Module-3

Time value of money

The value of money today is more valuable than tomorrow is known as time value of money. Time value of money
describes the greater benefit of receiving money now rather than later. It is founded on time preference. The principle
of the time value of money explains why interest is paid or earned. Interest, whether it is on a bank deposit or debt,
compensates the depositor or lender for the time value of money. It also underlies investment. An investor is willing to
forego spending their money now if they expect a favorable return on their investment.

Cash flow diagram:

Cash flow diagrams are visual representation of cash inflows and outflows along a time line, during the
construction of a cash flow diagram. it is usually advantageous to first define the time frame over which cash flows
occur. This establishes the horizontal scale, which is divided into time periods, often in years. Cash inflows and
cash outflows are then located on the time line in adherence to problem specifications. Individual inflows or
outflows are designated by vertical lines relative magnitude can be represented by the heights of lines, but exact
scaling is not necessary. Cash outflows are shown by vertical lines below the axis and cash inflows are shown by
vertical lines above the axis. This is as follows:

o
1 2 3 n

INTEREST

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by
deposited funds. It defined as the compensation paid by the borrower of money to the lender of money. The sum of
money paid by the borrower to the lender for the use of the borrowed money is called interest. The rate of interest is
usually expressed as a percentage. The amount lent is called principal. The sum of principal and the interest at the end
of any time period is called the amount.

Interest is two types:-

1)Simple interest

2) compound interest

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 1
Simple interest

When the total interest is directly proportional to the principal, the interest rate and the number of interest periods for
which the principal is committed, the interest and interest rate are said to be simple.

When ever the interest of a year is based on the remaining principal amount plus any accumulated interest
changes up to the beginning of that period, the interest is said to be compound.

Formula for simple interest is = P X R X T

100
Where P= principal or initial investment, R indicates to rate of interest, T indicates to time period of duration of period
between inflow and outflow.

Compound interest:

Whenever the interest of a year is based on the remaining principal amount plus any accumulated interest changes up to
the beginning of that period, the interest is said to be compound.

Formula for compound interest = P (1+i )n --P

Where P indicates to principal, indicates to rate of interest for compounded period, n indicated to number of
compounded period.

Nominal rate of interest:

Nominal interest rate is the annual interest rate computed as the product of interest rate per period and the number of
periods per year.

( )
nXm
i
F= p 1+
m

Normally the rate of interest is compounded annually. But in sometimes interest may be compounded over time period
of less than a year i.e. half yearly, quarterly or monthly or daily. Ex: interest @ 12% quarterly compounded.

in this case i = .03, m = no of compound installments i.e. 4.

Where F = future value , p= principal, i= rate of interest per annum, m= number of installments per annum, n= no of
years.

Effective rate of interest:

It is the interest rate for the year that is actually earned or paid on an investment, loan or other financial product due to
the result of compounding over a given time period, it is also called as annual equivalent rate.

( )
m
i eff = 1+ i -1
m

Annuities:it is a sequence of fixed equal payment or receipts made over periodic interval. Ex: salary, rent insurance
premium etc.

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 2
Compound interest factors

Compound interest factors are classified into 7 parts, which are as follows:

1) Single payment compound interest factor

2) Single payment present worth factor
3) Equal payment series compounded amount factor
4) Equal payment series sinking fund factor
5) Equal payment series present worth factor
6) Equal payment series capital recovering amount factor
7) Gradient series annual equivalentamount factor
In this case different formulas will be required for solving the problems. Therefore we need to know some terms
relating to the formulas which are as follows:
P= present value or present worth
F = future value
A = equal amount installment invested or received till maturity
n = number of years or interest periods
i = interest rate per annum in percentage .i.e., ex: 10%= 0.1.
G = fixed annual increase charges.
A” = future value realized on gradient series.

1) Single payment compound interest factor:

Hear the objective is to find the single future sum F of the initial payment P made at time 0 period at an interest
rate, I compounded every period. The following is the cash flow diagram is as follows:
F=?
i%

1 2 3 4 5 n-1n

Formula for the above factor is :- F = P(1+i)nor F = P( F/P,i,n ).

