Discussion

on

Time Value of Money (How to determine the value of resources)

Agenda:
- Plotting different types of CFs,
- Calculation of PV (value) and NPV (Measure of Value Maximization)
- Investment decision (selection of appropriate project)

The objective of financial management is to maximization VALUE of the firm.

Then the important question is, what do we mean by VALUE and maximized value?
Investors put their resources in a firm with expectation to get more than they put. This
excess return from their investment is termed as value maximization.
Now, the next question is: Or how can we define or determine the VALUE and value
maximization of the firm?
In fact, this is one of the most important questions of finance. Because: (a) investors invest
(their cash outflows) in one time and get cash inflows from the investment in future, means
time variance of cash inflows and outflows (b) investors sacrifice the benefits of the best
alternative opportunity (opportunity cost) to invest in the firm.
Finance has imported the theory of Time Value of Money from Mathematics to incorporate
these two factors in determining value of the resources invested in a firm.
As time of cash flows is very crucial, we can classify the value of resources into two
categories i.e., PRESESNT VALUE (PV) and FUTURE VALUE (FV). Then question is, which
value we would like to maximize as par finance? It is.PRESENT VALUE.
Present value of future cash flow can be calculated by discounting technique i.e.,
PV=FV/(1+DR)^n, here DR=discount rate or rate of opportunity cost or cost of capital, and
n=time period
Lets look at, how can we calculate the PRESENT VALUE of different cash flow streams as follows:

Page 1 of 5

Type 1: Single cash flow stream

Suppose you want to purchase a flat in Dhanmondi for tk. 15,000, and expect to sale it tk. 28,000
after 5 years. If the opportunity cost (discount rate) is 9%, what is the present value of the expected
cash inflow?
now/time of taking
decision
Time line
0
1
2
3
4
5
CF stream
-15000
0
0
0
0
28000
28000/(1+0.09)^5
PV (value of your
investment)
18198.08
Here, PV of your expected Cash inflow is higher than your cash outflow (investment) which is definitely
favorable to you, but question is how excess value it will create is. To know that we can calculate NPV as:
Net Present value (NPV)=PV of future cash inflow-Investment
NPV
18198.08-15000 =3198.08

Here, we get positive NPV because PV of future cash inflow is higher than investment,
means your investment is able to maximize the value of your resources by tk. 3198. So it
will be wise for you to purchase the flat by which you will be able to maximize the value of
your resources.
So, according to finance, the objective of a firm is to maximize the value of firms resources.
Above example tells us that:
VALUE (tk. 18198.08) means PV of future cash inflows of any project
VALUE maximization level (tk. 3198.08) means excess value of investment
Now lets look at the above example further that you need tk.21, 500 to buy the flat, in that
case, NPV = -3302, which indicates that your value tk. 18198.08 is lower than your
investment by 3302 means value of resources is minimized rather than maximizing.
SHOULD YOU BUY THE FLAT in this case? Definitely NOT. Because, you want to maximize
the value of your resources rather than minimize.
How many important points we have learned from the above example?
(a) To calculate value of future cash flow i.e. VALUE of any investment
(b) Two important inputs are required to calculate VALUE i.e., cash flow stream and
discount rate
(c) Value maximization measures i.e., NPV (Positive NPV means value is maximized,
Negative NPV means value is minimized)
(d) First function of finance i.e. INVESTMENT DECISION (where should the firm invest?)
based on NPV, if select project with positive NPV, reject project with Negative NPV
as firms objective is maximizing the value of firm.

