[Last Name] 1

value of money is the concept that the value of a dollar to be received in future is less than

the value of a dollar on hand today. One reason is that money received today can be invested thus

generating more money. Another reason is that when a person opts to receive a sum of money in

future rather than today, he is effectively lending the money and there are risks involved in lending

such as default risk and inflation. Default risk arises when the borrower does not pay the money back

to the lender. Inflation is the rise in general level of prices.

Time value of money principle also applies when comparing the worth of money to be received

in future and the worth of money to be received in further future. In other words, TVM principle says

that the value of given sum of money to be received on a particular date is more than same sum of

money to be received on a later date.

Few of the basic terms used in time value of money calculations are:

Present Value

When a future payment or series of payments are discounted at the given rate of interest up

to the present date to reflect the time value of money, the resulting value is called present value.

Read further: Present Value of a Single Sum of Money and Present Value of an Annuity

Future Value

Future value is amount that is obtained by enhancing the value of a present payment or a

series of payments at the given rate of interest to reflect the time value of money.

Read further: Future Value of a Single Sum of Money and Future Value of an Annuity

Interest

Interest is charge against use of money paid by the borrower to the lender in addition to the

actual money lent.

Read further: Simple vs. Compound Interest

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Application of Time Value of Money Principle

There are many applications of time value of money principle. For example, we can use it to

compare the worth of cash flows occurring at different times in future, to find the present worth of a

series of payments to be received periodically in future, to find the required amount of current

investment that must be made at a given interest rate to generate a required future cash flow, etc.

Written by Irfanullah Jan

Each one of us has financial needs and goals. Once the goals are identified, we need to set goal values (targets). This

means that we should be in a position to convert the needs / goals into financial terms. To do this, we should be aware

of and understand the most important aspect of ‘Financial Planning’ i.e., Time Value of Money (TVM).

Money has TIME value. A rupee today is more valuable than it will be a year hence or two years hence. Do

you agree with me?

In this post let us understand the importance of Time value of money and basics of TVM.

Why Money Has Time Value

Suppose you were given the choice between receiving Rs 100,000 today or Rs 100,000 in 10 years. Which

option would you rather select? Clearly the first option is more valuable for the following reasons:

 Purchasing power: Because of inflation, Rs 100,000 can be used to buy more

goods and services today than Rs 100,000 in 10 years from now. Put another way,

just think back to what Rs 100,000 could buy you 10 years ago. For example : 10
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years back the cost of one litre milk would have been say Rs 5, now its Rs 30 and

after 10 years, it could be Rs 100.

 Opportunity Cost: A rupee received today can be invested now to earn interest,

this can result in a higher value in the future. Sooner is better than later.

 Risk Vs Return: If you are giving your money to be used by another person /

company, that means you are taking the risk associated with it, which is known as

‘default risk’ (you may or may not get back your payments). So, you expect return /

interest to compensate the risk.

Time Value of Money : Compounding & Discounting

The basic principles of TVM are compounding and discounting methods.

Compounding : When we hear the word ‘compounds’, the first thing that comes to mind is GROWTH. That

means we expect our investment to grow and yield some return (or interest).

For example – Rs 10,000 invested today in a bank fixed deposit at 9% pa

interest rate for 5 years can fetch you Rs 15,386 (let’s ignore taxation part). So Rs

5,386 is the accumulation of the interest and also interest on the interest.

Discounting : Compounding is about the future value of today’s investment, where as discounting is the today’

value (PV) of money to be received in the future (FV – Future Value). Present value is calculated by applying a discount

rate (opportunity cost) to the sums of money to be received in the future.

For example – You want Rs 15,386 in five years from now and the prevailing bank rates are around 9%. What is

the amount that you need to invest now to receive Rs 15,386 after five years?
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The value of Rs 15,386 is equal to Rs 10,000 in today’s value at a discounting

rate of 9%.

