TIME VALUE OF MONEY

A farm manager has to take decisions over varying horizons of time. Time has a very
significant influence on costs and returns. There are many decisions where this time
comparison principle finds application, such as: soil conservation programmes which bear
fruits over a long time; putting land under an orchard which may not give returns for 5-10
years; and so on. Two aspects of the problem are considered under such situations: a) growth
of a cash outlay over time and b) discounting of future income.

Compounding:
Compounding is used to translate present cash flow into their future values. Compounding
factor enable calculation of future value of present money. In general, the compounded value,
FV (Future Value), of a present sum (P) invested at an annual interest rate (i) for ‘n’ years is
given by FV = P (1 + i)n .This procedure is called compounding.
Discounting:
Discounting derives the present value of future income at a specified rate of interest. This is
because, money has time value. Discounting factor enable calculation of present value of
future income. The present value, PV, can be determined using the procedure called as
discounting future returns. The expression is given as :
PV = P/ (1 + i)n
The concept of Compounding and Discounting are described through the following example:
Suppose the initial invest of Rs. 6000 is made during the first year, the Future Value (FV) can
be worked out using the compounding Procedure, while the Present Value can be worked out
using Discounting Procedure.
Future
Present
Initial Value at Compunding Discounting
Interest Value at the
Year amount the end of Factor @ 12 Factor @
@ 12 % end of the
(Rs) the year % 12 %
year (Rs)
(Rs)
1 6000 0.12 6720 1.12 0.89 6000
2 6720 0.12 7526 1.25 0.80 6000
3 7526 0.12 8430 1.40 0.71 6000
4 8430 0.12 9441 1.57 0.64 6000
5 9441 0.12 10574 1.76 0.57 6000
Project Appraisal
The long term investment analysis is carried out by using Capital Budgeting techniques. The
profitability of two or more alternative investment projects are determined through capital
budgeting techniques. Four components are required for the analysis of investment. They are
1) net cash revenues from different projects. 2) their costs, 3) terminal or salvage value of
investment, 4) interest or discount rate to be used.
Broadly there are two methods of project appraisal viz., undiscounted measures and
discounted measures. In the undiscounted measures, payback period, ranking by inspection,
proceeds per rupee of outlay, average annual proceeds of rupee outlay etc., are important.
Under discounted measures, Net Present Worth (NPW), Benefit cost Ration, Internal Rate of
Return (IRR) and Profitability Index are prominent.
Pay Back Period:
A simple method of ranking a project is the length of time required to get back the investment
on the project: The Payback period of the project is estimated by using the formula:
P = I/E Where, P = Pay Back Period, I = Investment of the project in rupees and E = Annual
net cash revenue in rupees.

Discounted Measures
The economic viability of a project indicates whether the proposed project is likely to
contribute reasonable returns on the investment which in turn will lead to economic
development of the farmer.

The economic viability can be measured by

1) Net Present Worth (NPW)
2) Benefit-Cost Ratio (BCR)
3) Internal Rate of Return (IRR)

Net Present Worth

The NPW of the project can be estimated using formula as given below:

Where,
Bn = Benefits in n'th Year.
Cn = Costs in n'th Year.
n = life span of the proect
r = interest or discount rate.
If the NPW of a project is positive, then it is considered that the project is economically
feasible.
Benefit-Cost Ratio (BCR)
The BCR can be calculated using the following formula:

To compute the NPW and BCR, the opportunity cost of capital (normal/market lending rate)
may be used as a discount rate. If the BCR is greater than 1, then it is worth wile to invest on
the project.
Internal Rate of Return (IRR)
IRR is that rate of discount which makes the present worth of benefits and costs equal or the
net present worth of cash flow equal to zero. If IRR is greater than the opportunity cost of
capital, the project is feasible.
IRR = Lower Discount rate + Difference X Present worth of the cash flow
between the at lower discount rate
two discount rate Absolute difference between
the present worth of
cash flow at two discount rates
Answer 2
Disc Present Present
Fixed Variable Total factor Value of Total Value of Net cash
Year cost cost cost @ 16 % costs Returns Returns flow
0 50000 0 50000 1.00 50000 0 0 -50000
1 14200 14200 0.86 12241 26300 22672 10431
2 14200 14200 0.74 10553 26300 19545 8992
3 14200 14200 0.64 9097 26300 16849 7752
4 14200 14200 0.55 7843 26300 14525 6683
5 14200 14200 0.48 6761 26300 12522 5761
6 14200 14200 0.41 5828 26300 10795 4966
7 14200 14200 0.35 5024 26300 9306 4281
8 14200 14200 0.31 4331 36300 11072 6741
9 14200 14200 0.26 3734 36300 9545 5811
10 14200 14200 0.23 3219 42300 9589 6370
192000 118632 299000 136421 17789
NPW 17789
BCR 1.15
IRR 7%

Answer 3:
Present
Disc value Present
Fixed Variable Total factor of Total Value of Net cash
Year cost cost cost @ 16 % costs Returns Returns flow
1 60000 14200 74200 0.86 63966 28000 24138 -39828
2 14200 14200 0.74 10553 28000 20809 10256
3 14200 14200 0.64 9097 28000 17938 8841
4 14200 14200 0.55 7843 28000 15464 7622
5 14200 14200 0.48 6761 28000 13331 6570
6 14200 14200 0.41 5828 28000 11492 5664
7 14200 14200 0.35 5024 28000 9907 4883
8 14200 14200 0.31 4331 28000 8541 4209
9 14200 14200 0.26 3734 28000 7363 3629
10 14200 14200 0.23 3219 28000 6347 3128
202000 120356 280000 135330 14974
NPW 14974
BCR 1.12
IRR 13%