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Task 1.Write a comprehensive essay on application of time value concepts in various financial management decisions. Your essay should be covered

a.Fundamentals of time value concepts
b.Discounting and compounding process and their uses (what is the rational for using discounting process rather than compounding process in decision making?)
c.Discount rate and main components of the discount rate (why do we use different discount rates for evaluating different decisions?).
d.Use of time value in valuation of financial instruments such as bonds, equity and preference shares.
e.Capital budgeting and time value.
f.The other issues

Task 2.Answer questions in the case study given below (Extracted from “Cases in Financial Management (2nd Edition), Sulock, Joseph and Dunkelberg, John, John Wiley & Sons, Inc”, Some contents of the case have been altered to suit the local condition).

Concept of Time Value of Money

  1. Fundamentals of Time Value Concept :

Time Value of money is widely used concept since long, we  use Time value of money in felid of economics and finance, such as in Capital budgeting, valuation of business, valuation of securities and many more.

As the name suggests basic approach of time value of money is that it is better to have the money today is present instead of having that same amount in future, as if one have that amount of money in his hands at present then one can invest it somewhere and can earn money by investing funds at present.

To make this clear in more better way we will explain it with an example ;

 If you have $1000 today in your hand and any way of investment at the rate of 10% per annum, you will have $1100 a year from now, and on the other hand a $1000 a year from now, at the same rate of 10 % per annum, are just $909 today (Woodruff 2018)

  1. Discounting and compounding process and their uses

Time value of Money concept says that worth of a unit today will be changed in future, for putting it simply, the value of one dollar today will decrease in future, the entire concept s about the present value of money and future value of money

There are two ways of ascertaining the value of money at different point of time, one is compounding and another is discounting (Gardner 2017)

Compounding method is used to determine future value of present money.

Discounting method is used to determine present value of future money.

Both have different rates for calculation for compounding , compounding rate of interest is used and for discounting, discounting rate of interest is used.

 Compounding and discounting both helps in rational decision making, as compounding helps in determining the future value of present cash flow, and on the other hand discounting helps in determining the present value of future cash flows.

Discounting is rational process to use for making appropriate decisions in comparison with compounding reason being, in compounding we use rate of return of future which is not certain at present, which leads to inappropriate decision making, however on the other hand in discounting method we need to determine present value of future return, and rate used for discounting is known at present which gives more appropriate results for decision making (Keythman 2015)

For Compounding following formula is used:-

Compounding and Discounting Methods

FV =  PV (1 + R) ^ n

For Discounting following formula is used:-

PV =  FV / (1 + R) ^ n

  1. Discount rate and main components of the discount rate

The term discount rate is most widely used fundamental term in finance in economics. Discount rate is used to determine present value of expected cash lows. These is an inverse relationship between present value and discount rate, higher the discount rate is used, lower will be the present value of cash flows, and lower the discount rate, higher will be the present value of cash flows.

As simple is to understand the concept of discount rate more difficult to determine appropriate discount rate, in determining the appropriate discount rate following must be Considered and assessed properly before determining any discount that that is to be used to discount future expected cash flows:

  1. Pure Interest
  2. Risk
  3. Inflation
  4. Reinvestment Risk
  5. Variability of returns

We use different discount rates or evaluating different decisions based on the above mentioned factors, more the risk, more will be the discount rate and vise-versa, each and every point mentioned above will affects the discount rate, this will depend on case to case basis (Dalfard 2016)

Discount rate may be calculated by using following formula :

  1. Use of time value in valuation of financial instruments such as bonds, equity and preference shares :-

Bonds, preference shares and equity shares are most common ways that are used while doing investment, to take appropriate decision as in which kind of securities investment must be made, it is necessary to determine value of these securities, there are many kinds of ways to determine value of these securities and Time value is widely used in valuation of Shares, Debentures, to determine value of these securities first one has to determine value of business,  In valuation of Business present value of cash flows for explicit period and present value of terminal value is calculated and added to arrive at Gross Value of the business. This value is for all funds providers, i.e. Debenture holders, Equity share holders and Preference shareholders.

