What is time value of money? Explain the concept of present value and future value with examples.
Money accumulates value over time. For example, if I am to choose between receiving 100$ today and receiving 100$ a year later, I would go ahead and take the money today. Why? Because I can invest the same in a bank (assuming it offers a 10% interest) and receive 110$ by the year end. This is greater than the $100 I was supposed to receive at the end of year. This accumulation of value over time is called the time value of money. Time value of money is a fundamental principle in finance and is used extensively, i.e., in Loan amortization, Valuation, Discounted cash flow analysis, Bond valuation, Capital budgeting etc. To calculate the value of money at different points in time, we use present value and future value. Present value (PV) is the value of money today and Future value (FV) is the value of money at a certain point in future. Considering the same example above, $100 is my PV, $110 is my FV at the end of one year considering a growth of 10% (rate of growth, R). Thus, to calculate FV of a PV, one can simply use FV = PV*(1+R) ^T (similar to compounding) where T is the time period and inversely PV = FV/ (1+R) ^T. Based on the frequency of compounding (monthly, quarterly, semiannually or annually), time value of money can result in significant variations. For instance, $1000 invested for 2 years at a rate of 10% per annum compounded annually would be 100*(1+10%) ^2 = $1210 $100 invested for 2 years at a rate of 10% per annum compounded semiannually would be 100*(1+10%/2) ^4 = $1215.5
Which is a better capital budgeting technique: NPV or IRR?
Capital budgeting is a process of evaluation of investments or large expenses and accordingly allocating the available funds. This is an important decision making step since the organization or company can only invest in limited projects and would want to maximize its gains. It involves forecasting the investments, expenses, profits etc., for each period for a certain duration and discounting the net cash flows to present value. There are multiple capital budgeting techniques but the most frequently used are Net Present Value (NPV) and Internal Rate of Return (IRR), however both of them have some drawbacks. A project is considered worth investing if its NPV is above zero. But a major drawback for NPV is that it is very sensitive to the discount rates. Small changes in discount rate, can turn the investment into viable or unviable. For example, let us say an investment costs us $3000 which would pay out $1000 annually for four years. Assuming a discount rate of 10%, the NPV is a positive $154, however if we assume 15% then it is a negative $126. Thus accurately determining the discount rates is a challenge as one has to consider the investment risk, return on other investment opportunities, inflation etc. Also the risk in an investment might not be the same throughout its timeline, it might be more risky in the initial stages and relatively risk free in the later stages. Different discount rates for every year or every couple of years makes determining the NPV all the more challenging. Coming to IRR, a project is worth investing if its IRR is greater than the discount rate. The biggest advantage is the use of a single discount rate, however IRR has to be compared to the discount rate if one has to evaluate the investment else it becomes useless. IRR also fails to provide a single rate when the project is long term and there are additional investments in the course of project. For instance, if the project has cash flows as -$5000 (year 0), $10000 (year 1), -$6000 (year 2), $15000 (year 3) etc. this leads to multiple IRR's (here, NPV is an effective method). Thus, a combination of both NPV and IRR is effective in capital budgeting exercise, rather than depending on a single technique.
What is monetary policy and how does it affect the flow of money in an economy?
Policy which affects the flow of money in a country/economy is called its monetary policy. We often come across the change in benchmark funds rate by Federal Reserve every 6 weeks or 8 times in a year. Raising/ decreasing rates alters the flow of money and various economic variables and thus the impacts state of economy. If we examine the current scenario of US, the Fed has raised interest rates 4 times in 2018 and present rates stand at 2.25% to 2.5%. As the interest rates are raised, banks raise their lending rates in tandem and borrowing rate for consumers is now higher. Since credit is now available at a higher rate, consumers purchase less and companies invest less. The reduced purchase and investment lower the overall demand and thus the growth of economy. The quantum of % increase and the prevailing economic conditions influence the impact of monetary policy. Also, It is important to note that the transition of monetary policy differs from country to country as no two countries have the same set of economic conditions. In India, for example, the transition of interest rates does not take place effectively as it is primarily a savings economy and thus the banks fund majority of their loans through consumer deposits.