2) Single payment present worth factor:
In this case the objectives is to find the present worth amount P of a single future sum, Where F is given as will be
received after ”n” no of years at a specified “ i” rate of interest percentage compounded at the end of every interest
period. Therefore the cash flow diagram is as follows:
F
i%

1 2 3 4 5 n-1 n

P =?

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 3
 F -n
Formula for the above factor is P= n = F(1+i) Or P = F (P/F,i,n)
(1+i)

3) Equal payment series compounded amount factor:

The objective is to find the future worth of” n” equal payments which are made at the end of every interest
periods till the end of the nth interest period at an interest rate of “i” compounded at the end of each interest
period.Here given item is annual investment money , time in years, rate of interest, finding is what amount of
money realized at the end of n period. Therefore the cash flow diagram is as follows:

F=?

O 1 2 3 4 5 6 n-1 n

( i%)
A A A A A A A A

[ ]
n
(1+i) −1
Formula for the above factor is F = A
i

Or F = A(F/A,i,n).
4) Equal payment series sinking fund factor:
The objective is to find the equivalent amount “A” that should be deposited at the end of every interest period for”
n” interest periods to realize a future sum at at the end of the” n” interest period at an interest rate of “ i”.
Given items are: future value, interest rate, number of years . finding is: what is the annual installment to be
deposited to get a lump sum of money. The diagram for that is as follows:

O 1 2 3 4 5 6 n-1 n

( i%)
A=? A=? A=? A=? A=? A=? A=? A=?

Formula for that is:

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 4
 [
A= F ( ) n
1+i −1
i
] or A= F(A/F,i,n)
5) Equal payment series capital recovery amount factor:
The objective is to find the annual equivalent amount , “A” which is to be recovered at the end of every interest
period for “n” interest periods for a loan,” p” which is sanctioned now at an interest rate of ”i” compounded at the
end of every interest period.
Here the given items are: present value (loan given how much), no of years of installments to recover an equal
amount, rate of interest. Finding is what amount money to be received as installment.
The following is the diagram:

A=? A=? A=? A=? A=? A=? A=? A=?

O 1 2 3 4 5 6 n-1 n

[ ]
n
i ( 1+i ) ❑
Formula for this is A=P or A=P(A/P,i,n)
( 1+i ) ❑n−1

6) Equal payment series present worth factor:

The object is to find the present worth of an equal payment made at the end of every interest period for” n”
interest periods at an interest rate of “i” compounded at the end of every interest period. The concept is what
amount of money to invest now, that can be realize “n” no of equal installments.
Given items are: equal payment of installment money, rate of interest, number of years. Finding is what is the
present value of the total installments.

P=?

O 1 2 3 4 5 6 n-1 n

Formula for this is P=A [ ( 1+i ) n−1

i ( 1+i ) n ] or P=A(P/A,i,n)

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 5
 7. Gradient series annual equivalent amount factor:
This is the non uniform series compound interest factor method. Every year the installment money is increased by
equal amount gradually. In this case it is to find out the future value of a series with an amount “A” at the end of
the first year and with an equal increment, G at the end of each of the following of first years with an interest rate”
i” compounded annually.
In this case the given items are: equal deposit amount per installment, equal increment at the end of each
installment G from the second year, rate of interest, and number of years.
We have to find out: what is the future value realized.
The following is the diagram:

A+G(n-1)

A+G2
A+G1
A

Formula for this is : A”= A+G [ ( 1+i ) n−i. n−1

i ( 1+i ) n −i ]or A”=A+G(A/G,i,n)
[ ]
n
(1+i) −1
F = A” or F= A” ( F/A,i,n).
i

Principles of economic equivalence

Two things are said to be equivalent when they have the same effects. When different cash flows
occurring a different time period are converted in to a common point of time is called time value
equivalents.

Economic equivalence is a combination of interest rate and time value of money to determine the different amounts
of money at different points in time that are equal in economic value. if the interest rate is 10% per year, Rs 1000 today
is equivalent to Rs 1100 after one year from today.

