MBA 202 Unit 2, Lesson 4

LESSON 4 INTRODUCTION AND TYPES OF CASH

FLOWS
4.0 OBJECTIVES ......................................................................................................3
4.1 INTRODUCTION ..................................................................................................3
4.2 TIME PREFERENCE OF MONEY............................................................................3
4.3 CASH FLOWS VS. PROFIT ...................................................................................4
4.4 TYPES OF CASH FLOWS .....................................................................................5
4.5 CASH INFLOWS AND OUTFLOWS..........................................................................6
4.6 SUMMING UP ....................................................................................................6
4.7 ASSIGNMENTS ...................................................................................................7
4.8 ANSWERS TO THE SELF-CHECK QUESTIONS. .......................................................7
4.9 TERMINAL QUESTIONS .......................................................................................7
4.10 SUGGESTED FURTHER READING .........................................................................7
MBA 202 Unit 2, Lesson 4

4. Introduction and Types of Cash Flows

The concepts learned in this unit will help in investment decisions (personal or
organizational) and also in identifying the true value or intrinsic value of securities.

4.0 Objectives
In this lesson you will be able to understand

 The concept of Time Preference for Money and the factors affecting it
 The difference between cash flows and profits
 The types of cash flows from time value of money point of view

4.1 Introduction

Time value of Money is a core concept of Finance. The other concepts are
risk – return trade-off, diversification and value creation or wealth
maximization. Time value of Money is extensively used in investment
evaluation decisions.

 Let us say you would like to know what is the value of an amount today
, which you are expecting to receive in future.
 You would like to know how much interest you will get if you invest a
certain amount for a certain period of time at a given rate of interest.
 How much you should set aside every month to repay a loan taken
gradually.

In all these situations we see that people prefer having the same amount
today than in the future. This concept is known as time preference of money.

4.2 Time Preference of Money

An investor prefers to receive a payment of a fixed amount of money today,
rather than an equal amount in the future, all else being equal. This
assumption is known as time preference of money. The time preference for
money arises because of three factors: i) inflation ii) utility and iii) investment.
Due to inflation, the value of the money declines over a period of time since in
an inflationary situation the same amount of money can buy fewer goods later
than it can buy today. So, having the same amount after some time does not
help as the value has declined. Investors also prefer consuming today than

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MBA 202 Unit 2, Lesson 4

consuming tomorrow. There is more utility if money is consumed today so

having money today make sense. Instead of getting the same amount in
future, one can get the money today and invest it to get interest and thus have
the initial money and the interest on it upto the future date. Thus time
preference of money i.e. preference for money today arises due to inflation,
utility of consumption today and investment. This time preference of money
implies that whenever you forego utilizing money today, you expect in the
future an amount greater than the money you have foregone. This is known
as Time value of money. The value of today’s rupee should be more in future
and the value of future expected rupees should be less in today’s terms.
When using time value of money concepts we consider cash flows and not
profits. So there is a need to understand the difference between cash flows
and profits.

Self-check Questions
1. Given an option between having Rs 1000/- today or having same Rs. 1000/- after one
year which option is preferred?

4.3 Cash Flows vs. Profit

Profit, in simple terms, is what is left after deducting all expenses from the
income. Cash flows are the amount of money a business receives and spends
during the period of activity. The difference in the two statements above arises
since businesses may incur expenses which form part of costs (ex.
depreciation) but may not pay for them in cash and conversely, businesses
may not receive all their incomes in cash (interest accrued but not due).
Further, cash may flow out for purchase of assets which would not account for
as an expense, while cash inflow on account of a loan taken would not be
income. Cash flows are considered in finance as they reflect the health of a
company. Many small businesses indicate that they are doing well. They have
good sales. But they do not have cash to meet the future orders. This
situation arises as they do not have adequate cash flows.

