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Financial Management - Chapter 2

Financial Management - Chapter 2

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Published by: mechidream on Feb 08, 2010
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Subject: Financial Management 
Chapter: Two – Time Value of Money 
Chapter No. 2 - Time Value of Money
Introduction to the concept of “inflation” – Wholesale Price Index and Consumer Price Index 
Money losing value due to reduction in purchasing power 
Concept of interest as compensation in purchasing power of money 
Four tier structure for rates of interest in any economy 
Compounding and discounting processes
 Application of time value of money to business decisions
Numerical exercises for practice
At the end of the chapter the student will be able to
Determine - Future value of a present sum by compounding
Determine - Present value of a future sum by discounting
Determine - Present value of a bond investment 
Explain - the different tiers of interest structure in an economy 
Choose – the best project based on its “Net Present Value”
Concept of “Inflation” – Wholesale Price Index and Consumer Price Index
Inflation means to increase. In this context, it means increase in prices of commodities. The priceincrease is due to the difference between “supply” and “demand” for a given commodity. If the supplyis more than demand, prices decline and if the demand is more, prices increase. In a developingcountry like India, the demand for most of the commodities will always be more than the supply.Hence “inflation” will always be experienced in developing markets. The increase is constantly measured in all the countries. The items included for determining the priceswould be different from country to country. For example, in India, essential commodities like sugar,kerosene, a loaf of bread etc. are included in the basket of commodities considered for calculation of “inflation”. Different from this, in a developed country, items that are luxury items in a developingcountry would also be included. For example, automobile could be included. The increase is expressedin % terms. For example if the rate of inflation is 5%, this means that over a period of one year, theprices have increased by 5%. The details of inflation are published regularly in all leading dailies in thecountry.
Wholesale price and not the retail price
 The prices of the selected commodities for determining the rate of inflation over a period of one yearcould be on the wholesale or retail. The latter one is mostly referred to as “consumer price”. Thus wehave a “wholesale price indexand “consumer price indexfor expressing rates of inflation.Conventionally in India the rate of inflation has always been expressed in “wholesale price index” basis
Punjab Technical University, Online Virtual Campus1
Subject: Financial Management 
Chapter: Two – Time Value of Money 
rather than “consumer price index” basis although the consumer price index increase is also publishedregularly. At present the wholesale price index inflation is around 3%. We will explain this conceptthrough an example.Example no. 1I had spent Rs. 100/- in getting a basket of commodities one year ago. If the rate of inflation is say 3%,now I will be required to spend Rs. 103/- to get the same basket of commodities. How do we getRs.103/-? Rs. 100/- x 1.03 = Rs. 103/-. This means that due to “inflation”, the purchasing power of thelocal currency decreases with the passage of time. This is exactly the concept of “time value of money”. In simple words, “time value of money” means that with the passage of time, money loses itsvalue.
Is there a situation in which the prices decrease over a period of time andopposite of “inflation” takes place?
Usually in a developing country, such a situation does not arise, as the demand is always greater thansupply. However currently Japan is experiencing “deflation” in which current prices would be less thanthe past prices. This is harmful to a developing economy, as units that save money would get very lowinterest or no interest. Hence there will be no incentive for the units to invest money in bonds, fixeddeposits etc.
Concept of Interest as compensation for loss of purchasing power due to“inflation”:
 You keep money in a deposit with a bank. It could be a Savings Bank or a Fixed Deposit. What does thebank pay to you? “Interest”. This is the “return” on your investment. Why should the bank pay interestto you? Let us enumerate the possible reasons for the bank’s action.
 The bank does the business of lending. For this, it requires funds through deposits. It earnsinterest on loans and pays interest on deposits;
With the passage of time, the purchasing power of money reduces. The same thing will happento your deposit with the bank. The bank gives compensation to you for this loss in value of money;
