Time Value of Money in a Cash Flow - Essay Example

PROJECT CASH FLOW Project Cash Flow Monisha Chattopadhyay Academia Research Q. When does it become necessary to incorporate the time value of money into project cash flow calculations A. The answer to the above question is divided into the following sections: I. Time value of Money-General Concepts II. Time value of Money-Estimating the discount rate III. When can the non discounting techniques be used IV. When does it become necessary to incorporate the time value of money into project cash flow calculations V. Project Cash Flows-an integrated approach VI. Conclusion-The nature of business decisions I) Time value of Money-General Concepts According to Sherrick, Elinger and Lins (2000, pp.3-4) If you are given the choice of being given $100 today or a week after you would certainly want to get the money today. If you analyze this simple situation you will realize that people want money immediately because they generally don't want to put off consumption i.e. they are impatient with regards to their consumption behaviour and the sooner they are able to consume the better. Secondly the money receivable in future has a certain degree of uncertainty; anything may happen in the future, as according to an old saying a bird in hand is worth two in the bush and thirdly in a certain time period the prices of commodities which the money can buy may rise which is called as inflation thus reducing the purchasing power of that certain amount of money. Therefore to have the money later you will certainly want a reasonable compensation for the delayed consumption, the risk or uncertainty and the inflation. All these factors: delayed consumption, uncertainty and inflation determine the interest rate over a certain amount of money which is due at present but the acquisition of which is put off till a future date. In any situation when a person or group becomes or become indifferent to these three factors then the value of time to that person or group in that particular situation ceases to matter. The situation can be caused by internal factors as well as external factors or both. We can imagine few such situations, for example if in a hospital the anaesthesia machine goes bust in the mid of an operation and the standby machine is at some other OT then irrespective of rational comparisons a new machine has to be ordered because the situation demands it, or for example if there is fire in a factory and machines become unavailable for completing the order at hand worth millions of dollars then new machinery has to be arranged for as soon as possible without going into much details of profitability etc. The example that we have taken are extreme cases. In real life, situations generally lie mid way between conditions of very high emergencies to conditions of no pressure at all. There is usually existence of some pressures which limits the time that can be infinitely spent on arriving at the best analysis. In real life decision making is often done amidst many known and many unknown variables.1 Situations of absolute unpredictability Situations of absolute predictability Reliance on the available and Reliance on complex decision making tools easy to operate decision making tools II) Time value of Money-estimating the discount rate The predictability of a situation depends on a host of internal and external factors. Internal factors can include the knowledge and experience of the organization the management information and coordination systems, the resources and time available to the organization etc. The external factors can include the market forces and the business environment. In the case of applying time value analysis in project decisions the uncertain factor is the cost of capital 2.The estimation of cost of capital or the discounting rate is a complex process and its accuracy depends on many factors. Estimating the cost of capital includes estimating the cost of debt, the cost of equity and cost of debt, infact it is the weighted average of these two. Cost of debt is relatively easy to estimate but estimating the cost of equity is very much complex. The cost of equity depends upon the estimation of the weighted projected return required by investors where the return is largely unknown, (Wikipedia).The assigning of weights and estimation of risk requires a very much deep insight into the business. Hence analyzing the profitability of a project based on the time value of money i.e. the time value of cash inflows and outflows is a relatively complex analysis as compared to non discounted method. III) When can the non discounting techniques be used The accuracy in discounting technique is based on how correctly the discounting rate that is the cost of capital has been estimated. In some situations the discounting rate may be ambiguous or vary. In such situations the decision maker may just be satisfied to estimate the pay back period that is the minimum time period within which he can get his/her investment back. The payback period is a non discounted method and its estimation just requires knowledge of the general market conditions. In the absence of other known factors or in the absence of the knowledge of how other factors can affect the