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Business Finance - Assignment

   

Added on  2021-05-31

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Business Finance1
Business Finance - Assignment_1

Time value of money:Time value of money is the concept which establishes the reasons for difference in the valueof the money today and in the future period. It states that a sum of money is worth more ifreceived today than at some other time[ CITATION Ade15 \l 1033 ]. This concept will be betterunderstood with the help of an example. Mr. X has $10 today, if he invests this sum for aperiod of 6 month, then he would receive $12 at the expiry of the stated period. Thedifference between $10 and $12 is due to earning capacity of the money, which is called timevalue. The major principle in finance states that if money has the capacity to earn interest,then the amount which is received first is of more worth. Few reasons for which money hastime value are as follows:-Risk: given an option to receive $100 today or after 1 year, a person would accept today.It is so because it eliminates the risk factor, removes uncertainty of not receiving moneysome time.-Inflation: more goods can be purchased today then after 1 year. This is so because heinflation rate increases and declines the purchasing power of money.[ CITATION Bie10 \l1033 ]-Opportunity cost: money received today can be invested to earn interest income.Whereas if amount is received after a year we will lose the interest for one year. The process which helps to calculate of value present value of money which is to be receivedin future if called discounting. Discounting cash flow technique is one of the majorcomponents in security pricing and investment decision.[ CITATION Pet12 \l 1033 ]The most important tool in time value of money is interest rate. It is the most important factoron which whole of the application of this concept depends. It is important that the investorcalculate his required rate of properly, else the whole result may conclude to something else.Calculation of this rate of return is the crucial part; it depends on lot of conditions andassumptions.[ CITATION Riv09 \l 1033 ] Change in any of the condition may result in calculationof wrong return. This is one of the greatest limitations of time value of money.Time value of money in valuation of securities:Time value of money helps calculate the worth of securities. It helps investor decide themaximum price they should pay for a given security, so that they can earn their desired rateof interest. When an investor invests a sum in a security, he is promised by the company that2
Business Finance - Assignment_2

he would earn interest income on this principle amount. The worth of money which isinvested today should be minimum present value of incomes which the investor is to receivein future. Therefore, by discounting the future cash flows from a security, we get themaximum price of the security which the investor should be willing to pay.[ CITATION Sei09 \l1033 ] It not only calculates the value of securities, it also helps calculate the value ofbusiness which helps investor analyse the worth of the company. Concept of time value ofmoney helps reduce arbitrage opportunities.The following example will help understand this concept better. Say there is a security Awhich is expected to earn $50 annually for 5 years and at the end of year 5, it will alsoredeem the face value of $1000. Given the required rate of return is 11%, how much aninvestor should invest today. For this we need to calculate the present value of the cash flows:YearCash FlowsPV factor @11%PV of Cash Flows150 0.9009 45.05250 0.8116 40.58350 0.7312 36.56450 0.6587 32.9451050 0.5935 623.12 Total 778.25 Therefore given the required rate of return of 11%, the investor should not invest more than$778.25 today.Time value of money in Capital budgeting:Time value of money helps in taking investment decisions. Capital budgeting is one of mostused financial tool which helps the investor in making decisions. Suppose we are providedwith two opportunities for investment, both these have same cash flows but the timing ofthese cash flows is different. Time value of money will help analyse the present value of3
Business Finance - Assignment_3

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