITAL BUDGETING:

The two basic issues associated with an investment decision are its feasibility and its desirability. Feasibility refers to the ability to actually access the necessary capital and complete the project. Clearly an investment could promise highly desirable levels of returns, but simply be infeasible in terms of the initial cash flow requirements -- the simplest illustration of a budget constraint. Alternatively, an investment may be affordable and completely feasible, but the returns could be so low as to make the investment alternative unattractive. There are a variety of ways by which one can evaluate returns on investment options. Five of the most common are: (1) net present value method, (2) internal rate of return methods, (3) profitability index or Q

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methods, (4) payback or breakeven period methods, (5) the average rate of return on investment. A study in Financial Management indicated that the capital budgeting practices employed most by large firms to make decisions were internal rate of return methods (88%) and net present value methods (63%). Both the payback and the average rate of return approaches fail to account for the time value of money. And, the profitability index simply a variant of the NPV approach that is used to control for size effects. Consequently, the following discussion focuses on net present value and internal rate of return methods of evaluating investments. These two methods are the most commonly employed in practice, both account for the time value of money, and together they provide the most meaningful decision making information in investment analysis and capital budgeting situations.

Information Needs:

The following information is needed to evaluate investments using time value of money concepts: 1. The expected net after-tax cash flows (NATCF, or ATNCF) for the investment by period including a salvage value, if any, 2. An appropriate interest rate or discount rate, 3. The length of planning horizon, 4. Terms of financing if borrowed funds are used, 5. The marginal tax bracket of the borrower, and the taxability status for each cash flow.

A.

The following example provided in Table illustrates the appropriate procedures for solving simple investment-type problems. Consider an investment that costs $6,000 initially. It is expected to yield net cash inflow of $1,500 per year for 5 years and have an expected salvage value of $1,500 at the end of 5 years. Assume an 8 percent after-tax discount rate. Table: Net Present Value Calculations Period Net After-Tax 8% Present Cash Value Factor Flow 0 -$6,000 1.0 1-4 +$1,500 3.31213 5 +$3,000 .68058

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$1,010

A negative cash flow reflects the outflow (in this example, the initial payment for the purchase) while the positive signs indicate net inflows. A common criterion for acceptance or rejection of a given project, abstracting from risk considerations and budget constraints, is to accept projects with positive NPV values and reject those with NPV values less than zero. At NPV = 0, the return is equal to the cost of capital, and the investor would be indifferent to making the investment or not. In the example above, note the technique used to discount the equal $1,500 flow per year for four years. The USPV factor can be used to discount an entire stream of income with one calculation. In year five, there is a salvage value of $1,500 plus the $1,500 net operating inflow, for a total of $3,000. For amounts different than the uniform flow, the SPPV factor must be applied. A positive NPV of $1,010 for the sample problem suggests the investment should be made. It is important to recognize that the NPV of $1,010 is not the amount of profit made by undertaking this investment. Rather, it is the amount by which this investment exceeds the return from the next best investment. The next best investment generates an 8% after-tax return as reflected by the discount rate. Remember, net present value is a measure of net cash returns expressed in today's dollars, and is not a measure of profit made on an investment.

In discounting after-tax cash flows, it is important to include all cash flow items that belong in the analysis and exclude those that do not belong. As a general rule, all incremental cash flows should be included, i.e., all cash flows which result from making the investment. In cases where two competing projects are made, many of the incremental cash flows or benefits are equivalent between the two options and can be canceled by evaluating the NPV of one project minus the other. But in most cases, all flow values that differ with or without the project should be included. Sometimes these incremental cash flows are complicated to isolate, or appear to exist when they really do not. Below, some of the common pitfalls in measuring cash flows are provided along with guidance on how they should be treated.

