Understanding Money

Money is a standardized unit of exchange. The physical form of money is currency. Different countries have different currencies. Interest is the amount earned or paid on money which is lent. Compound interest is the ‘interest earned on interest’. Compound Interest (C.I)= [P*(1+r/100)^t – P] P=Principal amount r=Rate of interest t=Time period in years Interest may be compounded annually, semi-annually, quarterly, monthly or even daily. This is known as the compounding frequency. Greater the frequency of compounding, the greater the effective return or yield. Always adjust the ‘r’ to map to the ‘t’. That is, if the compounding is quarterly, then take the quarterly interest rate, not the annual rate.

Compounded Annual Growth Rate (CAGR)
If we come across a projection of say, sales or profit 3 years from now, we need to arrive at a rate at which the sales was growing each year to arrive at that future number. That growth rate, which assumes compound growth each year, is called the CAGR. CAGR = (Final Value/Initial Value)1/n- 1 It’s defined as ‘the interest rate at which a given initial value will ‘grow’ to a final value in a given amount of time.’

Time Value Concept of Money
Money earns interest with time. That means, INR 100 today is worth different amounts at different points in time. Hence, money has a ‘time value’. The fundamental concepts involved in understanding the time value of money are: Future Value of Money: ‘Future value of an amount is the amount today’s money turns into at a point of time in the future

(assuming a certain rate of return)’. Future value is arrived at by multiplying the principal invested today by the compounding factor (1+r)^t . FV= PV (1+r/100)^t FV=Future Value Present Value of Money: If you want to get a known sum of money in the future after a time period t, what is the principal you must invest today, or in other words, what is its present value? In other words, the Future Value (FV) is known; we need to find the Present Value (PV) or Today’s Value. PV= FV/(1+r/100)^t The process of computing the present value is also called discounting, as the PV is at a discount (less) as compared to the FV. The ‘r’ here is also referred to as the discount rate. Net Present Value of Money: NPV is an evaluation tool used to find out if the rate of return of a series of cash flows, is higher or lower than a comparison rate. The situation in which you use NPV is • A set of cash flows, (meaning inflows and outflows/payments) at different points of time in the future are given. • You don’t know the rate of return all these cash flows will result in. If PV (C1) is the PV of the cash outflow for an investment , and PV (C2) and PV (C3) are the cash inflows, then NPV is the net of these flows: -PV(C1)+ PV(C2)+PV(C3). IRR or Yield to Maturity: The rate which makes the present value of all future cash inflows equal to the outflow or investment today, i.e. makes the NPV=0, is the yield of the investment. This is the yield to maturity – i.e. the yield or return after considering all the cash flows from the investment. This is also called the Internal Rate of Return (IRR).

Inflation
It is a rise in prices or put another way, a decrease in the value of money.

Nominal Rate (N) – Inflation Rate (I) = Real Rate (R) • Nominal rate of interest (N) refers to the stated interest rate in the economy. • Inflation rate refers to the rate at which money is losing value. • Real rate of interest (R) refers to the inflation-adjusted rate of interest. That is, it is the rate you actually get after deducting the effect of inflation.

Exercises:
Do try these. If you can crack all of them, you’ve got a good grasp of this chapter. Else, back to studying! 1. Ravi has invested INR 1,00,000 in a fixed deposit at Star Bank for a period of 5 years. The interest rate he earns on his investment is 8% p.a compounded quarterly. The average inflation rate is 4%. What is the real return he has earned after 5 years in rupees? 2. Your client needs INR 22 lakh for purchasing a home at the end of 5 years. He gets a bonus of INR 3.5 lakh every March 31st. He wants to invest this amount on 1st April each year in your bank, and wants to know how much he will have after 5 years, and whether it will be sufficient to buy the home. Can you tell him the answer? You are offering 9% p.a. (hint: use future value. Assume the investment starts from this year) 3. A project is giving cash flows of INR 10 lakh, INR 15 lakh and INR 30 lakh for Years 1, 2 & 3. Today (Year 0) there is an investment into the project of INR 50 lakh. What is the yield on this investment? Solutions 1. We need to find the real return – so use the real rate, which is = nominal rate (8%) – inflation rate (4%) = 4% per annum. But compounding is quarterly, so we need to consider the quarterly real rate, that is, 1% per quarter. And use t = 20 quarters! Plugging these values into the compound interest formula gives us an amount of INR 122,019 or a real return of INR 22,019. 2. Best done using Excel. First, we’ll put all the cash flows into a table:

Time period Cash Flow Values of t & r Value on Apr 1, 2015 Apr 1, 2010 350000 t = 5, r = 9% 538,518 Apr 1, 2011 350000 t = 4, r = 9% 494,054 Apr 1, 2012 350000 t = 3, r = 9% 453,260 Apr 1, 2013 350000 t = 2, r = 9% 415,835 Apr 1, 2014 350000 t = 1, r = 9% 381,500 Apr 1, 2015 350000 t=0 350,000 Total is Rs. 26, 33,167. More than enough. Note I’ve included the last cash flow, which becomes clear once you put the cash flows and sample dates into the table. 3. You need to use Excel for this, too. Look at the situation: multiple cash flows over a period of time, and the return is not known. That’s when we use the tool of NPV. But rather than asking whether one should invest in this project, the question is, what the yield of this project (IRR) is. Hence we put all the cash flows in a table and in any cell, type =IRR (cell range). That will give you the answer of 4.1%.

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