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 6
Economic equivalence is a fundamental concept upon which engineering economy computations are based. it refers
to the fact that a cash flow whether the single payment or a series of payment can be converted to an equivalent cash
flow at any point in time.

Evaluation of engineering projects

A project is an important activity where we expend capital recourses to create a producing asset from which we can
expect to realize benefits over an extended period of time. Project is an activity on which we will spend money in
expectation or returns and which logically seems to lend itself to planning, financing and implementation as a unit.

The followings are the various common methods of evaluating the projects:

1. net present value method or present worth method, ( NPV)

2. Internal rate of return method, (IRR)
3. Profitability index method, (PI)
4. Discounted pay back period method, (PBP)
5. Future worth method (FW)

We will discuss these in detail:

3. profitability index method:
It is very simple to understand. It will give the relation of NPV and initial investment.
It should be calculated by using the following formula= net present value/ initial investment.
If the answer is positive then the project is profitable and acceptable, if the answer is negative then the
project is in loss and not acceptable.

4. discounted pay back method: it is another type of evaluation of engineering projects ; that

This method sometimes called as pay out or pay off period method Represents the periods in which the total
investments in permanent assets pays back it self’s. This method is based on the principle that every capital
expenditure pays it self back within a certain period out of the additional earnings Generated from the capital assets.

Thus it measures the period of time for the original cost of a project to be recovered from the additional earnings of a
project itself. Under this method various investments are ranked according to the length of their pay back period in
such a manner that the investment with a short term pay back period is preferred to the one which has longer pay
back period.

6. Future worth method:

In this method the inflow and outflows of cash are converted into future values there after the realized values
will be compared. The alternative with the future worth of net revenue or with the minimum worth of net cost
will be selected as the best alternative for implementation.
EX: Questions, consider the following two mutually exclusive alternatives:

alternatives End of year

0 period 1st year 2nd year 3rd year 4th year
A -50,00,000 20,00,000 20,00,000 20,00,000 20,00,000
B -45,00,000 18,00,000 18,00,000 18,00,000 18,00,000

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 7
 If Interest is 18% P.A compound annually, select the best alternative based on future worth method of
comparison?

Ans) Alternative A
Initial investment, P = Rs 50,00,000
Annual equivalent revenue A, = Rs 20,00,000
Interest rate, I = 18%
life of alternative = 4years
finding the future value of all inflows and out flow:
the cash flow diagram of alternative A is shown below:

FW = -P (F/P,i,n)+ A (F/A,i,n)
FW = - 50,00,000 ( 1.939 )+ 20,00,000(5.215)
FW = - 96,95,000 + 1,04,30,000
FW = 7,35,000.

Alternate B:
Initial investment, P = Rs 45,00,000
Annual equivalent revenue A, = Rs 18,00,000
Interest rate, I = 18%
life of alternative = 4years
finding the future value of all inflows and out flow:
the cash flow diagram of alternative B is shown below:

FW = -P (F/P,i,n)+ A (F/A,i,n)
FW = - 45,00,000 ( 1.939 )+ 18,00,000(5.215)
Fw = -87,25,500 + 93,87,000
FW = 6,61,500.

The future worth of alternative A is greater than that of alternative B. thus alternative. A should be selected.
P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 8
P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 9
Net Present Value

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash
outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.

The formula for calculating NPV = Present value – initial investment

Generally, an investment with a positive NPV will be a profitable one and with a negative NPV will result in a net loss.
This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made
are those with positive NPV values.

The net present value (NPV) or net present worth (NPW) is a measurement of the profitability of an undertaking that is
calculated by subtracting the present values (PV) of cash outflows (including initial cost) from the present values of
cash inflows over a period of time.

Therefore a project with positive NPV will be acceptable

A project with negative NPV will be rejectable.

Ex: question) -calculate the present value and net present value of the following cash flows assuming the discount
rate or interest rate is 12%.