In case the bank does not pay interest, it will not get funds for lending. You will not keepdeposits with it. You will choose other willing banks or avenues of investment.While all of them are correct, we are more interested in the second reason. Value of money erodes dueto “inflation” as we have seen in the earlier paragraph. The rates of inflation would be different fordifferent countries. Further, it could be different for the same country at different times. Sometimes itcould be high while at some other times, it could be low.
Would interest be less in case the rate of inflation comes down?
Absolutely. As an example, we have already seen what is happening in Japan. The Japanese banks arepractically not paying interest on deposits right now. The rate of inflation in the US is around 2% p.a.and accordingly the rate of interest on investment would be around 3% to 3.5% p.a. Thus the rate of inflation in a country and the rate of interest on investment are closely linked to each other. For furtherdetails, please look at the “Tier structure” of rates of interest given below.Consider Indian market conditions. Hypothetically if the inflation comes down to say 1%, the rat e of interest on bank deposits and bank loans in turn would also come down. The banks would not pay thecurrent rate of interest. If the students may recall in India, the rates of interest on savings areconstantly coming down. This is the result of the rate of inflation coming down constantly at least tillthe last year.
“Rate of inflation coming down” - What does it mean? Does it mean that the prices of commodities are comingdown
the increase in prices of commodities is coming down? – Answer is: The increase in prices of commoditiesis coming down; in actual terms, the prices of commodities are not reducing.
Punjab Technical University, Online Virtual Campus2
Subject: Financial Management 
Chapter: Two – Time Value of Money 
Four tier structure for rates of interest in any economy
 The starting point for any interest is the rate of inflation in the economy. Like for example, in India atpresent, it is around 3% now. We have seen earlier that interest is the compensation for loss of purchasing power of Indian Rupee. This loss is due to the phenomenon of “inflation”. We have alsolearnt that the banks would normally offer a rate of interest higher than the rate of inflation. Based onthis, let us construct a 4-tier system of interest rates. This would build up stage-wise rates of interesttill investment in a project.
Tier 1
– Rate of inflation, say 3%
Tier 2
– Rate of interest on investment say in bank depositRate of inflation + some compensation from the acceptor of deposits, say banks. = 3% + 4% = 7%,that is the lowest interest offered by a public sector bank now on fixed deposits. The exact premiumpaid to the depositor depends on the following:
 The duration of the deposit – the longer the duration, the higher the premium and vice-versa. That is why the longer duration deposits would attract higher rates of interest and shorterduration deposits would have a lower rate of interest.
 The need for deposits by the banking company for a specific period. The bank would offer ahigher rate for that period. Suppose a bank wants more deposits for six months rather thanone year. It will attract deposits for six months by offering higher rate of interest than themarket.
Tier 3
– What does the bank do with the deposits that it accepts? It gives loans. The rate of interest onloans becomes the next tier, Tier 3.
What are the factors that a bank would consider to determine its lending rate?
Average interest paid out on deposits and expensesMinimum expected profit from lending operationsDegree of risk in lending – specific to a borrower, depending upon his businessContinuing discussion on Tier 3, we see that the minimum rate of interest on loans would be 7% + 3%+ 1% = 11%. This is the lowest interest that any bank offers now in India on loans. There is a specificname for this rate. It is referred to as “Prime Lending Rate” or PLR. The bank would add further to thisrate depending upon risk etc., which is called “risk premium”
. This would again be different fromborrower to borrower.Why discuss about a loan here?Who takes loans in a big way from the banks? This does not refer to the housing or consumer loanstaken by salaried persons. Obviously, business enterprises. It is for investment in theirbusiness/projects. Hence the rate of return on a project would be the last Tier, called
“Tier 4”.
Can you determine this rate? Yes and no. Yes, as you will be able to determine a formula for this. No,because, it is not always possible to evaluate risk associated with a project correctly. The formula is:Rate of interest on loans, say 11% + compensation for the additional risk taken by the project owner.For an outsider, it will not be possible to put a figure on this. This will depend upon the risk associatedwith the specific project.
This is the reason that for different activities, the same bank charges different rates of interest at thesame time. Similarly for different borrowers pursuing the same activity, the rates of interest would bedifferent as per perception of risk associated with them.
Punjab Technical University, Online Virtual Campus3

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