Time value of money in financial management decision making

1. Role of a Company Secretary in management of financial instruments

A Company Secretary is the key to the efficiency and effectiveness of governance by the Board of Directors. In order to carry out his duties in light of the above, it is important for a company secretary to understand at a thorough level the concept of time value of money (TVM) with regard to financial assets and financial liabilities (including financial derivative instruments).

2. Relevance of time value of money (TVM) in financial management

Time value of money is an important concept or notion in financial management of banks, financial institutions, insurance entities and all other non-financial business firms. The tipping point of time value of money is that a dollar in hand today is more valuable than a dollar in hand in future, because you could invest that dollar today and earn interest and thus multiply your financial assets or use it to your requirements. The present day use of money is also more useful because we live in the present time.

The CS can be a decision-maker in purchase, sale or trade of financial instruments by a financial or non-financial business firm and his reporting of such instruments at fair value to the Board. It may be noted that derivative financial instruments are only held for trading as compared to held to collect for all other types of financial instruments under IFRS 9.

The point being made here is to state financial instruments at historical costs would, unlike non-financial assets and liabilities, be incorrect as the hi-tech financial markets change every minute, which calls for valuation of financial instruments held at fair value or market-related indices.

3. Time value of money –a basic premise under IFRS and financial market transactions

Time value of money is the basic premise under IFRS accounting. Broadly, time value of money refers to the present value of future cash inflows and outflows. The difference between the present value and future value represents interest component (either as expense or income).

Historical accounting convention would record a $10,000 loan received @5% interest and payable in full at the end of 3 years, as merely at $10,000, whereas under IFRS using the notion of TVM the said loan would need be discounted at the going effective market rate of interest; the differential amount would need be amortised to income statement on effective interest rate (as distinct to the stated interest of 5%) over the loan tenure and loan account liability in the balance sheet would be initially recorded at the discounted value which will keep increasing at the end of year 3 to exactly $10,000 being the liability required to be paid off.

Financial market transactions work on the notion of TVM which is reflected in IFRS. Fair value is also described as equivalent of present value.  

4. Fair valuation rule for financial instruments

Fair value is nothing else than applying the time value of money by calculating either the (i) present value of future cash inflows or outflows or (ii) future value of present cash available. It may be noted that the exact method of fair valuation of financial instruments, reflecting time value of money, depends upon the investment classification rules in IAS 39 Financial Instruments: Recognition and Measurement, IFRS 9 Financial Instruments –Classification and Measurement and valuation rules in IFRS 13 Fair Value Measurement.

Accordingly, those financial instruments which have been classified as held to collect (HTC) are fair valued using amortised cost basis whilst those held for trading are valued at fair value (say quotes).

5. What is amortised cost basis of valuing financial instruments (say bonds or loans)

If financial assets and liabilities that are interest bearing are at a market rate of interest, the initial value exchanged (for example, loan made or received) will usually approximate to the present value of the future payments discounted at a market rate.

Amortised cost of a financial asset (or liability) is the present value of (i) future cash receipts (or payments) and (ii) interest expense (or income) in a period, both the cash loan inflows and interest cash outflows at stated rate, discounted at the stated rate, which will give the initial carrying amount of the financial liability (or asset) at the beginning of the period. Interest expense (or income) is computed by applying the effective interest rate for the interest period (normally a month or a quarter or semi-annually or annually). Remember, interest under EIR method considers compounding.

Amortised cost of a financial asset or financial liability at each reporting date is the net of the following amounts:

Amount at which the financial asset or financial liability is measured at initial recognition,

i. minus any repayments of the principal,

ii. plus or minus the cumulative amortisation using the effective interest method of any difference between the amount at initial recognition and the maturity amount,

iii. minus, in the case of a financial asset, any reduction (directly or through the use of an allowance account) for impairment or uncollectibility.

6. Transaction costs, premiums and discounts

If transaction costs and other premiums or discounts are applicable to the financial instrument, this will often mean the effective interest rate is not equal to the market rate of an instrument that does not have these features. In such cases, an entity shall amortise any relevant fees, finance charges paid or received, transaction costs or other premiums or discounts over the expected life of the instrument. This is consistent with existing practice or GAAP, where a loan is initially recognised at its net proceeds and finance costs are allocated over the period of the debt.