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Most investment opportunities for agricultural businesses or other businesses require some capital expenditure including the purchases of land, buildings or machinery. For example, a hog producer may build new confinement facilities to expand the size of the hog operation, or a meat packer might build and equip a new slaughter house. In doing a net present value calculation of these investment alternatives, it is important to remember that working capital requirements will also likely increase as a result of the expansion. For example, the hog producer will likely have more feed and livestock inventory as a result of the expansion. Likewise, the packer will have a larger inventory of slaughtered hogs. These increases in working capital must be accounted for as a cash outflow to do a proper net present value calculation of the expansion option. If this working capital is sold or returned at the end of investment period, an inflow of cash occurs from the sale of inventories or other items that return working capital at the end of the investment, much like a salvage value. In any case, the investment of additional working capital should be treated in terms of its incremental cash flows.

2. Sunk Costs:

Suppose a farmer spends $1,000 over a 6 month period searching for a property to expand the size of the operation. A parcel is now found and the farmer wants to do a net present value analysis of the purchase. However, the $1,000 spends searching for the property should not be included as a cash outflow in this calculation. The reason is that it is now a sunk cost and will exist whether the farmer does or does not buy the current property under consideration. Thus, it has no bearing on the financial rewards from the decision at hand. Although it is a real expense, it is not an incremental cash flow associated with the investment because it is not affected by the acceptance or rejection decision about the project.

3. Opportunity Costs:

Suppose an agribusiness firm is considering a new product line that will use up existing excess capacity in the firm's manufacturing plant. As a result, the firm will need to expand the size of their plant at the end of the second year rather than at the end of the fourth year. Should a net present value analysis of the new product line include a charge for using

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up existing excess capacity? The answer here is yes, because it causes the firm to rebuild in year two versus the current plans which call for expansion in the fourth year. As another example, suppose a farmer is doing a net present value analysis of a slurry store handling system versus a lagoon system. To construct the lagoon, the farmer will need to take 2 acres of land out of production. In doing the net present value analysis, one should account for the opportunity cost of using the land for something other than a lagoon. Perhaps more importantly in this case, there is an important contingency cost that can be thought about as the cost of insuring against liability created by the lagoon. Many companies explicitly budget to fund a legal reserve associated with new projects.

4. Synergies:

Suppose you were considering the addition of a new project that utilized products produced elsewhere in your operation, or otherwise contributed to the profitability of your operation. For example, suppose you run a pick your own orchard and are considering the addition of pony rides and Halloween hayrides. In addition to measuring the direct cash flows from the additional projects, the potential increase in apple sales while the new customers are on site should be included.

Suppose you now running a pick your own orchard and are considering the addition of a cider press to expand your product line. Clearly the value of the apples used in production should be accounted for in the NPV calculation, but so should any reduction in fresh apple sales that might occur if the availability of cider reduces the demand for fresh apples. (The example might be more obvious if prunes were replaced by apples, except that the authors know of no prune orchards). Cannibalism effects have been frequently noted in food manufacturing businesses. For example, when Post introduced Dino Pebbles to compete with Kelloggs Marshmallow Krispies, the main effect was in the reduction of sales of Posts other similar line -- Fruity Pebbles. This case illustrates the importance of including any lost revenues associated with other projects owned by the same person or firm as a cost of the project being evaluated.

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B.

NPV analysis results in a dollar-valued answer based on discounting cash inflows and cash outflows. Given no capital constraints, all projects generating positive NPV values would be accepted. However, because the NPV is simply a dollar value, it does not provide a measure of the rate of return generated by the project. And, NPV results are not always sufficient to evaluate the desirability of two very different sized projects. For example, suppose project A has NPVA = $100, and project B has NPVB = $105. If they were otherwise equal, project B would be more desired. However, if project B had twice as large an initial cost, and its acceptance prohibited other positive NPV projects, then project A may be more desirable. Thus, complementary information about the effective yield provided per dollar of cash flow in the project is also useful to know. That measure is the internal rate of return or IRR. Its solution uses the same principles that are employed in NPV calculations except that the discount rate being solved for is the one that results in the project having an NPV of zero. In this sense, it is simply the highest costs of capital that would make the project exactly break even in terms of the NPV. If the actual discount rate or cost of capital is less than the IRR, then the project is viewed as a desirable project because it generates more than it costs. If the IRR is lower than the costs of capital or negative, then the project is not desirable and should be rejected. To illustrate, the example problem used above to illustrate the basic NPV approach is solved for its IRR. The IRR is the discount rate that results in the present value of the inflows and the present value of the outflows being exactly equal and thus resulting in NPV equal 0. Because the discount rate in the time value of money formulas is inside an equation that often has an exponent greater than one, it often cannot be algebraically isolated and analytically solved. Fortunately, most financial calculators can be used to compute an IRR for the basic types of problems. Moreover, trial and error approaches converge fairly rapidly toward a solution, and simple interpolation methods are easily used at any stage of a trial and error process. Finally, the spreadsheet supplied with this booklet also contains a simple facility to calculate the IRR for most analyses. In attempting to solve for the IRR by hand, a trial and error process can be used to bracket the answer fairly quickly. Depending on the precision needed, the search can then be stopped and any two answers used to