Year ended Cash flows in rupees

Zero period 35,000 cash outflow
End of 1st year 10,000 cash inflow
End of 2nd year 20,000 cash inflow
End of 3rd year 10,000 cash inflow
End of 4th year 8,000 cash inflow

Ans) this is the non equal value cash flow. For calculation of present value of cash inflow at different periods , we need
to go through the compound interest factor table method, i.e., P= F (P/F, i,n) or P = F(P/F,12%,n). Here “ n” should be
taken as per the cash flow arises. Now we will prepare a present value table:

End of year Cash inflow Present value Present value

factor for Re 1, @
12%
1st year 10,000 0.8929 8,929
2nd year 20,000 0.7972 15,944
3rd year 10,000 0.7118 7,118
4th year 8,000 0.6355 5084
Total present value 37,075

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 10
The total present value of cash inflow of the project on zero period is Rs 37,075, where as the initial investment is Rs
35,000,

therefore NPV(net present value) is 37,075-35,000 = Rs 2,075.

Due to NPV is positive the project should be acceptable.

Advantages and Disadvantages Of Net Present Value (NPV)

Advantages Of Net Present Value (NPV)

1. NPV gives important to the time value of money.

2.In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered.
3. Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm's value.
Disadvantages Of Net Present Value (NPV)

1. NPV is difficult to use.

2. NPV can not give accurate decision if the amount of investment of mutually exclusive projects are not equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give correct decision when the projects are of unequal life.

Profitability Index

The profitability index is a regulation for evaluating whether to proceed with a project or investment. The profitability
index rule states: If the profitability index or ratio is greater than 1, the project is profitable and may receive the green
signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject
or abandon the project.

The higher the PI the better. A profitability index greater than 1.0 is considered to be a good investment, as it
means that the expected return is higher than the initial investment.

PI = PV / Initial Investment

The profitability index rule is a variation of the net present value (NPV) rule. In general, if NPV is positive, the
profitability index would be greater than 1; if NPV is negative, the profitability index would be below 1. The
profitability index differs from NPV in one important respect; Being a ratio, it ignores the scale of investment and
provides no indication of the size of the actual cash flows. For example, a project with an initial investment of Rs
1,00,000, and present value of future cash flows of Rs 1,20,000, would have a profitability index of 1.2. Based on the
profitability index rule, the project would proceed.

Internal Rate Of Return - IRR

This is a method of calculating rate of interest on investments. Till now we prepared some numerical, where rate of
interest is given, but in this method inflow, outflow of cash and time(n) also be given we need to calculate the rate of
interest or discounting rate. Internal rate of return (IRR) is a tool used in capital budgeting measuring the profitability

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 11
of potential investments. Internal rate of return is a discount rate ( interest rate) that makes the net present value
(NPV) of all cash flows from a particular project equal to zero. IRR calculations uses the same formula as NPV does.

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate r, which is here the
IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically, and must instead be
calculated either through trial-and-error.

CASH FLOW TABLE AT VARIOUS ASSUMEDDISCOUNT RATES OF 12%, 14% AND 15%
YEAR Annual Discount rate 12% Discount rate 14% Discount rate 15%
cash p.v Present p.v Present p.v Present value
flow factor value factor value factor
value value value
1. 1,50,000 .8929 1,33,935 .8772 1,31,580 .8696 1,30,440
2. 2,00,000 .7972 1,59,440 .7695 1,53,900 .7561 1,51,220
3. 3,00,000 .7118 2,13,540 .6750 2,02,500 .6575 1,97,250
4. 2,00,000 .6355 1,27,100 .5921 1,18,420 .5718 1,14,360

6,34,015 6,06,400 5,93,270

Advantages and disadvantages of internal rate of return

Advantages and disadvantages of internal rate of return are important to understand before applying this technique to
the projects. Most projects are well analyzed and interpreted by this well-known technique of evaluation and selection
of investment projects. This technique has certain limitations in analyzing certain special kinds of projects like mutually
exclusive projects, an unconventional set of cash flows, different project lives etc.