Valuation is not only done to determine the most appropriate way of investment however valuation is a most crucial decision for a company to determine value of its securities like bond, debentures, Preference shares and equities, as all the holders of these securities are very much concerned with the value if their existing investment, hence every company would like to use most appropriate way of doing valuation of business and securities like bonds, debentures, Preference shares and equities, as no company would like to lose its current investors and potential investors. Discounted cash flow method of valuation is most trusted way for determining value of securities (Sanders 2017)

The Role of Discount Rate in Discounted Cash Flow Analysis

To arrive at the value of equity share holders under Firm approach of valuation, we can use following formula :-

Value of Equity holders = Present value of Cash flows for explicit period + Present Value of Terminal Value – Opening balance of loan as on Valuation date + Opening Surplus cash which is not considered for working capital requirement + realizable Value of Surplus assets etc.

  1. Capital budgeting and time value:

Time Value of money is a very important part of capital budgeting, and it provide small business holders a base with the help of capital budgeting to take appropriate decisions, with the help of discounting and capital budgeting small business holders can adjust cash flows with the passage of time and this process is known as discounting to present value and allows preference to dollar received today over the dollar received tomorrow.

Time Value of Money is used in following concepts of capital budgeting :

  1. Net Present Value (NPV)
  2. Internal Rate of Return (IRR)
  3. Total Cost Approach (TCA)
  4. Project profitability Index (PPI)
  1. Net Present Value (NPV):

Net present value is most used technique of capital budgeting, In net present value technique of Capital budgeting, time value of money is used to determining profitability of project, by discounting future expected cash flows and its terminal value. If the projects net present value is grater or equal to zero the project is acceptable.

NPV = Present value of future cash Inflows – Present Values of cash out flow (Freedman 2018)

  1. Internal Rate of Return (IRR)

Internal rate of return is another most widely used technique of Capital budgeting,  The IRR method is applies in manner which is reverse of NPV method of capital budgeting technique, This Method tends to find out a discount rate, for undiscounted cash flows of the projects, in such a way resulting NPV of project to Zero, that Zero represents the BEP i.e. breakeven point of project profitability.

  1. Total Cost Approach (TCA)

The TCS approach allows small business owners to evaluate multiple projects together at one time. In this Method, all cash inflows and outflows are adjusted to determine competing alternative. All the projects which gives positive NPV are acceptable, however the project with the greatest NPV is preferred and most profitable.

  1. Project profitability Index (PPI)

Where there is a situation that funds available are limited, a small business owner can calculate profitability index to determine preferable project, by dividing NPV of project with the Investment made, this capital budgeting technique is known as PPI, higher PPI values imply more desirable project. (Wiley 2018)

There is always a biggest obstacle with time value of money is to determine discount rate or compound rate to be used to determine present value of cash flows, as discount rate and compound rates are dependent on various factors, and these factors changes form one business to other, thereby discount rate used for determining present value of cash flows may be different from discount rate used to determine present value of cash flows of any other business.

Application of Time Value of Money in Capital Budgeting Techniques

Same as discussed above applies to compounding rate, as it is also based on various factors, and those factors may be variable form one business to another, hence compound rate used for compounding cash flows of one business may be different for compounding cash flows of another business.

Hence to determine correct and appropriate discount rate is a critical matter.

Another issue with Time Value of Money is to determine future expected cash flows and there time of occurrence, as only expectation can be done, nothing can be said with certainty, and various fluctuation may come, these fluctuations may lead a decision based on TVM wrong.

The following goals Studebaker is focusing upon is the diversification of the business and buy and hold goal. Diversification is described as some technique where all the investment is not invested in one portfolio and it is allocated to different  baskets so that if one basket fails then the entire investment doesn’t fall out. Diversification helps in reducing the risk. It gives the portfolio in a non-risky position. It is a type of strategy which is a risk management technique which actually mixes different variety of investments in a portfolio. It actually strives to remove the unsystematic risk in a portfolio so that the positive investment outlast the negative ones and balances them. further change benefits can be expanded by investing in distant securities as they are less related to domestic investment. It is a good corporate strategy so that one can enter in to  new market and helps in managing risk.

The next strategy is buy and hold is opting for good profits and returns as compared to long run and not getting involved in day to day activities and one need to have good investment ways before the actual investment and also less attention is involved. In our opinion policy opted by Studebaker are helpful for him and goals are identified therefore which will help them in future.