7. Example of calculating amortised cost for a loan

On 1 January 20X1, an entity takes out a loan for $10,000. In doing so, it incurs transaction costs of $100, which are deducted from the loan amount to arrive at the initial carrying amount. A fixed rate of interest is payable, $700 a year (7%). Interest is payable in arrears on 31 December each year. The loan must be repaid on 31 December 20X5.

Step 2: See above table and below entries. *net present value of future cash flows $13,500

Interest charge has been calculated using an effective interest rate of 7.245496%, which is the rate that is applied for computing interest to the initial carrying value $9,900 and onwards (which is net of transaction cost $100 deducted by the lender) and not the stated rate. EIR has been applied to the carrying amount at beginning of a year (9,900.30 x 7.245496%=$717.30), for year-wise interest expense.

IFRS Entries in 20X1:

1. Bank account (actual receipt of loan – cash flow)  Dr $9,900.00

$7,130-100

Carrying value beginning=99000

To Loan account (at present value)  Cr $7,030.00

To Interest payable contra account (at present value)  Cr 2,870.00

*use stated rate 7% on expected cash inflows $10,000 and expected cash outflows $3,500 for discounting to compute initial carrying value at beginning of the period. Deduct $100 as transaction cost to arrive at net present value $9,900.

@Use effective interest rate to compute interest expense (or income) on the previous period end carrying value or current period opening carrying value, to follow amortised cost method subsequently. 

2. Interest expense account (at EIR)  Dr $717.30

To Carrying value account   Cr $717.30  

3 Carrying value account (annual interest cash flow)  Dr $700.00

To Bank account  Cr $700.00

IFRS Entries in 20X2, 20X3, 20X4 and 20X5

Repeat entries 2 and 3 above with interest amounts from the above table. In 20X5, an additional entry be made for repayment of the loan of $10,000:

4 Carrying value -Loan account (end of 20X5) Dr $10,000.00

To Bank account (loan repaid on 31.12.20X5)  Cr $10,000.00                       

Note that the end carrying value of $9,977.11 as on 31 December 20X4 (comprising the present value of original loan of $10,000 plus total interest payable $3,500) plus the interest expense on EIR basis $722.89 for the final year 5 minus interest payable $700.00 for the year 20X5 will leave an exact balance of $10,000 in BS being the original loan amount obtained on 1 January 20X1, which gets fully repaid on 31 Dec 20X5. No deferred expense $100 is recognised in this example because the lender has deducted it from loan proceeds. It would have been debited to BS and amortised to income statement on EIR, otherwise. Total EIR interest charge $3,600 is higher than the cash outflow $3,500 as EIR interest is always higher than that at the stated rate of interest due to principle of compounding. 

Remember, IFRS requires a financial instrument like this term loan to be recorded initially at fair value (discounted value of future cash flows at the stated rate) and subsequently at amortised cost (using the effective interest rate) when the carrying value $9,900 has gradually been increased to the actual value of loan repayment and interest payment in year 5 totaling $10,700, using the effective interest rate by recognising a higher interest charge $717.30 during 20X1 than payable as per the instrument $700.00 on the principle that EIR is higher than the stated rate. The above example reflects the application of these two methods of valuation i.e., fair value followed by amortised cost using EIR. See first step below:

8. Computation of discounted value of the initial carrying amount of loan at the beginning* –step 1

9. Determining effective interest rate –step 2

Effective interest rate (EIR) is the rate that exactly discounts estimated future cash payments ($13,500)  or receipts, comprising loan amount plus interest outgoes at stated rate, through the expected life of the financial instrument to the final year opening value of loan tenure carrying value $9,977.11 (repayable loan $10,000) of the financial asset or financial liability added by the EIR charge $722.89 for the final year thus equalizing $10,700 being the tenure-end loan repayable amount $10,000 and final year interest outgo $700, both at stated figures as per loan agreement.

The effective interest rate is determined on the basis of calculating the value of the stated interest rate of a financial asset or financial liability in an online EIR calculator or in the EFFECT formula in Excel which is multiplied by 100 to get the rate in percentage. 

EIR rate, so calculated, is applied to the initial net present value computed $9,900 of future cash flows of a financial asset or liability (say total of loan taken plus stated interest outgoes $13,500).

