Q.1. ‘Generally individuals show a time preference for money.’ Give reasons for such a preference.
A.1. Individuals generally prefer possession of a given amount of cash now, rather than the same at some future time. The main reason for the time preference or time value of money is the availability of investment opportunities. Other reasons are uncertainty of cash flows and preference for current consumption of goods, commodities and services.
A.1. Individuals generally prefer possession of a given amount of cash now, rather than the same at some future time. The main reason for the time preference or time value of money is the availability of investment opportunities. Other reasons are uncertainty of cash flows and preference for current consumption of goods, commodities and services.
Q.2. ‘An individual’s time preference for money may be expressed as a rate.’ Explain.
A.2. Time preference rate of money can be expressed as an interest rate. Interest rate gives money its value, and facilitates the comparison of cash flows occurring at different time periods. The minimum interest rate in the absence of any risk is known as risk-free rate. It is a compensation for time. If an individual is exposed to some degree risk, he would expect a rate of return higher than the risk-free rate from the investment compensating him for both time and risk. The rate added to compensate risk is known as risk premium. The interest rate permits the individual to convert different amounts offered at different time to amounts of equivalent value in the present, i.e., a common point of reference for decision.
Q.3. Why is the consideration of time important in financial decision making? How can time value be adjusted? Illustrate your answer.
A.3. Most financial decisions, such as the purchase of assets or procurement of funds, affect the firm’s cash flows in different time periods. Cash flows occurring in different time periods are not comparable. Hence, it is required to adjust cash flows for their differences in timing and risk. The value of cash flows to a common time point should be calculated. To maximize of owner’s equity, it’s extremely vital to consider the timing and risk of cash flows. The choice of the riskadjusted discount rate (interest rate) is important for calculating the present value of cash flows. For instance, if time preference rate is 10 percent, it implies that an investor can accept receiving Rs 100 if he is offered Rs 110 after one year. Rs 110 is the future value of Rs 100 today at 10% interest rate. Thus, the individual is indifferent between Rs 100 and Rs 110 a year from now as he/she considers these two amounts equivalent in value. You can also say that Rs 100 today is the present value of Rs 110 after a year at 10% interest rate.
Q.4. Is the adjustment of time relatively more important for financial decisions with short-range implications or for decisions with long-range implications? Explain.
A.4. Time value adjustment is important for both short-term and long-term decisions. If the amounts involved are very large, time value adjustment even for a short period will have significant implications. However, other things being same, adjustment of time is relatively more important for financial decisions with long range implications than with short range implications. Present value of sums far in the future will be less than present value of sums in near future.
Q.5. What happens to the present value of an annuity when the interest rate rises?
A.5. As the formulae given in A.5 above show, as the interest rate rises, the present value of a lump sum or an annuity declines. The present value factor declines with higher interest rate, other things remaining the same.
Q.6. What is an annuity due? How can you calculate the present and future values of an annuity due? Illustrate.
A.6. A series of cash flows (i.e., receipts or payments) starting at the beginning of each period for a specified number of periods is called an Annuity due. This implies that the first cash flow has occurred today. The future value, i.e., compound value of an annuity due is:
FV = A (CVAFn,i) (1 + i)
For example, if you deposit Rs.1, 000 in a saving account at the beginning of the each year for 4 years to earn 6% p.a., then the future value is:
FV= 1,000(4.375) (1.06) = Rs. 4,637
Notice that 4.375 is the future value factor for an annuity of Re 1 occurring at the end of
the period.
The present value of an annuity due i: Fn = A (PVAFn,i) (1 + i)
For example, the present value of Rs1,000 deposited in saving account at the beginning of each year for 4 years to earn interest 6% p.a. is: PV = 1,000 (3.170) (1.06) = Rs. 3,487
For example, the present value of Rs1,000 deposited in saving account at the beginning of each year for 4 years to earn interest 6% p.a. is: PV = 1,000 (3.170) (1.06) = Rs. 3,487
Q.7. Illustrate the concept of the internal rate of return.
A.7 The rate of return on an investment (based on its cash flows) is called internal rate of return (IRR). Since IRR depends on the cash flow patterns specific or internal to a project, it’s called internal rate of return. It is a rate where NPV is zero. Hence, IRR can be calculated manually by trial and error.