  1. In this LIC policy the sum that is invested will be increasing at a good rate with a return of around and it will automatically increase the investment overall which was there hence the sum will be calculated as below:

Year

Life Insurance value at beginning (Figures in $)

Return of 6 % that is earned (Figures in $)

LIC policy value at the end (Figures in $)

1

550,000

33,000

583000

2

583,000

34,980

617980

3

617,980

37,079

655,059

4

655,059

39,305

694,3624

5

694,364

41,662

736,025

6

736,025

44,162

780,186

7

780,186

46,812

826,998

8

826,998

49,620

876,618

9

876,618

52,597

929,213

10

929,213

55,753

984,966

11

984,966

59,098

1,044,064

12

1,044,064

62,644

1106,709

13

1,106,709

66,403

1,173,111

14

1,173,111

70,387

1,243,497

15

1,243,497

74,610

1,318,107

16

1,318,107

79,086

1,397,193

17

1,397,193

83,832

1,481,029

18

1,481,029

88,864

1,569,890

19

1,569,890

94,195

1,664,085

20

1,664,085

99,847

1,763,930

As calculated above, Morton has worked out in same way.

Installment formula is as follows:-

Installment = [P * r * ( 1 + r )^N] / [ ( 1 + r )^N – 1 ]

Installment  = [450000 * 9% * ( 1 + 0.09 )^20] / [ ( 1 + 0.09 )^20 – 1 ]

The amount of investment is  $77230.26. (WordPandit 2018)

Year

Beginning balance ( $)

Installment figure ( $)

Payment of Interest ( $)

Repayment of the Principal Amount($) (Figures in $)

Ending balance ( $)

1

705000.00

77230.26

63450.00

13780.26

691219.75

2

691219.75

77230.27

62209.78

15020.49

676199.26

3

676199.26

77230.26

60857.93

16372.33

659826.93

4

659826.93

77230.26

59384.42

17845.84

641981.10

5

641981.10

77230.26

57778.30

19451.96

622529.13

6

622529.13

77230.26

56027.62

21202.64

601326.49

7

601326.49

77230.26

54119.38

23110.88

578215.62

8

578215.62

77230.26

52039.41

25190.85

553024.76

9

553024.76

77230.26

49772.20

27458.03

525566.73

10

525566.73

77230.25

47301.01

29929.25

495637.48

11

495637.48

77230.26

44607.37

32622.89

463014.59

12

463014.59

77230.26

41671.31

35558.95

427455.64

13

427455.64

77230.26

38471.00

38759.27

388696.40

14

388696.40

77230.25

34982.68

42247.58

346448.81

15

346448.81

77230.26

31180.39

46049.87

300398.94

16

300398.94

77230.26

27035.90

50194.36

250204.59

17

250204.59

77230.26

22518.41

54711.85

195492.74

18

195492.74

77230.26

17594.35

59635.91

135856.82

19

135856.82

77230.26

12227.11

65003.15

70853.68

20

70853.68

77230.26

6376.85

70853.44

0.29

 9 percent mortgage in Exhibit 4, find the loan balance at the end of years 19

Challenges with Time Value of Money

and 20?

Answer :- 19th year end balance will be $466986.70 and 20 the will be $440393.35, which is calculated as follows : 

Amortization Amount  705000 /-  9  % Mortgage Rate and the loan id for 30 Years.

Year end

Beginning balance ( $)

Installment Amount(Figures in $)

Interest Payment (Figures in $)

Principle Repayment (Figures in $)

Ending Balance (Figures in $)

1

705000.00

68622

63450.00

5172.13

699827.87

2

699827.87

68622

62984.52

5637.62

694190.25

3

694190.25

68622

62477.13

6145.00

688045.25

4

688045.25

68622

61924.08

6698.06

681347.19

5

681347.19

68622

61321.26

7300.88

674046.31

6

674046.32

68622

60664.17

7957.96

666088.35

7

666088.35

68622

59947.95

8674.18

657414.18

8

657414.19

68622

59167.28

9454.85

647959.33

9

647959.33

68622

58316.34

10305.79

637653.54

10

637653.54

68622

57388.83

11233.32

626420.23

11

626420.23

68622

56377.82

12244.31

614175.92

12

614175.92

68622

55275.84

13346.29

600829.63

13

600829.63

68622

54074.68

14547.46

586282.16

14

586282.16

68622

52765.39

15856.74

570425.43

15

570425.43

68622

51338.29

17283.84

553141.59

16

553141.59

68622

49782.74

18839.38

534302.21

17

534302.21

68622

48087.20

20534.93

513767.28

18

513767.28

68622

46239.07

22383.07

491384.21

19

491384.21

68622

44224.58

24397.55

466986.66

20

466986.66

68622

42028.80

26593.33

440393.33

Exhibit 3 specifies that $1,763,925 will be collected after 20 years in the life

insurance policy. Is this true?

