Answer To: Financial Management Principles Term Paper Guidelines Summer Semester, 2020 type of work: It is an...
Soumyadeep answered on Jun 20 2021
Financial Management Principles: FINA311
Research Paper
Time Value of Money
Majed Alghamdi
Student ID: 201201185
Dr. Mohamed Khaled Al-Jafari
Financial Management Princples_101
July 5th, 2020
Table of Contents
Executive Summary 1
Introduction 2
Literature Review 2
Basics of TVM 3
Reasons for Time Value of Money 4
Interpretation of Interest/Discount Rate 5
Interest Rates: Investor Perspective 5
Types of cash Flow 6
Significance of Time Value of Money 7
Applications 8
Investment Appraisal 8
Valuation 10
Operation Optimization 12
Conclusion 14
References 15
Executive Summary
Time Value of Money (TVM) is the foundation concept of finance as demonstrated by the existing literature review of the concept. After discussing the basics of TVM and what drives it, we discuss the implications of the interest or the discount rate and factors driving its value. The significance of TVM has been clearly explained with several examples of investment in corporate finance, how the concept is useful in the valuation of stocks and bonds and how the concept helps in the management of current assets specially inventory control. The examples firmly establish that without proper deployment of time value of money, business will miss out on profitable opportunities and may even end up incurring losses without proper investment appraisal. Not only that, when individuals invest their hard-earned money in trading shares of companies, they should base their decisions on rational valuation of securities to maximize their returns.
Introduction
Time Value of Money (TVM), simply means that a dollar an individual receives today is worth more than a dollar that will be received in the future. A dollar or any amount that is received today and invested today will begin to earn a return earlier than the same amount invested tomorrow or in the future. The underlying concept of TVM is that it is not possible to compare the same amount of money from two different periods without considering the difference in their value caused due to time. TVM concept is valid for both corporate finance and personal finance and it is perhaps the foundation chapter for any finance course. Anyone who deals with finance and money on a regular basis, whether they be financial managers, investors, creditors or business students, it is critical for them to be able to understand and employ TVM concepts with a certain degree of efficiency and competency in order to make informed business decisions based on valuations, working capital management, capital budgeting and capital structure.
Literature Review
In the world of finance, two problems have persisted till eternity-limited resources and unlimited opportunities. This issue is effectively addressed by the TVM concept as proposed by Zarqa (1983) who proposes that the rate of return of ongoing projects with an equal risk profile should be used as the benchmark for the discount rate to evaluate the expected future cash flows of any project. He also explained the consumer time preference theory with the conclusion that it is neither a rationally nor an empirically established trend that is prevalent among consumers. Rosly (2005) proposed and demonstrated that time has an economic value as every production and consumption is a time consuming activity. As more satisfaction associated with current consumption than future consumption, people will need to be compensated to sacrifice and postpone current consumption in favour of future consumption. Kahaf (1994) highlighted that TVM should be perceived more as an investment concept instead of a consumption concept and TVM based valuation should be acceptable only if it happens at the end of investment when the outcomes are known. Any prior evaluation creates an illusion which can be utilized for mental exercise but must not be used to exchange products and services. Ahmad and Hassan (2004) also propagate TVM as an investment concept.
Ghare and Schrader (1963) were one of the first authors who incorporated the issue of deteriorating items to analyse inventory problems. Dave and Patel (1981) further introduced the impact of time on demand and computed an EOQ with equal replenishment cycles. This model was further improved by Sachan (1984) and Wee (1997) by considering shortages. Till then most studies on inventory management did not include the concept of TVM. Buzacott (1975) was the first author to incorporate inflation in inventory management. Mishra (1979) accounted for the TVM concept and inflation both internal and external inflation rate to analyse their impact on replenishment strategy. The result was extended by Chandra and Bahner (1985). Sarkar and Pan (1994) developed a replenishment model with a finite timeline and incorporated both inflation and TVM on order quantity includind shortages. Hariga (1995) developed an inventory model incorporating TVM with the impact of time on demand and shortages. Pattnaik (2015) applied the method of discounted cash flows to analyse inventory management problems to develop the economic production quantity (EPQ) model.
Basics of TVM
1. Present Value (PV) is a future cash flow or a series of future expected cash flows discounted at an adequate discount rate of interest up to the present date to account for TVM.
2. Future Value (FV) is amount evaluated by inflating the value of a current cash flow or sequence of payments
3. Rate of Interest (r) is the adequate rate used to discount expected cash flows in the future or inflate present values to facilitate comparison. It may be the required rate of return, interest rate or weighted average cost of capital.
4. Number of Periods (N) is the time period for which future cash flows are discounted to calculate appropriate return.
Given than an individual is expected to receive a future cash flow after N periods with a rate of return per period that is r, the PV can be evaluated by:
where: N = number of periods r = rate of interest FV = future value of investment,
Reasons for Time Value of Money
· In comparison to future consumption, present consumption is always preferred. To lure people to invest for the future taking up risk and sacrificing present consumption, they need to compensated with a return.
· Inflation happens in any economy, more so in the economy of the developed countries and the value of currency which is denoted by the purchasing power parity diminishes with time due to monetary inflation. The difference increases with increasing inflation (Irena & Mariana, 2017).
· There will also be risks or uncertainties regarding expected cash flows in the future and the greater is the degree of risk, less will be the present value of those cash flows.
To sum up everything, with other variables constant, the present value of expected cash flows in the future will decrease with:
· Increasing demand for current consumption
· Increasing in expected inflation
· Increasing in the uncertainty or risk of future cash flow
Interpretation of Interest/Discount Rate
1. Required rate of return: The fact an individual buys shares of a company at $50 per share with the hope that the value of the share will be $55 a year after means that the required rate of that investor is 10%. A similar logic applies to financial institutes or creditors lending money at interest with the interest rate being the required rate of return.
2. Discount rate: If an individual knows that he will get $1000 after 1 year, then to calculate the present value, he will interpret the rate as a discount rate.
3. Opportunity cost: The discount rate is also perceived as an opportunity cost. Opportunity cost is the cost foregone since it captures the profit on the next suitable opportunity (Spiller, 2011). If an individual is not investing $1,000 in a financial instrument which...