Techno Finance and Executive Diary...

Thursday, November 13, 2008

Time value of money- a nice article

Time value of money

Do you remember our three friends - Saver, Borrower and Investor and their tryst with Inflation?

Inflation is detrimental to Saver but favourable to Borrower and Investor.

But this lop-sided scenario can't last forever. Saver can't always be the 'poor guy'. And Borrower and Investor can't benefit endlessly at his expense.

We surely know why. If things continue as they are, then all of us would want to be borrowers and investors! And nobody would bother to save!

So, the stage is set for a new character, who would balance the disequilibrium. Enter Interest, the great balancer.

Interest tilts the balance in favour of our friend Saver, thereby levelling the playing field for our three friends. But how does he do that? Saver demands interest for postponing his consumption while Borrower and Investor have to pay up Interest for using Saver's surplus.

Hence, what Saver loses owing to Inflation, he gains through Interest.
Now that we have seen how Interest restores the balance, it is time for us to move on...

Assume that your friend calls and offers you Rs10000. He says that you can have it either now or tomorrow. What would you choose?

Pretty simple, eh? Your voice is loud and clear as you say, "I want now."

So, why did you choose to have the Rs10000 NOW?
You obviously are thinking of the many things that you can do with that money. You can buy a couple CDs or a pair of new jeans or even the pair of shoes teasingly displayed at the shoe shop on the way home. After much deliberation, you decide to go for the pair of shoes. With the cash in your pocket, all you need to do now is go to the shop and buy.

However, your friend is too busy and is unable to give you the money today, but he promises that you will get it a month later. You are sorely disappointed. All your plans of buying that pair of shoes lie shattered.

"Or what if somebody else buys those pair of shoes, which may well be the last such pair on earth?"

"Or what if your friend delays his gift by another month?"

'If' - the root of all uncertainties! What we commonly term as 'Risk' and what can ruin all your well laid plans...
Hence, if you have a choice, you would rather go to see this friend at his office and collect your money today.

Why would you do that?

This brings us to a fundamental truth: Time has value.
We all know that the value of a rupee does not stay the same across time horizons. Due to Risk and Inflation, a rupee today is worth more than a rupee tomorrow on the time line.

In simpler words, we are saying that the value of the same rupee differs at different points of time. This difference in value arises due to the passage of time. Hence, it is called the 'Time Value of Money'.

Expressing this in numbers, if you believe that you can buy the same pair of shoes with Rs11000 a month later, then the time value of money for you is Rs1000for a month.

Little twist in the tale
Now, let us assume that your friend actually turns up and gives you Rs10000. But while on the way to the shoe shop you meet your old classmate who badly needs Rs10000. In that case, will you part with the money?

You would, provided he promises to return at least Rs11000a month down the line, so that you can buy the same pair of shoes. (We know that, in real life, you would not take a penny more than what you have lent to your classmate, but just for academic purposes!)

So, what do you call this extra payment that you demand over and above the amount you have lent?

If the answer is 'Interest', you are right. But then what is Interest? And why is it charged?
Let me explain. When you are lending the money to your friend, you forego an opportunity to buy the shoes and use them when you wanted. Hence,you would charge the cost of losing this opportunity, commonly termed as 'Opportunity Cost', to your friend in the form of Interest.

One last exercise before we bid goodbye to 'Time Value of money' and 'Opportunity Cost' for now.

What is the Opportunity Cost for our friends, Saver, Borrower and Investor?

Saver:
Saver is a lot like you. He needs to get compensated for the erosion in his purchasing power with time as also the risk associated with postponing consumption.

Borrower:
Now that Saver has an ace up his sleeves in the form of Interest, Borrower needs to evaluate his decision to borrow and consume now. Why? Now there is interest to contend with.

Lost? If your classmate is borrowing Rs10000 from you today to meet his needs and is repaying Rs11000a month later. Then, he is better off fulfilling a need of his that will be worth at least Rs1000more a month later.

Investor:
Our most enigmatic friend, Investor has several opportunities knocking at his door. He can set up a beer factory or open a restaurant among other things. We could actually exhaust this page writing about the options that he has staring at him. As we all know, our clever friend hopes to maximise his profits and minimise his risks.

In case he decides to set up a beer factory, the profits he would have earned by setting up a restaurant are considered as his 'Opportunity Cost'!

He also has a very basic 'Opportunity Cost'. He can opt to lend his money to Borrower in return for Interest payment. Thus his investment needs to fetch him enough profits to compensate for all this.

Hence, Investor needs to know the value of his future profits in today's terms for all the investment opportunities. Only then can he make the best choice. This brings us to another vital concept: 'Present Value'.

source: sharekhan

Labels: Business Lessons, Consulting, Excellence, Forgotten Facts, Money Making, Stock Market

Posted by "CPerformance" :: 8:16 AM :: 0 comments

Wednesday, November 12, 2008

Power of Compounding

Power of compounding

"Compound interest is the eighth wonder of the world"
- Benjamin Franklin

"Compound interest is the world's greatest discovery"
- Albert Einstein

"In case you earn Rs20,000 per month, do you know how many years it will take for you to become a Crorepati? Not 10 or 20, but 50 years!" exclaims Amitabh Bachchan, the anchor for "Kaun Banega Crorepati".