Answer :-

It is correct and the LIC policy will be getting accumulated after

Years to 1763926 as shown in the exhibit 3 and also it is calculated in answer of the 1st Question. And if Studebaker will be opting the suggestions of Morton Studebaker will be taking a loan of $250000 and the loan will be repaid at the end of 30 year . The balance of loan at the maturity time (after 20 year ) would be $440393.33.

(A) If the excess $300,000 were invested in a long-term asset yielding 8 percent a year, how much would be accumulated after 20 years?

Answer :- $1,398,287, will be getting accumulated after 20 Years. Following are the calculations:-

End of Year

Long Term Assets Value at Opening of the year ($)

Return earned at 8%

 ( $)

Long Term Assets  Value (closing)($)

1

300,000

24,000

324,000

2

324,000

25,920

349,920

3

349,920

27,994

377,914

4

377,914

30,233

408,147

5

408,147

32,652

440,798

6

440,798

35,264

476,062

7

476,062

38,085

514,147

8

514,147

41,132

555,279

9

555,279

44,422

599,701

10

599,701

47,976

647,677

11

647,677

51,814

699,492

12

699,492

55,959

755,451

13

755,451

60,436

815,887

14

815,887

65,271

881,158

15

881,158

70,493

951,651

16

951,651

76,132

1,027,783

17

1,027,783

82,223

1,110,005

18

1,110,005

88,800

1,198,806

19

1,198,806

95,904

1,294,710

20

1,294,710

103,577

1,398,287

(B) Suppose Studebaker placed $26,145.31 a year into a long-term investment paying 8

percent a year. How much would be accumulated after 20 years ?

$1,292,179 is getting accumulated after 20 Years, if Studebaker Invests $26145.31/- each year collected will the investment made earlier. Calculation is as follows:

End of Year

Long Term Assets Value at Opening of the year (Figures in $)

Return earned at the rate of 8% during the year (Figures in $)

Long Term Assets  Value at Closing of the year (Figures in $)

1

26,145

2,092

28,237

2

54,382

4,351

58,733

3

84,878

6,790

91,668

4

117,814

9,425

127,239

5

153,384

12,271

165,655

6

191,800

15,344

207,144

7

233,289

18,663

251,953

8

278,098

22,248

300,346

9

326,491

26,119

352,610

10

378,756

30,300

409,056

11

435,201

34,816

470,018

12

496,163

39,693

535,856

13

562,001

44,960

606,961

14

633,107

50,649

683,755

15

709,900

56,792

766,692

16

792,838

63,427

856,265

17

882,410

70,593

953,003

18

979,148

78,332

1,057,480

19

1,083,625

86,690

1,170,315

20

1,196,461

95,717

1,292,178

Repeat problem 5 but assume a 7 percent return can be earned ?

A further loan of $2,50,000 shall be required for opting the suggestion of Morton which will require a total of thirty years to repay the loan in full . However, the life insurance policy will accumulate an amount of $21,28,328 with a return of 7% as suggested in Exhibit 3 and where the suggestion of Morton is accepted, the amount LIC on maturity will amount to $4,40,396.45.

Life insurance policy will be accumulated after 20 years to $21,28,326/- as indicated in Exhibit 3 and f rate of return is 7% instead of 6%, however if Studebaker will opt the suggestion of Morton, Studebaker will have to take loan further for $2,50,000/-, and that amount mortgage Loan will be repaid till the end of 30 years and balance of loan at the time of maturity of LIC (i.e. at the end of 20 years) would be $4,40,393.33 (Tonagatti 2017)

Comer’s criticisms implied that the single-premium life insurance policy is an

unattractive investment for Studebaker. What do your previous answers suggest?

