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Financial Management UNIT-1
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Financial Management UNIT-1
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To get completely into the syllabus of this subject Financial Management lovably called as just FM, please come here 👉💌
The central Idea behind the "Theory of time value of money" is the fact that the money received today is worth more than the same amount of money at any future date.
To understand it clearly, let's say that it simply means that "one rupee today is more than the same one rupee tomorrow".
When this concept is preferred for present money against the future money, then it is termed as time preference for money.
The difference between the value of money at present date and the value of same money at future date is termed as "time value of money"
Need/Reasons for time value of money
1. Risk and uncertainty
Cash outflow is always certain but cash inflow is always doubted and risky and hence, time value of money is preferred.
2. Preference for consumption
Goods and services consumed by the consumer are usually thier urgent and present requirements. Hence, they prefer to have money now to consume now.
3. Investment opportunities
A rupee invested today will give higher level of value in the future by considering time value of money.
4. Inflationary economy
The main reason behind considering the concept of time value of money is the inflationary behaviour of economy, as the purchasing power of same amount of money is decreasing year by year.
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Concept of simple interest and compound interest
Simple interest is the interest paid or computed only on the original amount (principal amt) of a loan or investment.
Compound interest is the interest calculated on the initial principle amount as well as accumulated interest on that amount. This is why it is also known as "interest on interest"
NOTE : The concept of compound interest makes a loan or deposit grow at a faster rate than that of simple interest.
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Basic valuation techniques
Basically there are two valuation techniques for finding the time value of money.
Compounding/ Future value techniques
Discounting/ Present value techniques
Compounding future value techniques
These techniques abide by the concept of compounding. This is similar to the concept of compound interest.
1. Future value of a single cash flow is calculated by the formula:
FV=PV(1+r)^n
FV is Future value
PV is Present value
R is rate of interest
n is no. of periods or no. of years or time gap
2. Future value of uneven cash flow
It can be easily derived by adding all the single cash flows in the uneven cash flow stream.
3. Future value of annuity / series of equal cash flows
Many imvestments provide fixed amount of regular cash flows at regular intervals and such regular clash flows are known as an annuity.
Formula to calculate them is:
Where
FVAn is future value of annuity with time period of n
A is constant periodic flow
r is rate of interest
n is time period of annuity
●Growing annuity
A finite series of regular cash flows growing at fixed rate every year is known as growing annuity.
Formula to calculate it :
WHERE,
FV(A) is the value of annuity
A is the value of individual payment
i is interest rate
n is number of period
g is growth rate
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Discounting present value technique
It is defined as the process of determining the present value of a payment or stream of payments which is likely to be the used in the future time.
It is just the opposite of compounding technique.
RELATION OF PV to OTHER FACTORS:
》》PV is positively related to FV which means in order to get higher future value, higher investment should be made today (which means higher present value).
》》PV is inversely related to interest rate(r) which means higher the interest rate, lower will be the present value requirement because money will grow quickly and vice versa.
》》PV is inversely related to time period(n) because longer the time period lower the present value will be required as money will grow more in longer time period and vice versa.
1. Formula for finding the present value of single cash flow is :
2. Present value of uneven cash flow streams can be calculated by adding up all the different cash flows in the streams together as we do in the calculation of finding future value of an even cash flows.
3. Present value of annuity / series of equal cash flows is calculated by the following formula :
●Present value of growing annuity is calculated by the following formula:
☆Where everything has same meaning as the formula of future value growing annuity Only CF1 here means cash flow at the end of period 1.
4. Present value of perpetuity
Annuity with no fixed time period is known as perpetuity.
The formula to calculate present value of perpetuity:
●Growing perpetutity is a type of annuity which increases the payment gradually over an indefinite period of time.
The formula to derive growing perpetuity is:
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Concept of annuity due
Phenomenon in which an annuity whose payment is to be made immediately rather than at the end of the time period is termed as annuity due.
Doubling period
Investors are generally interested in knowing the amount of time taken for doubling the value of their investment.
In regards to this, two rules are used to derive the doubling period of any investment.
1. Rule 72
It is the simple way to determine the time period for a investment to double its value (when the rate of interest is fixed).
By dividing 72 by the annual rate of return, we get a rough estimate of the amount of time required to double an investment.
2. Rule 69
It is the general rule to estimate the doubling period (when compound interest is used) on any investment.
It is done by dividing 69 by the rate of return.
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Applications of the concept of TVM
Concept of TVM is practically used for :
Finding out the implicit rate of interest.
Finding out the number of periods.
Requirement of sinking funds (Sinking funds are defined as the fund created by any business entity by setting aside a fixed amount of money for a particular time period which can help the business in the repayment of long term loans or can be helpful in paying for unforseen capital expenditure.)
Capital recovery(The concept of TVM can be used to find out the annual amount required to be paid for recovering the invested capital in a business.)
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Loan amortization
This concept states that there are some borrowers who are willing to repay the loan amount but after a definite time period.
For example, if a borrower has taken loan of 10000 and will start paying the interest on it after 6 months, then the lender will calculate the time value of those 6 months and then he will implement the interest on the loan taken and the borrower will have to pay the total interest of those 6 months.
To understand it clearly, it simply says that if the borrower is willing to repay loan after some amount of time, then the lender will calculate the time value of money from the day of lending and will then apply the interest on the loan amount.
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