Saturday, October 10, 2009



Concepts- value and return.

Most financial decisions affect the firm’s cash flows in different time periods.
The recognitions of the time value of money and risk is extremely vital in financial decision making.

Time Preference for Money.

Time preference for money is an individual’s preference for possession, of a given amount of money now, rather than the same amount at some future time.
There for reasons attributed for it,

  1. Risk
  2. Preference for consumption
  3. Investment opportunities

Required rate of return

Time preference of money is generally expressed by an interested rate.
Required rate of return = risk free rate + risk premium
  • Interest rate will be positive even in the absence of any risk it called risk free rate.
  • An investor will be exposed to some degree of risk there fore he would require a rate of return, called risk premium

The risk free rate compensates for time while risk premium compensates for risk. The required rate of return may also be called the opportunity cost of capital of comparable risk.

Future value
  • For a single cash flow
    Fn = P (1+i) n
    Fn = Future Sum
    P = Principal
    I = Interest rate
    n = Number of years

  • Future value of a lump Sum
    Fn = P X CVFn,i
    Fn = Future Sum
    P = Principal
    CVF = Compound value factor for n periods at I rate of interest

  • Future value of an annuity
    Annuity is fixed payment or receipt each year for a specified number of years.
    Fn = A X CVFAn,iFn = Future sum
    CVFAn,I = Compound value factor for annuity = ((1+i)n-1)/i)

  • Sinking FundSinking fund is a fund which is created out of fixed payments each period to accumulate to a future sum after a specified period.
    A = Fn X SFFn,i
    SFFn,I = ((i)/(1+i)-1)

Present Value
Present value of a future cash flow is the amount of current cash that is of equivalent value to the decision maker.
  • For a single cash flow.
    P = Fn (1/(1+i)n)

  • Present value of a lump sum.
    PV = Fn X PVAn,i

  • Present value of an annuity.
    PV = A X PVFAn,i
    A = Annuity
    PVFAn,i= Present value annuity factor

  • Present value of perpetuity.
    Perpetuity is an annuity that occurs indefinites.
    P = A/ i

  • Present value of an uneven cash flow.
    P = (A1 X PVF1) + (A2 X PVF2) +………………………+ (An X PVAFn)
Net Present ValueNet present value of a financial decision is the difference between the present value of cash inflows and the present value of cash outflows.
That the financial objective should be monetize the shareholders wealth. Wealth is defined as net present value.

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