Let us look at business A. It has a sale of Rs. 4.0. lacs and has various costs
at Rs. 2.0 lacs. It ‘s annual profits are thus , Rs. 2.0 lacs. But let us say the
cash inflows during the same year are Rs 1.6 lacs and cash outflows (cash
paid for manufacturing and other expenses) are Rs. 1.8 lacs. This results in a
net cash outflow of Rs. 20,000. So cash flows are a better indicator (refer to
the table below)

Sales 4.0 lacs Cash inflows 1.60 lacs

Costs 2.0 lacs Cash outflows 1.80 lacs
Profit 2.0 lacs Net cash flow (0.20) lacs
Table 4.1

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MBA 202 Unit 2, Lesson 4

While items like depreciation are considered for calculating profits, they are
non-cash items. While estimating cash flows only cash revenues and cash
expenses are considered. Also the entire investment is considered as a cash
out flow whereas while calculating profits, its deducted as an expense over
the life of the project.

Self-check Questions

2. Why are cash flows more important than profits?

4.4 Types of Cash Flows

There are number of methods of classification of cash flows. We consider
here the cash flows from the time value of money point of view only. Basically
cash flows are classified as ‘single’ and ‘multiple’ cash flows. Multiple cash
flows can be equal or unequal. Equal multiple cash flows can be ‘certain’ or
‘infinite’. Infinite cash flows are known as ‘perpetuity’. ‘Certain’ cash flows are
known as annuities. Annuities can again be classified as ‘annuity regular’ if
cash flows happen at the end of the year or ‘annuity due’ if the cash flows
happen at the beginning of the year. (see Fig 4.1)

Cash Flows

Single Multiple

Un Equal Equal

Finite (annuity) Infinite (perpetuity)

End of the year Beginning of the year

(Annuity regular) (Annuity Due)

Fig 4.1 Types of Cash Flows from the Time Value of Money view

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4.5 Cash inflows and Outflows

The cash flows received by an individual or an organization are known as
cash inflows. The cash paid by an individual or an organization is known as
cash out flows. Typically the income received as salary by an individual is an
inflow and all expenses requiring payment of cash are cash out flows. When
companies issue securities they have cash inflows. When they pay dividends,
interest on loans and borrowings or repay the principal amount of a loan, they
are a cash outflows for the company. As shown in Fig 2.2 below, inflows are
shown as an arrow pointing downwards and outflows are shown as arrow
pointing upwards.

Inflow Outflow

Fig 4.2 Cash Inflows and Outflows

Self-check Questions
3. Can we say that amount of cash flows are alone important for a company?

4.6 Summing Up
Money is preferred today than in future. This time preference for money arises
because of inflation, preference for current consumption and investment
opportunities. So an amount in rupees expected in future in exchange for
today’s rupee would be more than a rupee. Also the value of future rupee
today will be less than a rupee. We use cash flows in time value of money
concepts. Cash flows are different from profits. Cash flows are more important
indicators of financial position than profits. Cash flows can be classified into
various categories based on the time value of money. The cash payments are
out flows and the cash receipts are in flows.

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4.7 Assignments
Class assignments

(i) Identify the inflows and outflows that arise when a company raises
funds through the issue of debentures. You can use both
organizational point of view and investor point of view for the same.

Home assignments

(i) Identify various cash inflows and outflows during a month connected
with the maintenance of your home

4.8 Answers to the Self-Check questions.

1. Due to time preference of money having Rs. 1000/- i.e. more preferred
than having Rs. 1000/- after one year.
2. Since cash flows reflect the cash available (inflows – out flows) at any
given point of time to carry out business they indicate the financial position
better than profits.
3. For a company it is not only the amount of cash flows but also their
location (timing) which is important.

4.9 Terminal Questions

1. What is time preference of money and what are the factors leading to the
time preference of money?
2. Classify cash flows based on the time value of money point of view.
3. From an investor’s point of view, identify various types of cash inflows and
out flows arising out of investment in debentures.

4.10 Suggested further Reading

 Kishore, R.M. 2007. Financial Management, 6 Ed. Taxmann Allied Services

(P) Ltd., New Delhi.
 Srivastava, R. and Misra, A. 2008. Financial Management. Oxford University
Press, New Delhi.

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MBA 202 Unit 2, Lesson 4