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interpolate (or extrapolate) an approximate answer. To do so, the common steps are: (1) guess a discount rate and solve for the NPV. If the NPV is positive, then increase the discount rate and try again. (2) If the trial NPV is negative, decrease the trial discount rate and recalculate. (3) Repeat this search until you have two trial discount rates that bracket the answer (one negative NPV and one positive NPV). Then, (4) a manual method of bisection search can be used to locate the exact solution. The bisection involves the following approach. First take the average of the two rates that are known to bracket the IRR and recomputed the NPV at the average rate. If the NPV is positive, use the average and the higher rate for the next bracket. If the NPV at the average rate is negative, then use the average and the lower rate for the next bracket. Then, re-average the rates from the new bracket and repeat the process until the NPV is suitably close to zero. At any time, the two rates that bracket the IRR can also be used in a process known as interpolation to approximate the answer. The interpolation process is illustrated below using the same example that was used to demonstrate the NPV technique above. Table: Interpolation Calculation Inputs Present Value Present Value Factors Factors Net After Period Tax Cash 12% 14% Flow 0 -$6,000 1.0 1.0 1-4 +1,500 3.03735 2.91371 5 +3,000 .56743 .51937 Net Present Value (NPV) =

The Table above shows that at a 12 percent discount rate, the NPV is still positive, but at 14 percent it is negative, and thus the IRR is bracketed between 12 and 14 percent.

Addition to problems associated with calculating an IRR; there are several other issues with which the user should be aware. First, if the series of cash flows has more than one sign reversal (changes from a positive to

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negative cash flow, or vice versa) then there are multiple solutions. For example, there are two sign changes in the following series of cash flows (Table 4 below) and thus we have two IRRs, in this case equal to 25% and 400%. Table: Multiple IRRs Illustrated Time 0 1 2

In fact, according to Descartes rule of signs, there are as many roots (solutions) as there are changes in signs, so a problem with 4 sign reversals would have 4 different solutions. To deal with this issue, a modified internal rate of return, or MIRR, is often used. Under this approach, all negative cash flows are first treated as a single problem and placed into an equivalent negative single present value. Then, all positive cash flows are treated as a single problem and represented as a single positive future value. Finally, NPV methods are applied to the two values the negative single initial value and the positive single future value as though these were the only two cash flows and therefore having only one solution. Note that to use the MIRR approach, a discount rate is needed in the first stage to compute the single positive and negative values. It is suggested that the firms cost of capital be used for this stage to compute both the present value of the cash outflows and the future value of the positive cash flows. Denoting the present value of the cash outflows as P0 - and the future value of the positive cash flows as Pn +, the MIRR is the discount rate, r, that solves: Po-(1+r)n = Pn+ The MIRR is also used in cases where the IRR is unrealistically influenced by the assumption that the cash flows can be reinvested in the project at the same long-run rate of return. In this case, using the MIRR approach is useful because a lower, often more realistic cost of capital is used to first convert cash flows to a future value that is then used to solve for an MIRR assuming that cash flows are taken out of the project and employed elsewhere in the firm at a return equal to the discount rate. In fact, according to Descartes rule of signs, there are as many roots (solutions) as there are changes in signs, so a problem with 4 sign reversals would

