(^32) Financial Management
Measurement
Time Value of Money
If an individual behaves rationally, then he would not equate money in hand today with
the same value a year from now. In fact, he would prefer to receive today than receive
after one year. The reasons sited by him for preferring to have the money today include:
- Uncertainty of receiving the money later.
- Preference for consumption today.
- Loss of investment opportunities.
- Loss in value because of inflation.
The last two reasons are the most sensible ones for looking at the time value of money.
There is a 'risk free rate of return' (also called the time preference rate) which is used
to compensate for the loss of not being able to invest at any other place. To this a 'risk
premium' is added to compensate for the uncertainty of receiving the cash flows.
Required rate of return = Risk free rate + Risk premium
The risk free rate compensates for opportunity lost and the risk premium compensates
for risk. It can also be called as the 'opportunity cost of capital' for investments of
comparable risk.
To calculate how the firm is going to benefit from the project we need to calculate
whether the firm is earning the required rate of return or not. But the problem is that the
projects would have different time frames of giving returns. One project may be giving
returns in just two months, another may take two years to start yielding returns. If both
the projects are offering the same %age of returns when they start giving returns, one
which gives the earnings earlier is preferred.
This is a simple case and is easy to solve where both the projects require the same
capital investment, but what if the projects required different investments and would
give returns over a different period of time? How do we compare them? The solution
is not that simple. What we do in this case is bring down the returns of both the projects
to the present value and then compare. Before we learn about present values, we have
to first understand future value.
Future Value
If we are getting a return of 10 % in one year what is the return we are going to get in
two years? 20 %, right. What about the return on 10 % that you are going to get at the
end of one year? If we also take that into consideration the interest that we get on this
10 % then we get a return of 10 + 1 = 11 % in the second year making for a total return
of 21 %. This is the same as the compound value calculations that you must have
learned earlier