Five components of Time Value of Money

Based on the above examples, we can say that the components of any TVM problems or calculations are;

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 Tenure (The total number of compounding or discounting periods)

 Rate of Interest

 Present Value (PV) or Today’s value

 Future Value (FV)

The fifth component is Periodic Payments (Pmt).

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For example : If you acquire a home loan of Rs50 Lakh @ 10% pa for a period of 20 years, your EMI (Equated

Monthly Installments) would be around Rs 48,000.

So, Payments (pmt) represents equal periodic payments received or paid each period. When payments are

received they are positive, when payments are made they are negative.

Why Is the Time Value of Money So Important in Capital

Budgeting Decisions?
by John Freedman; Updated April 20, 2018

The time value of money is important in capital budgeting decisions because it allows
small-business owners to adjust cash flows for the passage of time. This process, known
as discounting to present value, allows for the preference of dollars received today over
dollars received tomorrow. Understanding some common capital budgeting techniques that
use the time value of money can help you understand why this concept is so important in
capital budgeting decisions.
Net Present Value

The net present value method uses the time value of money to determine whether a
project is profitable, even after adjusting for the time value of money. To perform this test,
a small-business owner would first determine the cash inflows and outflows required for
the project. Once identified, these figures are adjusted to present value and their difference
is determined.

If the project's net present value is greater than or equal to zero, the project is acceptable,
as it provides a return greater than or equal to the company's acceptable rate of return. If
the owner does not use the time value of money to discount cash inflows and outflows,
projects with a long time horizon or in periods of a high discount rate could be mispriced,
and the owner could make an unprofitable decision.
Internal Rate of Return

The internal rate of return method applies the net present value method in reverse. This
method finds the discount rate, given the undiscounted cash flows of the project, which
results in a net present value of zero. The zero point represents the break-even point of
project profitability.
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To apply this method, a manager divides the investment required by a project by the net
annual cash inflow the project is expected to produce. This calculation yields the internal
rate of return factor. This factor can be looked up in a net present value table to discern the
appropriate internal rate of return. This internal rate of return is then compared with the
company's minimum acceptable rate of return. If the project promises a higher return, it is
accepted.
Total Cost Approach

The total cost approach allows small-business owners to evaluate multiple projects at one
time. In this method, the manager adjusts all cash inflows and outflows for each competing
alternative and then compares them. All projects with positive net present values are
acceptable; however, the project with the greatest net present value is the most profitable.
This method can be time-consuming, because costs that do not differ across competing
projects are calculated, even though they are irrelevant.
Project Profitability Index

When funds available for projects are limited, a small-business owner can calculate the
project profitability index, or PPI, to determine which project is preferred. By dividing the
net present value of a project by the investment preferred, the owner is calculating a value
of net present value obtained per dollar invested. This is known as the PPI. Higher project
PPI values imply more desirable projects.

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Risk and Returns: Concept of Risk and Returns
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After investing money in a project a firm wants to get some

outcomes from the project. The outcomes or the benefits that the
investment generates are called returns. Wealth maximization
approach is based on the concept of future value of expected cash
flows from a prospective project.
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So cash flows are nothing but the earnings generated by the

project that we refer to as returns. Since fixture is uncertain, so
returns are associated with some degree of uncertainty. In other
words there will be some variability in generating cash flows,
which we call as risk. In this article we discuss the concepts of
risk and returns as well as the relationship between them.

Concept of Risk:
A person making an investment expects to get some returns from
the investment in the future. However, as future is uncertain, the
future expected returns too are uncertain. It is the uncertainty
associated with the returns from an investment that introduces a
risk into a project. The expected return is the uncertain future
return that a firm expects to get from its project. The realized
return, on the contrary, is the certain return that a firm has
actually earned.

