Time Value of Money

Suppose Bharat is purchasing some goods worth Rs.100/- today.  We all know that in a year’s time, you would require more than Rs.100/- to purchase the same goods as you have done today.  This is due to the “Rise in Prices”.  This phenomenon is observed constantly in almost all the economies, though the degree of increase would depend upon so many factors and hence it differs from time to time and country to country.

This “increase” in prices is due to the fact that at any given time, more money chases less goods and services.  This means that there exists a gap between “Supply” and “Demand” of goods and services and the degree of price rise directly depends upon the extent of gap.  The more the gap the higher the price rise and vice-versa.  This general increase in prices of goods or services with the passage of time is called “Inflation”.

Inflation in India as a Developing Country:

All Developing Countries experience a fair to heavy dose of Inflation depending upon the Current Growth Rate of the Economy.  Usually, when the economic activity is at its peak in the growth phase in any country, the rate of Inflation tends to be high, as money in circulation increases appreciably and growth in terms of economic activity requires a little time to catch up with.

India, as a developing country is no exception to this phenomenon of “Inflation”.  At present, it is indicated that the rate of Inflation as per “Wholesale Prices Index (WPI) ” is around 9%.

However, in all Developed Economies, the rate of Inflation is measured in terms of “Consumer Prices Index”, which is the correct measure, as consumers do not buy at wholesale prices and that in a country like India, there are any number of intermediaries between wholesale trade and retail trade; usually, the average consumer gets his goods from the retail trade and not the wholesale trade.

What do you mean by “Rate of Inflation of 5%”?

This means on a comparative basis, the difference between prices of a basket of Commodities last year and this year works out to 5%.  Hence, in case there is a reduction in the rate of Inflation, it does not mean that the prices have come down in an absolute sense.  It only means that the rate of increase in price rise of a basket of selected commodities has come down.                                                                                                                                                                                                                                                                                                                                                                              What is the difference between inflation in a Developing Country and a Developed Economy?

Inflation in a Developing Country appears due to the gap between “Supply” and “Demand” of goods and services, whereas, in a Developed Country, this is not the case.

Developed Countries experience, what is known as “Cost Pushed” Inflation.  This essentially occurs because of  “high levels of income”, which pushes up the “Cost of Production”, resulting in Inflation.  This does not necessarily indicate that there is a gap between “demand” and “supply”.

Inflation and Interest Rates:

In any Economy, there is a 4-tier Structure for Rates of Interest as under:

Tier No. I – Rate of Inflation;

Tier No. II – Rate of Interest on Deposits, i.e., Rate of Inflation + Certain % loading depending upon the degree of compensation expected by the Depositors;

Tier No. III – Rate of Interest on Loans, i.e. Rate of Interest on Deposits + Certain % loading depending on the risk perceived in the lending activity by the lender which could be borrower specific and the profit margin of the lender and

Tier No. IV – Rate of return expected by a promoter from Investment in a project = Rate of Interest on Loans + Certain % loading as a reward for the risk incurred by the promoters in the project.

What is “Time Value of Money”?

That with the passage of time, the value of “Present Money” reduces due to “Inflation”is clear to us and this phenomenon is referred to in finance as “Time Value of Money”.

Interest is in fact primarily a Compensation for the loss in value of money due to passage of time. Hence we should familiarise ourselves with terms associated with “Time Value of Money”such as “Compounding and Discounting”.

Compounding:  It is a process by which given a specific present value, at a fixed rate of interest and depending upon the frequency of compounding, the future compounded value can be determined for a specific period.

All of us know this formula to be

F.V. = P.V. (1+ r /100) raised to “n” times, “n” representing the period in number of years.

This presupposes that the periodicity of compounding is yearly.

In case the periodicity of compounding is half-yearly, then the formula would change as follows: F.V. = P.V. (1+ r /200) raised to “2n” times. Similarly, the formula could be amended for quarterly compounding or monthly compounding.

Discounted value:  This is converse to the process of “Compounding”. Just as we know the present value for compounding, we should know the future value for discounting.

This value, when discounted at a given rate of discount, which is usually the rate of return expectation, by a promoter or an investor gives us the present value.

This again depends upon the period for which the discounting is done.  Just as in the case of compounding, in the case of discounting also, the formula which is given below needs amendment for adjusting for a more frequent periodicity of discounting than 1 year.  P.V. = F.V./(1+r/100) raised to the power of “n”, wherein “n” is the number of years.