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have 4 different solutions. To deal with this issue, a modified internal rate of return, or MIRR, is often used. Under this approach, all negative cash flows are first treated as a single problem and placed into an equivalent negative single present value. Then, all positive cash flows are treated as a single problem and represented as a single positive future value. Finally, NPV methods are applied to the two values the negative single initial value and the positive single future value as though these were the only two cash flows and therefore having only one solution. Note that to use the MIRR approach, a discount rate is needed in the first stage to compute the single positive and negative values. It is suggested that the firms cost of capital be used for this stage to compute both the present value of the cash outflows and the future value of the positive cash flows. Denoting the present value of the cash outflows as P0 - and the future value of the positive cash flows as Pn+, the MIRR is the discount rate, r that solves: P0-(1+r)n = Pn + The MIRR is also used in cases where the IRR is unrealistically influenced by the assumption that the cash flows can be reinvested in the project at the same long-run rate of return. In this case, using the MIRR approach is useful because a lower, often more realistic cost of capital is used to first convert cash flows to a future value that is then used to solve for an MIRR assuming that cash flows are taken out of the project and employed elsewhere in the firm at a return equal to the discount rate. Table: Illustration of Non Existent IRR Time Cash Flow 10% Present Present Value Value Factor 1 1000 .90909 909.09 2 3000 .82645 2,479.35 3 3000 .75131 2,253.93 Net Present 5,642.37 Value IRR NA A third issue in interpreting IRR is that of borrowing versus lending or investing. Consider the following projects A and B, with cash flows as shown in Table. Table: IRRs under Lending versus Borrowing Cash Flows at: NPV at:

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t=1 +2,400 -2,400

Project A B

Notice each project has an IRR of 20%, but A has a positive NPV while B has a negative NPV. Project A represents an investment which is, in essence, lending money at a rate of 20%. When lending 32 money, the highest IRR is preferred. For Project B is in essence a case of borrowing with a positive cash flow today followed by the repayment at time 1. In this case, the IRR indicates an interest rate on borrowed money of 20%. When borrowing, the lowest IRR is preferred. The point is that the IRR alone does not indicate whether the project is a borrowing or lending style investment, a fact which can lead to confusion on how to interpret the IRR number.

Capital Expenditures:

Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to back-out. Therefore, we need to carefully analyze and evaluate proposed capital expenditures.

Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question:

24

2nd Assignment

Will the future benefits of this project be large enough to justify the investment given the risk involved? It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three stages within Capital Budgeting Analysis: Decision Analysis for Knowledge Building Option Pricing to Establish Position Discounted Cash Flow (DCF) for making the Investment Decision KEY POINT Do not force decisions to fit into Discounted Cash Flows! You need to go through a three-stage process: Decision Analysis, Option Pricing, and Discounted Cash Flow. This is one of the biggest mistakes made in financial management.

25

2nd Assignment

Conclusion

The topic which was assign was How Time Value of Money Affects Investments and Financial Decisions in Financial Management The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory. Some standard calculations based on the time value of money are Present value, Present value of an annuity, Present value of a perpetuity, Future value and Future value of an annuity. Where finance investment is putting money into something with the expectation of gain that upon thorough analysis has a high degree of security for the principal amount, as well as security of return, within an expected period of time. So, any organization of having any type of business can calculate its future worth of investments by Time value of money and can make its operations more efficient and effective. So, by using Time value of Money concepts, any organization can make good and accurate decisions.

26

2nd Assignment

Recommendation

I recommend some things for all type of organizations, Every organization should have to calculate its investment worth before investing by using different formulas of Time value of Money Every organization should have to analyze its capital budgeting by using Time value of money techniques. Should have to take steps for cost saving by using Time value of Money. Should have to apply Time value of money concept in segments in the whole organization.

27

2nd Assignment

Reference

www.slideshare.com http://www.googler.com.pk/ http://www.business.com.pk/ http://en.wikipedia.org/wiki/ http://www.scribd.com/doc/24651033/

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