Page 2 of 5

Now lets look at, if your investment produces multiple cash flows based on the
sample example:

Type 2: Multiple cash flow stream

Suppose you want to purchase a flat in Dhanmondi for tk. 15,000, and expect to get rent tk.
4000 in first year, tk. 5000 in second year, tk. 5500 in the third, fourth and fifth year and
sale it tk. 28,000 after 5 years. If the opportunity cost (discount rate) is 9%, plot the cash
flow in the time line, calculate the value and value maximization measure.
Time
line
CF
stream
**
PV (sum
of **
column)
NPV

0
-15000

4000
5000
5500
5500 28000+5500=33500
4000/(1+.09)^1 5000/(1+.09)^2 5500/(1+.09)^3 5500/(1+.09)^4 33500/(1+0.09)^5

37794.17
37794.17-15000=22794.17

Type 3: Multiple equal cash flow stream (Annuity cash flow)

Suppose you want to purchase a flat in Dhanmondi for tk. 15,000, and expect to get rent tk.
7000 in each year for next 5 years. If the opportunity cost (discount rate) is 9%, plot the
cash flow in the time line, calculate the value and value maximization measure i.e., NPV, and
make your investment decision based NPV.
Time
line
0
1
2
3
4
5
CF
stream
-15000
7000
7000
7000
7000
7000
Please look at this CF stream carefully. What is the difference between this one and prior CF stream? Both are
multiple CF stream but in this cash your cash inflows are equal in every period, and this type of CF stream is called
ANNUITY cash flow stream. Next question, can we calculate the PV of this with the same way? Why not? As we know
CF and DR, there is no problem to get PV like prior two steams. Therefore PV of the steam as follows:
7000/(1+.09)^1 7000/(1+.09)^2 7000/(1+.09)^3 7000/(1+.09)^4 7000/(1+0.09)^5
PV
27227.56
NPV
27227.56-15000=12227.56

However, we can calculate the PV of annuity CF stream with alternative way by using PV
table as well. In this case
PV=ACF x PVIFA 9%, 5years
Here our Annuity CF (ACF) is tk. 7000 (equal CF in every period), PV Interest Factor
Annuity (PVIFA) for 9% and 5 years is 3.890 (this value is available from Financial table
which is attached in your email as well)
Page 3 of 5

Therefore, PV = 7000 x 3.890=27230 which almost we calculated the value earlier.

Type 4: Perpetual Cash flow stream

Suppose you want to purchase a flat in Dhanmondi for tk. 15,000, and expect to get rent tk.
2500 in each year for the unforeseeable future. If the opportunity cost (discount rate) is
9%, plot the cash flow in the time line, calculate the value and value maximization measure
i.e., NPV, and make your investment decision based NPV.
Time
line
0
1
2
3
4

CF
stream
-15000
2500
2500
2500 .
..
Here, equal CF for each year but for infinitive time. This type of CF steam is called PERPETUAL cash
flow stream, PV of Perpetual CF stream = Perpetual CF/DR
PV
2500/.09 = 27777.78
NPV
12777.78

Type 5: Growing Perpetual Cash flow stream

Suppose you want to purchase a flat in Dhanmondi for tk. 15,000, and expect to get rent tk.
2500 in first year which will be growing at 4% in every year for the unforeseeable future. If
the opportunity cost (discount rate) is 9%, plot the cash flow in the time line, calculate the
value and value maximization measure i.e., NPV, and make your investment decision based
NPV.
Time
line
0
1
2
3
4
CF
stream
-15000
2500
2600
2812.16 .
..
Here, CF is growing at a constant rate (g) i.e., 4% for unforeseeable future; this type of CF stream is
called growing perpetual CF stream. PV of growing perpetual CFs = CF of first period/(DR-g)
PV
PV=2500/(.09-.04)=50000.00
NPV
35000.00

Page 4 of 5

Summary Note:
We have learned to calculate the PV of different CF streams which can be faced by the firm
for its different type of investment opportunity. I hope based on this discussion, you will
come up with your understanding how to calculate the value of a firm or its any project.
The key challenges are that:
(a) What every the context, draw your time line
(b) Plot the CF in the time line according to the incidents
(c) Find DR
(d) Come up with the value, and compare it with your investment
(e) You can easily understand whether you will be able to maximize the value or not
(f) Finally, you can take the investment decision by selecting the project which is able
to maximize the value
I will highly appreciate your any questions about the above discussion for further
clarification.

Page 5 of 5