cash flows the project which has the shortest payback period will be given preference. In this way the decision maker can reach a satisfactory decision if not the best decision. Another non discounted technique is the Average Rate of Return (ARR). In this method the decision maker just needs to estimate what will be the Average return during the project life time and divide it by the Average investment if this rate is higher than a cut off rate say the bank rate on fixed deposits (the cut of rate may vary from individual to individual) then the decision might be acceptable and projects with higher ARR will have higher preference in investment decisions. Non discounted techniques may more or less provide reliable estimate when the organization is vague regarding the cost of capital and it neither has the time nor resources to calculate it. In situations where one has to arrive at accept reject decisions that is when screening the projects one can use the non discounted techniques if he/she is vague about the cost of capital which is the discounting rate If the cost of capital has been estimated with a high accuracy level then the discounting technique should be applied to arrive at more accurate figures and better decisions in the case of accept reject decisions also. IV) When does it become necessary to incorporate the time value of money into project cash flow calculations The concern arises when comparing projects which on the face of it seem to yield almost similar cash inflows and outflows and only one of these projects have to be chosen(mutually exclusive decision making) or in ranking such projects for assigning the limited resources (capital rationing decisions).A hypothetical example as below will further clarify the point Year 0 Year 1 Year 2 Year 3 Year 4 Project A -1000 pounds 500 200 300 500 Project B -1000 pounds 300 500 200 500 In the above example the ARR (Average rate of return) and the payback period (in this case 3 years) is same for both projects A and B. Then how to determine which project is better than the other especially in a situation when one has to choose only one project The answer is using the discounted technique From the compound sum of a rupee we know that PV=FV/ (1+k) n .Where K is the discounting rate and n is the no. of years. In the above example for project A the present value of cash inflows will be 500/ (1+k) 1 + 200/ (1+k) 2 + 300/ (1+k) 3 +500/ (1+k) 4 and the PV of cash inflows for Project B will be 300/ (1+k) 1 + 500/ (1+k) 2 + 200/ (1+k) 3 +500/ (1+k) 4 From the present value tables we can determine the PV of cash inflows for Projects A and B for different values of k as below k=1 k=2 k=n Project A Project B For a range of value of k cash inflows of Project A may be better than Project B but for another range of value of k it may be vice versa. The decision maker may then say well I am not sure regarding the exact value of k but I am sure it will be between 10-15 percent or it cannot certainly be more than 15%and hence he/she can then determine which project is better in terms of cash flows. The calculation as shown above is tedious but in our times we can use computer programmes to make the calculations automatic. V) Project Cash Flows-an integrated approach The following table provides a guideline for decision making in choosing projects: Non discounted technique Discounted Technique Projects Pay back period (PB) Average rate of Return (ARR) Internal Rate of Return (IRR),for an estimated range of k Net Present value (NPV),for an estimated range of k A B C Projects which have uneven cash flows, varied life times can be impossible to rank, we can then compute the values as above, these values may be at sync with each other for some projects for others they may not be tallying, a deeper analysis can then be made on such projects where values do not tally. VI) Conclusion-The nature of business decisions To compete in any industry organizations need to increase their competitive advantage and one way of doing this is by making more accurate decisions .Organizations ideally should continuously improve their learning and integrate the new knowledge into their systems. In the case of estimating the cost of capital with a high precision the organization should improve its learning on the estimation and risk analysis tools and techniques and integrate the new learning into the financial management systems. Management is not an absolute science, decisions are not classified simply as good or bad rather decision making can be visualized on a continuous scale of improvement. References Sherrick B.J. Ellinger P.N. and Links D.A. (2000).Time value of Money and Investment Analysis: Explanations and Spreadsheet Analysis for Agricultural and Agri Business Firms, volume 1.2, viewed 22 may, 2007, The Center for Farm and Rural Business Finance Department of Agricultural and Consumer Economics and Department of Finance University of Illinois, Urbana-Champaign. Robbins, SP 1996, Organizational Behavior, 7th edition, Prentice Hall of India Pvt. Ltd ,New Delhi, India Khan and Jain 1996, Financial Management-text and problems, 7th edition, Tata McGraw-Hill Publishing Company Limited, New Delhi, India Cost of Capital, Wikipedia, viewed 22 May, 2007. Read More