Corporate Finance

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Corporate Finance

BASIS FOR TIME VALUE OF MONEY

A cash flow available in the future is worth less than a similar cash flow today, because of:

• Inflation. Due to inflation, the value of money decreases over time. Higher the inflation, lower the value.


• Preference for current consumption. Individuals prefer current consumption to future consumption. So
  they have to be offered more in the future to give up current consumption.


• Riskiness of the cash flow. The uncertainty of the cash flow reduces the value of the cash flow. Higher
  the uncertainty, lower is its value of today.

Lastly, money can be invested profitably in some productive activity. In short, money has time value. A rupee
available now cannot be compared to a rupee available, say, a year from now.

Future Value and Compound Interest

Suppose you deposit Rs 1,000 in Global Trust Bank for one year, and the bank pays 13 percent interest.

Interest = 0.13 × 1000 = Rs 130

Amount at the end of 1 year = Principal + Interest

= Rs (1000 + 130) = Rs 1310

It is easy to see that:

Value of investment after 1 year = Initial investment × (1 + r)
where ‘r’ is the interest rate in decimal form.

Now, if you wish to keep the balance in the bank, the principal for the second year would be Rs 1,310
(and not 1,000) and interest would be paid on this amount.

Interest for the second year = 0.13 × 1310 = Rs 170.30

Amount at the end of second year = Rs (1310 + 170.30) = Rs 1480.30

An investment of Rs 1,000 grew to Rs 1,310 in one year and Rs 1,480.30 in two years The amount
available at the end of the investment horizon is called future value and the process of multiplying the
investment is called compounding. Note that the interest earned in the first year also earned interest in the
second year.
In general,

Future Value of an amount, FV = Amount (1 + r)n (1)

where r= interest rate, and
t= investment horizon.

The term (1 + r)n is called the Future Value Interest Factor (FVIF). It is the value of Re 1 interest at ‘r’ percent
after ‘n’ years. Exhibit 2.1 illustrates the future value of an amount A at the end of 1, 2, 3,..., n years.