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The realized return from the project may not correspond to the
expected return. This possibility of variation of the actual return
from the expected return is termed as risk. Risk is the variability
in the expected return from a project. In other words, it is the
degree of deviation from expected return. Risk is associated with
the possibility that realized returns will be less than the returns
that were expected. So, when realizations correspond to
expectations exactly, there would be no risk.

i. Elements of Risk:
Various components cause the variability in expected returns,
which are known as elements of risk. There are broadly two
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groups of elements classified as systematic risk and unsystematic

risk.

Systematic Risk:

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Business organizations are part of society that is dynamic.

Various changes occur in a society like economic, political and
social systems that have influence on the performance of
companies and thereby on their expected returns. These changes
affect all organizations to varying degrees. Hence the impact of
these changes is system-wide and the portion of total variability
in returns caused by such across the board factors is referred to
as systematic risk. These risks are further subdivided into
interest rate risk, market risk, and purchasing power risk.

Unsystematic Risk:
The returns of a company may vary due to certain factors that
affect only that company. Examples of such factors are raw
material scarcity, labour strike, management inefficiency, etc.
When the variability in returns occurs due to such firm-specific
factors it is known as unsystematic risk. This risk is unique or
peculiar to a specific organization and affects it in addition to the
systematic risk. These risks are subdivided into business risk and
financial risk.

ii. Measurement of Risk:

Quantification of risk is known as measurement of risk.

Two approaches are followed in measurement of

risk:
(i) Mean-variance approach, and

(ii) Correlation or regression approach.

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Mean-variance approach is used to measure the total risk, i.e.

sum of systematic and unsystematic risks. Under this approach
the variance and standard deviation measure the extent of
variability of possible returns from the expected return and is
calculated as:

Where, Xi = Possible return,

P = Probability of return, and

n = Number of possible returns.

Correlation or regression method is used to measure the

systematic risk. Systematic risk is expressed by β and is
calculated by the following formula:

Where, rim = Correlation coefficient between the returns of stock i

and the return of the market index,
σm = Standard deviation of returns of the market index, and
σi = Standard deviation of returns of stock i.
Using regression method we may measure the systematic risk.

The form of the regression equation is as follows:

Where, n = Number of items,

Y = Mean value of the company’s return,

X = Mean value of return of the market index,

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α = Estimated return of the security when the market is

stationary, and

β = Change in the return of the individual security in response to

unit change in the return of the market index.

Concept of Return:
Return can be defined as the actual income from a project as well
as appreciation in the value of capital. Thus there are two
components in return—the basic component or the periodic cash
flows from the investment, either in the form of interest or
dividends; and the change in the price of the asset, commonly
called as the capital gain or loss.

The term yield is often used in connection to return, which refers

to the income component in relation to some price for the asset.
The total return of an asset for the holding period relates to all
the cash flows received by an investor during any designated
time period to the amount of money invested in the asset.

It is measured as:
Total Return = Cash payments received + Price change in assets
over the period /Purchase price of the asset. In connection with
return we use two terms—realized return and expected or
predicted return. Realized return is the return that was earned
by the firm, so it is historic. Expected or predicted return is the
return the firm anticipates to earn from an asset over some
future period.

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Capital Asset Pricing Model (CAPM)

A method for calculating the required rate of return, discount rate or cost of capital

Resources › Knowledge › Finance › Capital Asset Pricing Model (CAPM)

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What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of investing in a security. It shows

that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an

illustration of the CAPM concept.

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CAPM formula and calculation

CAPM is calculated according to the following formula:

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Where:

Ra = Expected return on a security

Rrf = Risk-free rate

Ba = Beta of the security

Rm = Expected return on market

Note: “Risk Premium” = (Rm – Rrf)

The CAPM formula is used to calculate the expected return on investable asset. It is based on the premise that investors have assumptions of systematic

risk (also known as market risk or non-diversifiable risk) and need to be compensated for it in the form of a risk premium – an amount of market return

greater than the risk-free rate. By investing in a security, investors want a higher return for taking on additional risk.
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Expected return

The “Ra” notation above represents the expected return of a capital asset over time, given all of the other variables in the equation. The

expected return is a long-term assumption about how an investment will play out over its entire life.

