Practical 7: Time Value of Money and Opportunity Cost Principle

Question 1
Find out the present value of income expected to earn NRs. 300,000 at the end of year one, NRs.
350,000 in the year two, NRs. 400,000 in the year three, NRs. 450,000 in the year 4, and NRs. 500,000
in the year five. Assume that the discounting (interest) rate is 10% (i=0.1).

Question 2
A bank provides interest on savings account compounded quarterly at the annual interest rate 8%.
Estimate the value of your money NRs. 400,000 after two years when you saved in the bank. What
will be the value of your money if the bank provides the same interest however compounded
annually? (i = 0.08 and N = 2 in case of annual compounding, i = 0.02 and N = 8 in case of quarterly
compounding)

Purchase of old vs new machine

The farmer may come to a problem of choice whether to buy the new or old machine. While deciding
upon purchasing a new or an old machine, the farmer has to make a special discrimination. Depending
upon the resources available to him, he needs to make use of "Time Comparison Principle". The
principle, mathematically states:

FV
PV =
(1 + i)n

Where,
PV = present value of the future amount
FV = amount to be spent in the future (future value)
i = interest rate per conversion period (i.e. annual interest rate)
n = number of conversion periods (i.e. number of years)

Question 3
A farmer may come to a problem of choice whether to buy a new or an old tractor. The farmer wants
to purchase a tractor. The alternatives with him are:
i) Purchase a new tractor for NRs. 1,500,000 that can be used for 10 years (economic life).
ii) Purchase an old tractor for NRs. 900,000 and replace it after 5 years with another old tractor
worth NRs. 900,000. This means that he shall have to invest NRs. 900,000 now and lay aside
an amount which will become NRs. 900,000 within 5 years to replace the old tractor.
For 10 years of operation, which tractor the farmer should buy? New tractor or old tractor? Let the
interest rate is 10% per annum.

Here, i = 0.10, n = 5, and FV = 900,000

Year Value of new Value of 1st old Value of 2nd old Present value of
tractor tractor tractor two old tractors
0 1,500,000 900,000 900,000
5 - - 900,000 558,829
Total 1,500,000 1,458,829
1
Though the value of two old tractors seems NRs. 1,800,000 which is NRs. 300,000 more than the
new tractor. The calculation suggests that the farmer should decide to buy two old tractors because
the discounted value of two old tractors (NRs. 1,458,829) is less than the value of new tractor (NRs.
1,500,000).

Continue-Question 3 (Opportunity cost principle)

a) Farmer with unlimited capital has the opportunity of lending the money at usual interest rate, say
5%.
900,000
PV = = 705,171
(1.05)5
His comparison is NRs. 1,500,000 for new tractor and NRs. 900,000 plus NRs. 705,171 (total =
NRs. 1,605,171) for old tractor. The new tractor is profitable for the farmer with unlimited capital.

b) Farmer with limited capital has an opportunity of investing money in poultry and can make a
return of 15% within the year. His discounting rate will be 15%, i.e. opportunity cost of not using
money for poultry.
900,000
PV = = 447,459
(1.15)5
His comparison is NRs. 1,500,000 for new tractor and NRs. 900,000 plus NRs. 447,459 (total =
NRs. 1,347,459) for old tractor. The old tractor is profitable for the farmer with limited capital.