This discounting is useful for saving a fixed sum at a future date and for evaluating projects, whose cash flows can be determined now for a future date.

Pour in to your thoughts on the article through your valuable comments.

Concept of Present Value & Future Value in Investment Arena

Intuition Behind Present Value

There are three reasons why a dollar tomorrow is worth less than a dollar today.

• Individuals prefer present consumption to future consumption. To induce people to give up present consumption you have to offer them more in the future.

• When there is monetary inflation, the value of currency decreases over time. The greater the inflation, the greater the difference in value between a dollar today and a dollar tomorrow.

• If there is any uncertainty (risk) associated with the cash flow in the future, the less that cash flow will be valued.

Other things remaining equal, the value of cash flows in future time periods will decrease as

• the preference for current consumption increases.

• expected inflation increases.

• the uncertainty in the cash flow increases.

Discounting and Compounding:

The mechanism for factoring in these elements is the discount rate.

Discount Rate:

The discount rate is a rate at which present and future cash flows are traded off. It incorporates –

(1) Preference for current consumption (Greater ….Higher Discount Rate)

(2) expected inflation (Higher inflation …. Higher Discount Rate)

(3) the uncertainty in the future cash flows (Higher Risk….Higher Discount Rate)

• A higher discount rate will lead to a lower value for cash flows in the future.

• The discount rate is also an opportunity cost, since it captures the returns that an individual would have made on the next best opportunity.

·Discounting future cash flows converts them into cash flows in present value dollars. Just a discounting converts future cash flows into present cash flows.

·Compounding converts present cash flows into future cash flows.

Present Value Principle 1

Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregations are made.

                                    

               or in other words

     

Key Concept in Calculating Returns on the Investments -> CAGR

What Does Compound Annual Growth Rate – CAGR Mean?

The Compounded Annual Growth Rate (CAGR) is the rate at which something (e.g., Revenues, Savings, Population) grows over a period of years, taking into account the effect of Annual Compounding.

A Compound is composed of two or more parts. In the case of compound growth, the two parts are Principal and the Amount of change in the principal over a certain time period, which is called “interest” in some circumstances.

This is sometimes called “growth on growth” because it measures periodic growth of a value, that is itself growing periodically. If we are calculating the annual compound growth rate, then each year the new basis, is the previous basis plus the growth over the previous period.

Thus, a Compound Annual Growth Rate (CAGR) measures the rate of return for an investment — such as a Mutual Fund or Bond — over an Investment period or Horizon, such as 5 or 10 years.

The CAGR is also called a “Smoothed” rate of return, because it measures the growth of an investment, as if , it had grown at a steady rate on an annually compounded basis.

It’s Significance & Importance :

In looking at an Investment, the CAGR is a measure that is commonly used to show how quickly the investment, or certain aspects of it, such as gross sales, have been growing.

Investment analysts often look at 5 year periods to discern a trend. A specific company’s rate of growth is often then compared with that of competitors or with the industry as a whole.

For example, Company A had a revenue CAGR of 8.5% over the past 5 years. One of its direct competitors has grown by 9.4% and two others have seen slower growth. The industry as a whole has seen revenues grow by 7.3% per year, compounded annually.

On this basis, one would conclude that Company A is doing well and in fact might be gaining market share. Of course, other factors need to be looked at, such as debt and the outlook for the industry.

                                            Formula for Calculating CAGR :

The formula for Compound Annual Growth Rate is:

((Ending Value/Beginning Value)^(1/# of Years))-1

There are five variables in a compound growth rate calculation:

Beginning value
Ending value
Length of time between the values
Periodic scale (days?, months? years?)
Periodic rate of change

You need to know four of these values to make the calculation of the fifth.

For example, Company A had revenues of $1.35 billion in 2002. Revenues grew by a CAGR of 8.5% through 2007, a period of five years. We know the beginning value, the length of time, the periodic scale (years) and the periodic rate of change. Now we can determine what the revenue was in 2007.

CAGR (Compounded Annual Growth Rate) is growth rate annualized over a period of time. This is not actual growth year on year, but it shows the annualized growth, if the same Investment would have experienced a steady growth rate over the period. Let’s understand it with an example:

Year ->                                                                       0              1            2            3                 4               5                    6

Growth Rate (%)  ->                                                          20         -8           11               -5             35                   5

Value of Investment (Principal) ->    100       120    110.4      122.54     116.42    157.16       165.02

CAGR will be calculated based on the evidence that an Investment of Rs 100 turned out to be Rs 165.02 in 6 Years.
CAGR will be (165.02/100)^(1/6)-1 = 0.0871=8.71%

1 More Example :

Say the sales of a Company 4 years back was 100. Today, after 4 years, it is 200. A simple conclusion is that sales has increases by 100% in 4 years. But does it mean that it has increased by 25% each year?