Therefore, step 1 is to discount the future cash payments $13,500 comprising loan and interest, at stated rate 7%, reflecting initial carrying value $9,900 as the net present value net of transaction cost $100. Thus, a financial asset or liability together with interest thereon is initially converted to fair value from nominal (stated) amount under the loan agreement.

Step 2 will be to value the financial asset or financial liability at the reporting dates at amortised cost using the effective interest rate. This is done by applying the effective interest rate to the initial discounted carrying value $9,900 (amortised cost) of the stated loan plus interest, to get the EIR charge $717.30 for year 1. Closing carrying value increases by the incremental interest $17.30 (EIR charge$717.30 minus nominal interest payout $700.00 at stated rate); and so on, such that the beginning year 5 discounted carrying value $9,977.11 (amortised cost) would be equivalent of the higher principal value of the loan $10,000 under the agreement that needs be repaid at the end of its tenure plus $722.89 as EIR charge for year 5 on the opening carrying value $9,977.11 which will exactly total to $10,700 being stated total cash outflows at the end of year 5 and tenure-end of the loan, per loan agreement.

In other words, EIR rate of 7.245496% has exactly discounted the estimated future cash outflows $13,500, in the form of year 5 opening carrying value $9,977.11 and EIR interest charge for year 5 $722.89, matching with a total of stated cash outflow of $10,700 at the end of year 5 (tenure-end). In nutshell, the initial carrying value or amortised cost gradually increases such that the carrying value opening balance and EIR charge for the final year of loan, is exactly equal to the total of the stated amounts of payouts on account of the principal loan repayment and nominal interest charge for the final year.  

Thus, interest charge recognised in the Income Statement on effective interest rate has reflected the compounding interest principle which is how transactions in financial instruments and their valuations are decided in the marketplace.    

There are the 2 important terms needed to calculate effective interest rate. The stated (also called nominal) interest rate (5%) will be expressed as a percentage. The compounding periods (12 monthly) will generally be monthly, quarterly, annually, or continuously. This refers to how often interest is applied. Effective interest rate is calculated through a simple formula: r = (1 + i/n)^n – 1, wherein r represents the effective interest rate, i represents the stated interest rate, and n represents the number of compounding periods per year.

For example, consider a loan with a stated interest rate of 5 percent that is compounded monthly. Using the formula yields: r = (1 + .05/12)^12 - 1, or r = 5.12 percent. The same loan compounded daily would yield: r = (1 + .05/365)^365 - 1, or r = 5.13 percent. Note that the effective interest rate will always be greater than the stated rate. Excel EFFECT formula figure 0.051161898 x 100=5.116% or 5.12%.

There are several online calculators that you can use to calculate the effective interest rate quickly. In addition, the EFFECT() function in Microsoft Excel will calculate the effective rate given the nominal rate and number of compounding periods.

In simple words, effective interest rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears. It is used to compare the annual interest between loans with different compounding terms (daily, monthly, quarterly, semi-annually, annually, or other). It is also called effective annual interest rate, annual equivalent rate (AER) or simply effective rate. Note that effective interest rate is always greater than the stated interest rate because of compounding principle, as shown below.

As an example, effective interest rate can be ascertained from an EIR table per sample given below:

Excel EFFECT formula figure 0.010025 x 100=1.002% as given in the table.

Therefore, step 1 is to discount the future cash payments $13,500 comprising loan and interest, at stated rate, reflecting initial carrying value $9,900 as the net present value net of transaction cost $100. Then calculate the EIR rate using online calculator or keying in the formula in Excel as stated above.

Step 2 will be to apply the effective interest rate to the initial discounted carrying value $9,900 to get the EIR charge; closing carrying value increases by the incremental interest $17.30 (EIR charge minus nominal interest at stated rate); and so on such that the final year opening carrying discounted value $9,977.11 plus that year’s EIR charge $722.89 would be equivalent of the principal value of the loan $10,000 and interest payouts $700 both under the agreement that need be paid at the end of its tenure.

10. Current trade debtors and trade creditors

For simple current financial assets and current financial liabilities, such as trade debtors and trade creditors, the amounts recognised in the balance sheet under current IFRS would usually be at cost (less any provision for bad debts).