Risk-free rate

The “Rff” notation is for the risk-free rate, which is typically equal to the yield on a 10-year US government bond. The risk-free rate should correspond to

the country where the investment is being made, and the maturity of the bond should match the time horizon of the investment. Professional

convention, however, is to typically use the 10-year rate no matter what, because it’s the most heavily quoted and most liquid bond.

To learn more, check out our free fixed-income fundamentals course.

Beta

The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of returns) reflected by measuring the fluctuation of its price

changes relative to the overall market. In other words, it is the stock’s sensitivity to market risk. For instance, if a company’s beta is equal to 1.5 the

security has 150% of the volatility of returns of the market average. However, if the beta is equal to 1, the expected return on a security is equal to the

average market return. A beta of -1 means security has a perfect negative correlation with the market.

To learn more: read about asset beta vs equity beta.

Market risk premium

From the above components of CAPM we can simplify the formula to reduce (expected return of the market – risk free rate) to be the “market risk

premium”. The market risk premium is the excess return expected to compensate an investor for the additional volatility of returns they will experience

over and above the risk-free rate.

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Why CAPM is important

The CAPM formula is widely used in the finance industry by various professions such as investment bankers, financial analysts, and accountants. It is an

integral part of the weighted average cost of capital (WACC) as CAPM calculates the cost of equity.

WACC is used extensively in financial modeling. It can be used to find the net present value (NPV) of the future cash flows of an investment and to

further calculate its enterprise value and finally its equity value.

CAPM example – Calculation of expected return

Let’s calculate the expected return on a stock, using the Capital Asset Pricing Model (CAPM) formula. Suppose the following information about a stock is

known:

 It trades on the NYSE and its operations are based in the United States

 The current yield on a U.S. 10-year treasury is 2.5%

 The average excess historical annual return for U.S. stocks is 7.5%

 The beta of the stock is 1.25 (meaning it’s average weekly return is 1.25x as volatile as the S&P500

over the last 2 years)

What is the expected return of the security using the CAPM formula?

Let’s break down the answer using the formula from above in the article:

 Expected return = Risk Free Rate + [Beta x Market Return Premium]

 Expected return = 2.5% + [1.25 x 7.5%]

 Expected return = 11.9%

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We hope this guide to the CAPM formula has been helpful. To continue learning and advancing your finance career as a financial analyst, we have

developed several more articles that are highly relevant. To learn more please see:
 [Last Name] 19

 WACC

 Asset beta

 Valuation methods

 Comparable company analysis

 Financial modeling guide

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Capital Asset Pricing Model

The CAPM allows investors to quantify the expected return on investment given the investment risk, risk-free rate of
return, expected market return and beta of an asset or portfolio. The risk-free rate of return that is used is typically the
federal funds rate or the 10-year government bond yield.
An asset's or portfolio's beta measures the theoretical volatility in relation to the overall market. For example, if a
portfolio has a beta of 1.25 in relation to the Standard & Poor's 500 Index (S&P 500), it is theoretically 25% more volatile
than the S&P 500 Index. Therefore, if the index rises by 10%, the portfolio rises by 12.5%. If the index falls by 10%, the
portfolio falls by 12.5%.

CAPM Formula
The formula used in CAPM is: E(ri) = rf + βi * (E(rM) - rf), where rf is the risk-free rate of return, βi is the asset's or
portfolio's beta in relation to a benchmark index, E(rM) is the expected benchmark index's returns over a specified
period, and E(ri) is the theoretical appropriate rate that an asset should return given the inputs.