ADVANTAGES OF INTERNAL RATE OF RETURN:

The various advantages of internal rate of return method of evaluating investment projects are as follows: Time Value
of Money:

1) The first and the most important thing is that it considers the time value of money in evaluating a project
which is a big lacking in accounting rate of return.
2) The most attractive thing about this method is that it is very simple to interpret after the IRR is calculated.
3) It is very easy to visualize for managers and that is why this is preferred till the time they come across certain
occasional situations such as mutually exclusive projects etc.
4) In IRR, the hurdle rate or the required rate of return is not required for finding out IRR.
5) It is not dependent on the hurdle rate and hence the risk of a wrong determination of hurdle rate is mitigated.
6) Required Rate of Return is a Rough Estimate: A required rate of return is a rough estimate being made by the
managers and the method of IRR is not completely based on required rate of return.

DISADVANTAGES OF INTERNAL RATE OF RETURN:

The method of internal rate of return does not prove very fruitful under certain special type of conditions which are
discussed below:

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 12
 1) Economies of Scale Ignored: One pitfall in the use of IRR method is that it ignores the actual dollar value of
benefits.
2) Impractical Implicit Assumption of Reinvestment Rate: While analyzing a project with IRR method, it implicitly
assumes that the positive future cash flows are reinvested at IRR. If a project has low IRR, it will assume
reinvestment at a low rate of return and on the contrary if the other project has very high IRR, it will assume
reinvestment rate at the very high rate of return. This situation is practically not valid. At the time you receive
those cash flows, having the same level of investment opportunity is rarely possible.
3) Dependent or Contingent Projects: Many times, finance managers come across a situation when the project
under evaluation creates a compulsion of investing in other projects. Such projects are called dependent or
contingent projects which have to be considered by the manager.
4) IRR may permit buying of the vehicle but if the total proposed benefits are wiped off in arranging the parking
space, there is no point investing.
5) Mutually Exclusive Projects: Sometimes investors come across mutually exclusive projects which mean if one
is accepted other cannot be accepted. Building a hotel or a commercial complex on a particular plot of land is
an example of mutually exclusive projects. In such situations, knowing whether they are worth investing is not
enough. The challenge is to know which one is the best. IRR will give a percentage interpretation value which
is not enough. Refer the first disadvantage of economies of scale which is ignored by IRR.
6) Different Terms of Projects: Consider two projects with different project duration. One ends after 2 years and
the other ends after 5 years. The first project has an additional point of reinvesting the money which is
unlocked at the end of the 2nd year for another 3 years till the other project ends. This point is not considered
by IRR method.
7) A mix of Positive and Negative Future Cash Flows: When a project has some negative cash flow in between
other positive cash flow, the equation of IRR is satisfied with more than one rate of return i.e. it reaches the
trap of Multiple IRR.

Accounting rate of return

ARR' The accounting rate of return is the amount of profit, or return, that an individual can expect based on an
investment made. Accounting rate of return divides the average profit by the initial investment in order to get the
ratio or return that can be expected. This allows an investor or business owner to easily compare the profit potential
for projects, products and investment

Accounting rate of return Accounting rate of return This article is about a capital budgeting concept.. Accounting rate
of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does
not take into account the concept of time value of money. ARR calculates the return, generated from net income of
the proposed capital investment. If the ARR is equal to or greater than the required rate of return, the project is
acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR,
the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

Advantages And Disadvantages Of Accounting Rate Of Return (ARR)

Advantages Of Accounting Rate Of Return (ARR)

1. ARR is based on accounting information, therefore, other special reports are not required for determining ARR.

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 13
2. ARR method is easy to calculate and simple to understand.
3.ARR method is based on accounting profit hence measures the profitability of investment.

Disadvantages Of Accounting Rate OF Return (ARR)

1. ARR ignores the time value of money.

2. ARR method ignores the cash flow from investment
3. ARR method does not consider terminal value of the project.
While making investment decision computations will be done in many ways. To simplify all these
computations, it is extremely important to know how to use interest formulas more effectively. Before discussing the
effective application of interest formulas for investment decision making, the various interest formulas are presented
first. Those are simple interest and compound interest.

P Narasimha Murty, Asst. Professor, School of Management Studies, GIET University, Gunupur.Page 14