That would not be correct, as simply dividing 100% by 4 doesn’t take into consideration the compounding effect.

So, to find out the per year growth rate of a company, we use the compound interest formula.

A = P * ( ( 1 + r ) ^ n )   Same as above formula, but in a Simplified Notation for better Understanding

Where
A = Final Amount
P = Principal amount
r = Rate of interest, expressed in %
n = Number of years

In our example,

A = 200
P = 100
r = The annual growth rate (that we want to find out)
n = 4 years

From this formula, we find out that r is around 19%.

How do we interpret this?

It means that the average growth of the company over these 4 years, taking into account the impact of compounding, is 19%.

In the first year, the company grew from 100 to 119. In the second year, it grew 119 to 142. In the third year, it grew by 19% from 142 to 168.5, and in the fourth year, it grew from 168.5 to 200.

This principle is very important to understand, because it is used at many places.

For example, it is looked at while examining at returns generated by mutual funds (MFs). Whenever one sees returns for more than 1 year, they are expressed in terms of CAGR. If they are not expressed in CAGR terms, the returns are not accurate!

Let me know your thoughts on this Article.

What is Debt and Equity?

When we talk about Asset Allocation and selecting Financial Products, we also need to understand the difference between the two broad Classification of Financial Products: Debt and Equity.

A company can raise Capital by using the two means – Equity & Debt

   In Simple (Layman) words : When a provider of capital loans money to a user of capital, it’s a Debt transaction. When he owns a portion of the user of capital, it’s an Equity transaction.

The basic difference between Debt and Equity would be the ownership level. Let’s take an example where you invest in me.

If you give out some money to me and expect that I return the money along with interest that I pre promise, that would be a Debt investment. I’m indebted to you but since I have promised you a return with interest, you don’t actually own me.

In other words, by investing in a Debt instrument such as a Bond, you are guaranteed the Principal of the bond, plus any interest that is owing.

In another case, you give me money at your own risk. But you trust me/hope that I’ll be a billionaire in the future and I’ll payback from my profits. The more profits I make, the more you do. If I am bankrupt, you don’t get anything back. And so you have invested in my Equity.

By trusting me, you own me in a way!

Equity refers to part ownership in a company, and in the Indian context – Equity and Shares (Stocks) are used interchangeably.

So, if  Bharat/knowledge2finance  were a company that had 100 shares in the market, and if you bought 1 share of knowledge2finance – you would be the owner of 1% of knowledge2finance.

If knowledge2finance was valued at 1 lakh Rupees today, then your share would be worth Rs. 1,000.

If 5 years from now – knowledge2finance were valued at Rs. 10 lacs then your share would be worth Rs. 10,000.

If however, the company went bankrupt then your share would be worth nothing. Equity products are generally considered to be high risk – high return products for this reason.

       However, for equity investors, you become an owner. As such, you also take on the risk of the company not being a success. Just as a small business owner has no guarantee of success with each new venture, neither is a shareholder. As a shareholder, if the company is successful, you stand to make a lot of money. On the flip side, you stand to lose a lot of money if the company is less than successful.

                                         Examples of equity products:

   Shares/Stocks: Shares trading on the stock exchange are the most direct examples of equity products.

Equity Mutual Funds: Mutual funds that own shares are another example of equity products. ELSS mutual funds that are eligible for 80C tax savings are a popular example of equity mutual funds.

Equity based ETFs: ETFs that are based on shares like Nifty Index Funds are also an example of equity products.

                                                       In other Words : 

      Equity means ownership. Everyone who owns an equity share of a company owns a part of the company. He/she can influence the decision-making in the company

Debt represents an obligation.

Debt is loan, and carries a fixed rate of interest, and a promise to repay. Debt is generally safer than equity, and there is generally no upside in it. You get paid the promised interest, and as long as the company (or country) is not bankrupt – you’re safe.

Examples of debt products:

Fixed Deposits with banks (FD) are the prime example of debt products. They are extremely safe investments, which have a pre-determined interest rate. The stock of SBI may have wild swings but your fixed deposit with SBI is safe, and won’t be affected till something really serious happens.