Arbitrage Pricing Theory

The APT serves as an alternative to the CAPM, and it uses fewer assumptions and may be harder to implement than the
CAPM. Ross developed the APT on a basis that the prices of securities are driven by multiple factors, which could be
grouped into macroeconomic or company-specific factors. Unlike the CAPM, the APT does not indicate the identity or
even the number of risk factors. Instead, for any multifactor modelassumed to generate returns, which follows a return-
generating process, the theory gives the associated expression for the asset’s expected return. While the CAPM formula
requires the input of the expected market return, the APT formula uses an asset's expected rate of return and the risk
premium of multiple macroeconomic factors.
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Arbitrage Pricing Theory Formula

In the APT model, an asset's or a portfolio's returns follow a factor intensity structure if the returns could be expressed
using this formula: ri = ai + βi1 * F1 + βi2 * F2 + ... + βkn * Fn + εi, where ai is a constant for the asset; F is a systematic
factor, such as a macroeconomic or company-specific factor; β is the sensitivity of the asset or portfolio in relation to the
specified factor; and εi is the asset's idiosyncratic random shock with an expected mean of zero, also known as the error
term.
The APT formula is E(ri) = rf + βi1 * RP1 + βi2 * RP2 + ... + βkn * RPn, where rf is the risk-free rate of return, β is the
sensitivity of the asset or portfolio in relation to the specified factor and RP is the risk premium of the specified factor.

Differences Between CAPM and APT

At first glance, the CAPM and APT formulas look identical, but the CAPM has only one factor and one beta. Conversely, the
APT formula has multiple factors that include non-company factors, which requires the asset's beta in relation to each
separate factor. However, the APT does not provide insight into what these factors could be, so users of the APT model
must analytically determine relevant factors that might affect the asset's returns. On the other hand, the factor used in the
CAPM is the difference between the expected market rate of return and the risk-free rate of return. Since the CAPM is a
one-factor model and simpler to use, investors may want to use it to determine the expected theoretical appropriate rate
of return rather than using APT, which requires users to quantify multiple factors.

Read more: CAPM vs. Arbitrage Pricing Theory: How They Differ |

Investopedia https://www.investopedia.com/articles/markets/080916/capm-vs-arbitrage-pricing-theory-how-they-

differ.asp#ixzz5YEfrfqIx

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Working Capital: Meaning, Concept & Nature – Explained!
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Meaning:
In an ordinary sense, working capital denotes the amount of
funds needed for meeting day-to-day operations of a concern.
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This is related to short-term assets and short-term sources of

financing. Hence it deals with both, assets and liabilities—in the
sense of managing working capital it is the excess of current
assets over current liabilities. In this article we will discuss about
the various aspects of working capital.

Concept of Working Capital:

The funds invested in current assets are termed as working
capital. It is the fund that is needed to run the day-to-day
operations. It circulates in the business like the blood circulates in
a living body. Generally, working capital refers to the current
assets of a company that are changed from one form to another
in the ordinary course of business, i.e. from cash to inventory,
inventory to work in progress (WIP), WIP to finished goods,
finished goods to receivables and from receivables to cash.

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There are two concepts in respect of working capital:

(i) Gross working capital and

(ii) Networking capital.

Gross Working Capital:

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The sum total of all current assets of a business concern is termed

as gross working capital. So,

Gross working capital = Stock + Debtors + Receivables + Cash.

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Net Working Capital:

The difference between current assets and current liabilities of a
business concern is termed as the Net working capital.

Hence,

Net Working Capital = Stock + Debtors + Receivables + Cash –

Creditors – Payables.

Nature of Working Capital:

The nature of working capital is as discussed
below:
i. It is used for purchase of raw materials, payment of wages and
expenses.

ii. It changes form constantly to keep the wheels of business

moving.

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iii. Working capital enhances liquidity, solvency,

creditworthiness and reputation of the enterprise.

iv. It generates the elements of cost namely: Materials, wages

and expenses.

v. It enables the enterprise to avail the cash discount facilities

offered by its suppliers.

vi. It helps improve the morale of business executives and their

efficiency reaches at the highest climax.
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vii. It facilitates expansion programmes of the enterprise and

helps in maintaining operational efficiency of fixed assets.

Need for Working Capital:

Working capital plays a vital role in business. This capital
remains blocked in raw materials, work in progress, finished
products and with customers.