11 Use of TVM for investment decisions and Company Secretary’s governance role

The Company Secretary should analyse and inform the time value of money of financial assets and financial liabilities, to those charged with governance (and not their historical cost), to enable the Board of Directors to (i) compare the investment alternatives of such financial assets and financial liabilities or (ii) to solve problems involving loans, mortgages, leases, savings and annuity payments.

12. Example of application of time value of money in business decision-making

Time value of money refers to the fact a Rupee in hand today is worth more than a Rupee promised at a future time.

Suppose your friend owed you Rs. 5,000. Would you rather have this money repaid to you right away, in one payment, or spread out over a year in four installment payments? Would it make a difference either way?

According to a concept that economists call the time value of money, you would probably be better off getting your money right away, in one payment.

Reason being that you could invest this money and earn interest on it or you could use this money to pay off all or part of a loan. There are a million things you could do with this money.

Time value of money is related to another concept called opportunity cost. Cost of any decision includes the cost of the second best forgone opportunity.  If you pay Rs. 100 for a movie ticket, your cost of attending the movie is not just the ticket price, but also the time and cost of what else you might have enjoyed doing instead of the movie. Applying this concept to the Rs. 5,000 owed to you, you see that getting the money in installments will saddle you with opportunity cost.

13 Elements of present value (fair value) in computing time value of money

• Expectations about possible variations in amounts and timing of cash flows, representing uncertainties in cash flows,
• Time value of money represented by rate on risk-free monetary asset which have maturity dates coinciding with periods covered by cash flows and pose neither uncertainty in timing nor risk of default to the holder (risk-free interest rate),
• Price for bearing the uncertainty inherent in the cash flow (cash risk premium),
• Other factors that may be considered by market participants under the circumstances.

14. Techniques of measuring present value

1) Discounted rate adjustment technique is used for contractual or promised or most likely cash flows (as in the case of bonds). Discount rate is derived from observed rates of return for comparable asset or liabilities that are traded in the market. It requires an analysis of market data for comparable assets or liabilities. In all cases, cash flows are conditional upon occurrence of specified events (contractual or promised). Bond cash flows depend on no default by debtor.

2) Expected present value technique is used for all possible cash flows, that is, a set of cash flows which represent in theory the probability-weighted average of all possible cash flows. In making an investment decision, risk-averse market participants would consider risk that the actual cash flows may differ from the expected cash flow.

In Sub technique 1 of expected PV technique, expected cash flows are determined after adjusting systemic market risk (non-diversifiable or general market risk) by subtracting a cash- risk premium (risk-adjusted expected cash flows -inherent risk of uncertainty) which represent a certainty-equivalent cash flow, which is discounted at a risk-free interest rate –no uncertainty in timing and default risk to the holder –MPs are compensated for bearing the risk.

In sub technique 2, expected cash flows aren’t adjusted for systemic (market) risk, rather adjustment of risk is included in the discount rate by adding a cash risk premium to the risk-free interest rate. Expected cash flows are discounted at a rate that corresponds to an expected rate associated with probability-weighted cash flows (expected rate of return).

Fair value amount is the same under both the two sub techniques. Note that for un-systemic (diversifiable) risk specific to asset or liability, market participants cannot be compensated.

15. Computation of present value of future cash flows

Now we will learn how present value of a future cash flow is determined. If $5,000 were to be received in a year, the present value of the amount would not be $5,000 because you do not have it in your hand now, in the present. To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest at market rate from the $5,000. This can be done by discounting future cash flows by the effective interest rate method say @ 4.5% pa. Thus, present value at the end of year 1 would be $4,784.69 (5,000÷1.045=4,784=4,578=4,381), year 2 $4,578.64 and year 3 $4,381.48. So the present value of a future payment of $5,000 is worth $4,381.48 today if interest rates are 4.5% p.a. (market rate). Hope time value of money is not elusive to get!

16. Concluding comments –good governance by a CS in financial assets, liabilities & derivative trades

Time value of money resulting in fair valuation of financial instruments (assets, liabilities, derivative instruments) empowers a Company Secretary to make informed investment decisions, in light of the present market valuations. An entity’s financial instruments thus reflect market-consistent valuations – based on time value of money -of significant value of financial documents held either for trading or maturity by many entities, which can make or break an entity. Company Secretary can facilitate good governance by the Board in an important area of financial instruments that all businesses have to deal.

Authored by:

CS. Anand Varma

Company Secretary

varma1002003@yahoo.co.in

June 2013