Infrastructure bonds that have recently been launched are another type of debt product as they pay you a fixed interest rate, and the principal is protected as well. They are not as safe as bank fixed deposits, but if any infrastructure company defaults on their debt – that would be an exception rather than the norm.

Fixed Maturity Plans (FMPs) – These are a special type of mutual funds that have become popular in the past few years, and work like fixed deposits (though not as safe as them). They have become popular due to favorable tax treatment when compared with a fixed deposit,  so people don’t mind taking the little bit of extra risk.

Post Office Monthly Income Scheme (POMIS): Post Office schemes are also debt schemes as they pay a fixed interest, and are also guaranteed. These are very safe instruments.

Provident Fund (PF): This is also a debt product, which is quite safe and pays a fixed rate of interest.

These are some of the key things that come to my mind when explaining the difference between a debt and an equity product – feel free to add anything that I have missed, and as always – comments are welcome.

ABC of Repo & Reverse Repo Rate & its Impact

        How many of us read the news last week “RBI increases Repo and Reverse Repo rate by 25 bps” ? For most of us these words do not make sense, and we move on to next news item. Little do we realize that we are affected by these rates and a basic knowledge about it is a must.

         I found many non-finance guys actually struggling to figure out the jargons used in & across us in a way or other.  So here are some key monetary policy rates definition or banking terms, which might help in understanding things better, and then we’ll see how these rates affect a layman.

        bps
        It is an acronym for basis point and is used to indicate changes in rate of interest and other financial instruments. 1 basis point is equal to 0.01%. So when we say that repo rate has been increased by 25 bps, it means that the rate has been increased by 0.25%.

Repo Rate and Bank Rate
People often get confused between these two terms. Though they appear similar there is a basic difference between them.

Repo rate or repurchase rate is the rate at which banks borrow money from the central bank (read RBI for India) for short period by selling their securities (financial assets) to the central bank with an agreement to repurchase it at a future date at predetermined price. It is similar to borrowing money from a money-lender by selling him something, and later buying it back at a pre-fixed price.

Bank rate is the rate at which banks borrow money from the central bank without any sale of securities. It is generally for a longer period of time. This is similar to borrowing money from someone and paying interest on that amount.

Both these rates are determined by the central bank of the country (RBI in Indian Banking Context) based on the demand and supply of money in the economy.

 Let’s try to dig a bit more to Understand it better:

Repo rate is basically the rate charged on this thing called a repo or “repurchase agreement”. Essentially, a repurchase agreement is an agreement between one party and another in which the former sells a security (like a bond) to the latter with a promise to buy it back after a particular period.

When we take a loan from any bank, we pay Interest for that. In the same way, Banks also take short-term loans from Central Federal Bank (RBI in Indian Context) & RBI charges the Interest at the rate , which is well-known as Repo Rate.

   For instance, a bank may enter into a repo with RBI, selling a security to RBI and then telling RBI, that I will buy this security back from you after 3-months.

   RBI tells the bank…OK I will pay Rs. 100 for this security now but when you buy it back from me, please pay me Rs. 103. The extra Rs. 3 that RBI charges constitutes the repo rate (translates into 12% pa for this example).

 Hence, repos are a form of “collaterlised or secured borrowings” in which the borrower must place a collateral with the lender (in this case RBI). If the borrower does not manage to buy back the security, the lender can redeem its collateral value. Generally, repos are used for managing domestic liquidity in the economy.

  Thus, the repo rate, often referred to as the short-term lending rate, is the interest charged by the central bank on borrowings by commercial banks. A hike in the rates makes cost of borrowing costlier for the commercial banks. 
 

Reverse Repo Rate:

“Reverse Repo” rate is just what the name suggests. It’s the reverse of the repo.

A reverse repurchase agreement or a ‘reverse repo’ is something like a switch between the buyer and the seller in a repurchase agreement. More specifically it’s a switch in the perspective.

For example in the case of reverse repo, the RBI would be the one,who will be selling the security to the commercial bank and telling it….if you give me Rs. 100 for 3 months today, I’ll pay you Rs. 3 as interest on it after 3 months and you give me back this security.

So it is actually a ‘repo’ from RBI’s perspective but a ‘reverse’ repo from the commercial bank’s perspective.

I hope you got the difference. The interest rate that RBI promises the commercial bank for placing its money with RBI is the reverse repo rate.