Mr Bachchan, did you know that if you invest just Rs9,250 once and earn 15% per annum on this investment then, in 50 years you will be a 'Crorepati' too!

And in case you invest Rs20,000 every month for 50 years under similar terms, you will be worth more than (hold your breath) Rs173cr! That is Crorepati 173 times over!!!

Welcome to the 'Power of Compounding'
One of the basic premises of investing is that your money multiplies manifold over time. And this multiplication of money is normally referred to as the "Power of Compounding".

So, how does money compound?

When you invest money, it earns interest (or returns, if you may). If you keep the interest invested, then it does not sit idle while only the original investment sweats it out. The interest earns interest too! And then the interest on interest earns interest again!

That is the beauty of compounding. That is what made great men like Albert Einstein and Benjamin Franklin extol the virtues of 'compounding'.

What does the 'Power of Compounding' mean to an investor?
Ms Thrifty, Mr Realist and Ms Follower went to the same school and the same class.

On her 10th birthday, Ms Thrifty's father gave her Rs100. She wisely invested the money that earned her an interest of 15% every year.

Mr Realist won Rs200 as prize money when he was 16 years old. His friend, Ms Thrifty, advised him to invest his prize similarly.

When Ms Follower earned her first salary at the age of 21, she salted away Rs400 in the same investment.

After reaching the age of 60, all three decide to withdraw their investments. Who do you think realised the most from his/her investment?

You think it's Ms Follower, right? After all, she invested four times the money that Ms Thrifty had invested. So what if she invested the money 10 years later. She did earn interest for 40 years anyway after that.

But think again. Ms Thrifty makes the most out of her investment! In fact, her Rs100 is worth Rs1,08,366. On the other hand, Ms Follower's Rs400 is worth Rs93,169!

It simply means that the LONGER you stay invested the MORE you make.
Now you know why Ms Thrifty made more money than Mr Realist and Ms Follower.

Let us try another small exercise.

Let us assume Ms Thrifty, Mr Realist and Ms Follower invest Rs100 for 10 years. However, all three of them earn interest at different rates. Ms Thrifty earns 20% while Mr Realist earns 15% and Ms Follower manages a 10% interest rate.

Can you work out what each one of them will have ten years hence?

Ms Thrifty will have Rs619 while Mr Realist, Rs405. Ms Follower will have the least - Rs259 in ten years. Did you notice something though? While the interest rates differ by just 5%, in 10 years the worth of the original capital, Rs100 was vastly different!

That is another way of understanding the 'Power of Compounding' or the power to grow exponentially.
Now that we have understood the magic of compounding, it is time to take a look at an interesting rule associated with 'compounding' - the Rule of 72.

The 'Rule of 72' is an easy way to find out in how many years your money will double at a given interest rate. Lost?

Suppose the interest rate is 15%, then your money will double in 72/15= 4.8 years. In case, the interest rate is 20%, then the money will double in 3.6 years.

Interesting rule indeed!

Moral of the story: The longer you stay invested the more you make!

Labels: Business Lessons, Stock Market

Posted by "CPerformance" :: 12:37 PM :: 0 comments

Monday, November 10, 2008

Balance Score Card - a Performance Management Tool

What is the balanced scorecard?

The balanced scorecard is a strategic planning and management system that is widely applicable to organizations regardless of size or type of business. The system, extensively used in business and industry, government, and nonprofit organizations worldwide, provides a method of aligning business activities to the vision and strategy of the organization, improving internal and external communications, and monitoring organization performance against strategic goals. It was originated by Robert Kaplan and David Norton of Harvard University in about 1990, but the roots of the balanced scorecard are deep, and include the pioneering work of General Electric on performance measurement reporting in the 1950’s and the work of French process engineers (who created the Tableau de Bord – literally, an instrument panel or dashboard of performance measures) in the early part of the 20th century in France. Additional details on the balanced scorecard can be found here.

Because the balanced scorecard is a generic term, it means different things to different people, and in practice, there are wide variations in both understanding and implementation. To some, the balanced scorecard is a simple dashboard of performance measures, while to others it is a comprehensive planning and management system covering the whole organization and designed to focus efforts on organization strategy and, more importantly, on performance and results.

What are the benefits of the balanced scorecard approach?
The benefits of the balanced scorecard have been identified by many organizations:

• Improved organization alignment
• Improved communications, both internally and externally
• Linked strategy and operations
• More emphasis on strategy and organizational results
• Integrated strategic planning and management

What challenges will I encounter trying to develop and deploy a balanced scorecard system?

There are several major challenges to developing and sustaining the balanced scorecard:
• Engaged leadership
• Maintaining momentum
• Measuring what matters
• Not using a disciplined framework to build the system
• Mistakenly thinking a scorecard system is a short-term project (it’s not….it’s a journey)
• Not involving a cross-section of the organization in developing the system
• Not thinking strategically enough
• Not incentivizing desired behavior changes

Labels: Balance score card, Consulting, Performance Management, Robert Kaplan, Tools and softwares

Posted by "CPerformance" :: 9:27 AM :: 0 comments