All the Comer’s criticisms is very correct that the single investment policy does not prove to be attractive investment for Studebaker which is calculated:

Studebaker's Goals for Business Diversification and Buy and Hold Strategy

Studebaker if he has adopted the Morton;s way in the investment field than at the end of 20 years Studebaker will have to invest $1763925 and it will increase the loan installment of $26145.31 each and every yearand the balance of the loan is $440393.33 and at the end the balance that @7 percent will be $2128326.

Woth the same resources the inidivual could have invested $ 300000 in a asset which is long term which yields 8 percent for 20 year and also the accumulated balance will be $1,398,287 and also and if $26145.31/- is being invested each year together and also with the invested sum @ 8%, accumulated balance at the end of 20 years would be $1,292,178/-, and after taking total of both of the Investments the total collected with same incomes is  $26,90,465/-, as the rate of return has been incraesed, the accumulated weighing scale of the investments are greater than Morton’s proposals by $9,26,540/-.

(a) Answer :-

Requirement at end of 20 years

                    $3,500,000.00

Amount which will be getting received out of the investment of $300000 in end of  20 years as calculated in 6 (a)

                    $1,398,287

Balance Amount which is required at the end of 30 years

$2,101,712

End of Year

Long Term Assets Value at Original /Beginning year ($)

Return @8 percent ($)

Long Term Assets  Value at ending($)

1

42,525.05

3,402.00

45,927.05

2

88,452.10

7,076.18

95,528.28

3

138,053.3

11,044.27

149,097.59

4

191,622.64

15,329.81

206,952.45

5

249,477.50

19,958.20

269,435.70

6

311,960.75

24,956.86

336,917.61

7

379,442.66

30,355.41

409,798.07

8

452,323.12

36,185.85

488,508.97

9

531,034.02

42,482.72

573,516.74

10

616,041.79

49,283.34

665,325.14

11

707,850.19

56,628.01

764,478.20

12

807,003.25

64,560.26

871,563.52

13

914,088.56

73,127.08

987,215.65

14

1,029,740.70

82,379.26

1,112,119.95

15

1,154,645.00

92,371.60

1,247,016.60

16

1,289,541.65

103,163.33

1,392,704.98

17

1,435,230.03

114,818.40

1,550,048.44

18

1,592,573.49

127,405.88

1,719,979.37

19

1,762,504.42

141,000.35

1,903,504.77

20

1,946,029.82

155,682.39

2,101,712

 $2101712/- will be received after 20 years by capitalizing $42525.05/- each year.

  1. (B) Answer :-

Requirement at the end of 20 years

                    $3,500,000.00

Amount will be received out of the investment of $300000 at the end of 20 years as calculated in 6 (a)

                    $1,398,287.14

Balance Amount required at the end of 30 years

$2,101,712.86

End of Year

Long Term Assets Value (Beginning) ($)

Return earned at the rateof 8% ($)

Long Term Assets  Value at the end ($)

1

55,402.45

4,432.20

59,834.65

2

115,237.10

9,218.97

124,456.06

3

179,858.51

14,388.68

194,247.19

4

249,649.64

19,971.97

269,621.62

5

325,024.07

26,001.93

351,025.99

6

406,428.44

32,514.28

438,942.72

7

494,345.17

39,547.61

533,892.78

8

589,295.23

47,143.62

636,438.85

9

691,841.30

55,347.30

747,188.60

10

802,591.05

64,207.28

866,798.34

11

922,200.79

73,776.06

995,976.85

12

1,051,379.30

84,110.34

1,135,489.64

13

1,135,489.64

90,839.17

1,226,328.82

14

1,226,328.82

98,106.31

1,324,435.12

15

1,324,435.12

105,954.81

1,430,389.93

16

1,430,389.93

114,431.19

1,544,821.12

17

1,544,821.12

123,585.69

1,668,406.81

18

1,668,406.81

133,472.55

1,801,879.36

19

1,801,879.36

144,150.35

1,946,029.71

20

1,946,029.71

155,682.38

2,101,712.09

If only 12 years investment is done he has to invest  $55402.45/- to receive $2101712/ at the end.

$5,672.59/- will required to paid on monthly basis till 20 years for repayment of loan of $705,000/- which means yearly payment will be ($5,672.59/- * 12)  $68,071.08/-, however if we go for yearly installment basis then installment amount was $68,622/- .