The needs for working capital are as given below:

i. Adequate working capital is needed to maintain a regular
supply of raw materials, which in turn facilitates smoother
running of production process.

ii. Working capital ensures the regular and timely payment of

wages and salaries, thereby improving the morale and efficiency
of employees.

iii. Working capital is needed for the efficient use of fixed assets.

iv. In order to enhance goodwill a healthy level of working

capital is needed. It is necessary to build a good reputation and
to make payments to creditors in time.

v. Working capital helps avoid the possibility of under-

capitalization.

vi. It is needed to pick up stock of raw materials even during

economic depression.

vii. Working capital is needed in order to pay fair rate of

dividend and interest in time, which increases the confidence of
the investors in the firm.
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Importance of Working Capital:

It is said that working capital is the lifeblood of a business. Every
business needs funds in order to run its day-to-day activities.

The importance of working capital can be better

understood by the following:
i. It helps measure profitability of an enterprise. In its absence,
there would be neither production nor profit.

ii. Without adequate working capital an entity cannot meet its

short-term liabilities in time.

iii. A firm having a healthy working capital position can get

loans easily from the market due to its high reputation or
goodwill.

iv. Sufficient working capital helps maintain an uninterrupted

flow of production by supplying raw materials and payment of
wages.

v. Sound working capital helps maintain optimum level of

investment in current assets.

vi. It enhances liquidity, solvency, credit worthiness and

reputation of enterprise.

vii. It provides necessary funds to meet unforeseen contingencies

and thus helps the enterprise run successfully during periods of
crisis.

Classification of Working Capital:

Working capital may be of different types as
follows:
(a) Gross Working Capital:
Gross working capital refers to the amount of funds invested in
various components of current assets. It consists of raw
materials, work in progress, debtors, finished goods, etc.
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(b) Net Working Capital:

The excess of current assets over current liabilities is known as
Net working capital. The principal objective here is to learn the
composition and magnitude of current assets required to meet
current liabilities.

(c) Positive Working Capital:

This refers to the surplus of current assets over current liabilities.

(d) Negative Working Capital:

Negative working capital refers to the excess of current liabilities
over current assets.

(e) Permanent Working Capital:

The minimum amount of working capital which even required
during the dullest season of the year is known as Permanent
working capital.

(f) Temporary or Variable Working Capital:

It represents the additional current assets required at different
times during the operating year to meet additional inventory,
extra cash, etc.

It can be said that Permanent working capital represents

minimum amount of the current assets required throughout the
year for normal production whereas Temporary working capital
is the additional capital required at different time of the year to
finance the fluctuations in production due to seasonal change. A
firm having constant annual production will also have constant
Permanent working capital and only Variable working capital
changes due to change in production caused by seasonal
changes. (See Figure 7.1.)
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Similarly, a growth firm is the firm having unutilized capacity,

however, production and operation continues to grow naturally.
As its volume of production rises with the passage of time so also
does the quantum of the Permanent working capital. (See Figure
7.2.)

Components of Working Capital:

Working capital is composed of various current
assets and current liabilities, which are as follows:
(A) Current Assets:
These assets are generally realized within a short period of time,
i.e. within one year.

Current assets include:

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(a) Inventories or Stocks

(i) Raw materials

(ii) Work in progress

(iii) Consumable Stores

(iv) Finished goods

(b) Sundry Debtors

(c) Bills Receivable

(d) Pre-payments

(e) Short-term Investments

(f) Accrued Income and

(g) Cash and Bank Balances

(B) Current Liabilities:

Current liabilities are those which are generally paid in the
ordinary course of business within a short period of time, i.e. one
year.

Current liabilities include:

(a) Sundry Creditors

(b) Bills Payable

(c) Accrued Expenses

(d) Bank Overdrafts

(e) Bank Loans (short-term)

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(f) Proposed Dividends

(g) Short-term Loans

(h) Tax Payments Due

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