Time Value of Money
MAXIMIZE THE VALUE OF THE
BUSINESS (FIRM)
The Investment
Decision
The Financial
Decision
The Dividend
Decision
Invest in assets that
earn a return greater
than the minimum
acceptance hurdle rate
Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations
If you cannot find
investments that make
your minimum acceptable
rate, return the cash to
owners of your business
The hurdle
rate
Should reflect
the riskiness
of the
investment
and the mix of
debt and
equity used to
fund it
The return
Should reflect
the magnitude
and the timing
of the cash
flows as well
as all side
effects
The optimal
mix of debt
and equity
maximizes
firm value
The right
kind of debt
matches the
tenor of your
assets
How much
cash you can
return
depends on
current and
potential
investment
opportunities
How you
choose to
return cash
to the
owners will
depend on
whether they
prefer
dividends or
buybacks
• Money has time value. A rupee today is more valuable than a rupee a year
hence. Why? There are several reasons:
• Individual, in general, prefer current consumption to future consumption.
• Capital can be employed productively to generate positive returns. These returns are risky and
therefore more the risk the less is the value of cash flows.
• In an inflationary period a rupee today represents a greater real purchasing power than a rupee a
year hence.
• Other things remaining equal, value of cash flows will decrease, if
- Preference for current consumption increases
- Expected inflation increases
- Uncertainty increases
Discounting and Compounding
• Compounding converts current cash flows into future and vice versa
is discounting
• Discount rate is the rate at which present and future cash flows are
traded off
- Preference for higher consumption ( SME/shopkeeper)- Higher
discount rates
- Expected inflation – Higher discount rates
- Uncertainty/Risk – Higher discount rates
We will discuss here the following issues:
•
Simple cash flows
• Annuities
• Growing annuities
• Perpetuities
• Growing Perpetuities
When you value assets, it’s a combination of these cash flows- Bonds
are annuity (coupon) and simple cash flow at the end ( face value at
maturity). Stock/company valuation is growing annuity and growing
perpetuity.