The following table summarizes the terminology:

                                            Repo                      Reverse repo
Participant              Borrower                     Lender
                                           Seller                            Buyer
                                     Cash receiver           Cash provider

Near leg                 Sells securities             Buys securities
Far leg                    Buys securities             Sells securities

Impact of these on Us:

    When the repo rate increases borrowing from RBI becomes more expensive.  Therefore, we can say that in case,  RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate:)

Thus, a hike in these rates makes cost of borrowing costlier for the commercial banks.

An increase in the reverse repo rate  means that the RBI will borrow money from the banks at a higher rate  of interest. As a result, banks would prefer to keep their money with the RBI.

A hike in this rate makes it more lucrative for banks to park funds with the RBI(which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk).

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while Repo rate signifies the rate at which liquidity is injected.

The Central bank uses these rates to control inflation.

Banks earn profit by borrowing at a lower rate of interest from the central bank, and lending the same amount at a higher rate to the customers.

If the repo rate or the bank rate is increased, bank has to pay more interest to the central bank. So in order to make profit, banks in turn increase their interest rate at which they take deposit from the customer and lend money to the customer. So the demand for loan decreases, and people start putting more and more money in bank accounts to earn higher rate of interest. This helps in controlling inflation.

An increase in Reverse repo rate causes the banks to transfer more funds to the central bank, because banks earn attractive interest rates and also their money is in safe hands. This results in the money being drawn out of the banking system, thus banks are left with lesser funds.

Thus, by lowering repo rate, central bank injects liquidity in the banking system and by increasing reverse repo rate it absorbs liquidity from the banking system.

Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks.

Increase in CRR  rate (https://planurmoney.wordpress.com/?p=23&preview=true) means that banks will have less power to give loans (see our example above), which again controls the amount of money floating in the market; thereby controlling inflation. It also makes banks safer to keep money because banks will have a higher liquidity to meet the demand of customers. As we learnt from the recession, giving loans expose banks to great risks. So if banks have lesser funds to give as loan, they become relatively safer.

Please add your valuable suggestions & feedback for the article for further Improvement.

1st Blog Today

1st Blog Today !!!

I have been a silent reader of so many blogs, which are doing justice to the value addition to thought process of an Individual. So many Creative, Informative & sometimes Oh My God types of wonderful ideas struck our minds, once we go through these blogs & it turns out to be -Life can be thought of this way as well:).

Every person sitting next to you will have a blog for sure, which will make you think, Why not I? Blogging has taken us in an era, where you think slightly, you get either Implemented thoughts, or Mindblowing Ideas beforehand, or there are ample amount of facts & resources available on Internet, which would help to shape your internal thoughts in to a complete ground reality.

Even having a flair for writing & a strong appetite for knowing much more in this word from all the scholars around you, I have always been reluctant to start a blog of my own. But I am enjoying it today & hope to develop a habit of continuing this habit of mine & write that stuff which can help others as well. Will stop for tonight here & hope some great thoughts & Info pour in from all corners of my mind for my further Post.

Bharat Sahni

Hello world!

Welcome to PlanUrMoney.

Today happens to be my 1st Article & hence I would like to take this Opportunity, to share how & what we are going to do here.

This will be no more of a Website, which we come across, while surfing Internet, to make ourselves aware about Financial Terminology.

Here it will be a collective effort of sharing the best of an Individual’s knowledge about any fundamental concept of Finance & at the same time get your queries for a particular hard-to-understand Concept in a very simple way, taking day-2-day (i.e. routine life) example to clarify a concept.

Rest be assured, & I will try my level best to share whatever I come across & know about Finance & Related Relevant areas.

Flow of Information shall be spontaneous & continuous & any specific topics to be discussed, can be notified to me, through my contact email id, so that those can be addressed & healthy discussions round the blog, can take place.

More we share, more we learn & knowledge repository gets a Value addition.

Do not forget to leave your comments, Likes or Dislikes for any article you come across here, as your feedback, will help us for a Gradual Improvement & maintain a User Friendly healthy discussion atmosphere.

This is purely a Non-Profit blog to share collective knowledge of economy and financial markets.

The opinion in this blog represents the view of authors and primarily for knowledge purpose.Neither the information nor any opinion expressed constitutes an offer, or any invitation to make an offer, to buy or sell any specific Financial Market Product.

These entries have been prepared on the basis of published/other publicly available information considered reliable, we are unable to accept any liability for the accuracy of its contents.

Regards,

Bharat Sahni