In case of Monthly payment system total of yearly installments is less in comparison with yearly payment system, and the reason is that in  Monthly installment System interest is being allocated on less principal amount as the payment iare being made monthly and main part is reducing monthly which is also in case of yearly payment system, installment is given at end of the year and also the interest is granted on proportional large sum of principle.

The calculation of Corner which has a cost of $ 47145 is for the 1st year and the total interest of $21000 on the amount of $30000 at the rate of 7 percent and also 26145$ as the installment amount which has been increased

In20th year Corner has designed $1,70,502- as an extra twelve-monthly cost

Increase Installment number of loan $26,145.31/-

Interest lost on $300000 in 20th year $75,947/-

Interest which has been lost on $26145.31 with the cumulative Investment 20 years which is $68,410/-

Calculation of above is mentioned below:-

($)

End of Year

Long Term Assets Value at Opening of the year

Return earned at the rate of 7% during the year

Long Term Assets  Worth at the end

Long Term Assets Worth at Opening of the year

Return earned @ of 7% during the year

Long Term Assets  at closing

Total cost which is incurred

1

300,000

21,000

321,000

26,145

1,830

27,975

47,145

Continued Calculation

18

947,645

66,335

1,013,980

888,915

62,224

951,139

148,923

19

1,013,980

70,979

1,084,958

977,285

68,410

1,045,695

159,348

20

1,084,958

75,947

1,160,905

1,071,840

75,029

1,146,869

170,502

The policy which was suggested by Morton don’t consider the oppurtuinity  costs that is the amount that is required to be invested in the Life Insurance Policy which was 6 percent and also the market rate was 7 to 8 percent then it can be concluded that thenpolicy of Morton contain enough misakes and don’t provide good benefit to the users. (Bahner 2007)

It was found in the critical evalution it is found that the investment of all the funds in the external assets which posses a return of 8 percent per annum is portrayed better as compared to the Lifeinsurance Policy and also it is not feasible to take loan at the rate of 9 percent rate of interest and then invest that for 6 percent as the return will be low hence the Morton option is incorrect  and thus only 300000 investment should be made.

Bahner, M 2007, The effects of inflation and the time value of money on some inventory systems, viewed 30 May 2018, <https://www.tandfonline.com/doi/abs/10.1080/00207548508904740>.

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Freedman, J 2018, Why Is the Time Value of Money So Important in Capital Budgeting Decisions?, <https://yourbusiness.azcentral.com/time-value-money-important-capital-budgeting-decisions-12009.html>.

Gardner, N 2017, The Time Value of Money:, viewed 30 May 2018, <file:///C:/Users/com/Downloads/1965-Article%20Text-7799-1-10-20110128.pdf>.

James, R 2015, Morton Private Wealth Strategies, <https://www.raymondjames.com/mortonpws/about-us/what-makes-us-different>.

Keythman, B 2015, How to Compound & Discount Corporate Cash Flow Valuations, viewed 30 May 2018, <https://smallbusiness.chron.com/compound-discount-corporate-cash-flow-valuations-14550.html>.

Larson, J 2015, Applying the Time Value of Money Principle, <https://www.larsonfinancial.com/financial-articles-for-doctors/applying-time-value-money-principle/>.

Merittt, C 2015, Why Is the Time Value of Money So Important in Capital Budgeting Decisions?, <https://smallbusiness.chron.com/time-value-money-important-capital-budgeting-decisions-61898.html>.

Sanders, B 2017, Why shoppers don't understand the time value of money, viewed 30 May 2018, <https://www.bizjournals.com/bizjournals/how-to/growth-strategies/2017/04/why-shoppers-dont-understand-the-time-value-of.html>.

Surbhi, S 2015, Difference Between Compounding and Discounting, <https://keydifferences.com/difference-between-compounding-and-discounting.html>.

Tonagatti, B 2017, LIC Policies-How to calculate returns?, viewed 30 May 2018, <https://www.basunivesh.com/2013/02/19/lic-policies-how-to-calculate-returns/>.

Wiley, J 2018, Time Value of Money, viewed 30 May 2018.

Woodruff, J 2018, Define what is "Time Value of Money", viewed 30 May 2018, <https://smallbusiness.chron.com/define-time-value-money-876.html>.

WordPandit 2018, Interest and Installment, viewed 30 May 2018, <https://wordpandit.com/interest-and-installment/>.

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