Question

* Why does money have a time value?

* Provide a real world example of application of Time Value of Money.

( min 250 words .)

Answer 1

Money have a time value because it has potential to grow with time. The rate of growth may vary depending upon what kind of instrument we have chosen.

The future cash flows need to be discounted because there is a time value of money. Cash flows which occur earlier are more valuable than cash flows which occur later.

The time value of money is there because of three reasons / factor:

• inflation,
• uncertainty, and
• opportunity costs.

The discount rate by which cash flows are discounted should be good enough to compensate an investor for all the three parameters.

Real Life Example

A friend of mine along with my brother runs a financial training institute in the name of "Edupristine". It recently acquired one new classroom, where it could have run the batches either for financial modeling (FM) or CFA course. Initial investment in both the courses are same and subsequent cash flows for both the courses are shown below. All financials in $

Year	0	1	2	3	4	5
FM	(8,00,000)	3,00,000	3,50,000	4,00,000	70,000	50,000
CFA	(8,00,000)	80,000	1,40,000	3,00,000	4,00,000	5,00,000

Edupristine uses a hurdle rate of 12% to decide on its investment decision. The question in hand was, which course should Edupristine go ahead with?

How it was solved?

The corporate finance team calculated the time value of money and used the NPV method of capital budgeting as evaluation tool.

NPV method discounts all the future cash flows of the firm with the required rate of return (RRR) to obtain their present values. Present value of a future cash flow is that value of cash required today that will grow to the future value if invested at RRR. Hence, present value of a cash flow (CF_t) in period t (years) from now at a RRR of k is given by,

The present values of all the future cash inflows are aggregated and netted against the present values of all the future cash outflows to obtain NPV.

Projects with normal or conventional cash flows have outflows, or costs, in the first year (or years) followed by a series of inflows. Projects with non-normal or non-conventional cash flows have one or more outflows after the inflow stream has begun. In case, the project involves just one cash outflow in t = 0 and cash inflows in subsequent year (normal or conventional project) then,

This can be interpreted as: A project’s NPV is the present value of the project’s future expected cash flows minus the proposal’s initial cash outflow.

The discount rate used here is RRR which can be interpreted as:

• Minimum return required by the firm from a capital investment
• A return which is available to the company had it invested the funds in an alternative with same risk profile
• Desired rate of return, hurdle rate, threshold rate, opportunity cost of capital

The RRR chosen to discount the cash flows and compute the NPV must be appropriate to the risk of the project. It must reflect all the three factors behind time value of money: inflation, uncertainty and opportunity costs. RRR is not directly observable. It’s subjective and will vary from investor to investor. Two commonly used surrogates for discount rate are:

• Minimum rate of return: based on firm’s strategic objectives, industry averages and common investment opportunities.
• Weighted average cost of capital: weighted average cost of funding instruments used by the company for financing the project.

Presented below was the NPV analysis of FM course. All financials in $

Year	0	1	2	3	4	5
Cash flows	(8,00,000)	3,00,000	3,50,000	4,00,000	70,000	50,000
PV @ 12%	(8,00,000)	2,67,857	2,79,018	2,84,712	44,486	28,371
NPV	1,04,445

Presented below was the NPV analysis of CFA course. All financials in $.

Year	0	1	2	3	4	5
Cash flows	(8,00,000)	80,000	1,40,000	3,00,000	4,00,000	5,00,000
PV	(8,00,000)	71,429	1,11,607	2,13,534	2,54,207	2,83,713
NPV	1,34,490

On the basis of NPV, the management's decision was to run the CFA training program in the newly acquired classroom.