Time is Money

Time is Money (Time Value of Money)

This week’s Skype session did not have any set agenda. “How are you doing in your studies, you must be enjoying your college life”, I asked Apurva. “Well college life has been exciting for last 2 months but I have my exams starting from next week and I have not started studying. Time is running out and as they say, Time is Money, and if that is true, I have already lost lots of it”, she laughed. “There is a reason behind why they say Time is Money let us discuss that today”, I said. It was time to refresh Corporate Finance lectures that I had taken during the MBA program.

“If I offer you ₹ 100 today and ₹ 105 after one year, which one will you accept?” I asked. “I will accept both”, said Apurva with a huge smile on her face. This answer of hers reminded me that I was dealing with a talented yet very notorious cousin of mine and I had to be very specific in my questions. “I wish I could offer you both but you have to select between either of the choices”, I told her. “If I accept ₹100 today I loose on ₹5 but one year time frame is too long, you might forget about our deal in 1 years’ time which is very risky. I am confused but I trust my brother who is doing his MBA from an IIM so will go for ₹ 105”, she said. “Well that is not how decisions are made in real life, since the cash you are being offered is during two different time periods, it cannot be compared directly as value of money changes with time”, I started explaining her.

Money today is not same as money tomorrow it is actually worth more than in the future. Between ₹100 today and ₹100 one year after, ₹ 100 today is more valuable. In the offer that I made to you, it becomes even more difficult to compare because you need to compare ₹100 with ₹ 105 after one year which is comparing Apple with Oranges. Hence in order to compare the same, we need to compare both of them on a single time period which can be either one year hence or today. Let us compare them one year hence. What will be the value of the ₹ 100 today after one year? It depends on the earning potential of ₹100. You can put ₹100 today in the bank account with 4% saving rate which will give you ₹ 104 after 1 year or you can put it in a Bank FD for 1 year with the bank rate of 9% and get ₹ 109. If you are like Warren Buffet, the ace investor, you can also invest the amount in the equity market and get possible 15% return i.e. ₹ 115 , but  if the market performed badly the way it did in 2008 due to crisis you might see negative 15% return which will end up ₹ 85 in your hand after one year. Now the important thing is which of these will you compare with ₹ 105 which is confirmed amount that I will pay you if you decide to go for that option? Will it be ₹ 104(Saving), ₹109 (Fix Deposit), ₹ 115 (Equity when Good), ₹85 (Equity when Bad). If you consider saving/Equity when performed badly then ₹ 100 today is not a good option as its value one year hence is less than ₹ 105 and if you consider Fix deposit or Equity performance during good times, ₹ 100 today is good option as its value after one year is more than ₹ 105.

“It is like a KBC question with four options, do I get any lifeline? I go with a “Skypofriend” and would want to get this answer from my MBA cousin brother”, Apurva with a smile on her face again, managed to have a go at me yet again. She was in tremendous form today I thought. “The correct answer will be ₹ 109, please lock it”, I continued with a smile. We need to see a risk free opportunity with a maximum earning potential. The equity option with 15% return is maximum earning opportunity but has tremendous risk involved in it while the 4% saving rate is risk free but not maximum. Hence given the options fixed deposit rate is the maximum earning risk free opportunity and should be considered and with 9% rate ₹100 today, due to compounding it would be ₹ 100*1.09 i.e. ₹ 109 which is greater than ₹ 105 and hence it is wiser to accept ₹ 100 today than accepting ₹ 105 after one year.  Instead of giving 105 after one year if I would have given you ₹ 50 in year 1 and ₹ 60 in year two it becomes slightly more complicated. Now you have to compare all the cash flow in year 2. So ₹ 100 two years from now would be ₹ 100*(1.09)² i.e. ₹118.8 due to compounding. ₹ 50 would be would ₹ 50*1.09 i.e.₹ 54.5, due to compounding of 1 year. So now you are comparing ₹ 118.8 with ₹ (54.5+60=114.5). Since ₹118.8 is greater than ₹ 114.5, you would go for ₹ 100 today.

Now instead of comparing both the options in future time period it is better to compare them as of today since you have to make the decision today. The final result would be same but it is more meaningful for decision making. It means to compare between ₹ 100 today and ₹ 105 one year hence, instead of finding out value of ₹ 100 one year hence and comparing it with ₹ 105, now you need to find present value of ₹105 which you will receive one year hence. The way we did compounding in earlier case now we need to discount the future payment to the present value and compare. With the same 9% rate we now need to discount ₹ 105 which would be received one year hence to today. Hence sometimes 9% is also called as discount rate. To discount 105 to present value we need to divide 105 by 1.09 which is ₹ 96.33. Now it is ₹ 100 today vs. ₹ 96.33 today and obvious choice is ₹ 100 today. In the second example we discussed we would have to discount (divide) ₹ 50 by factor of 1.09 (i.e. ₹ 45.87) and ₹ 60 by factor of (1.09)² (i.e. 50.5) total of which comes out to be ₹96.37 (50.5+45.87=96.37) and it is less that 100 hence you would select ₹ 100 today. The end result is same as we had got earlier.

Managers of the large corporations use this method to select the project. They compare the initial investment that they would make in the project against the cash flow that the project would generate in future. If the sum of the discounted future cash flow to present is greater than the initial investment then they would go for the project. The important thing here to note is the real world situation is slightly more complicated as the discount rate we discussed does not remain constant. Manager of corporations need to predict these future discount rates as per the macro economic conditions and continuously check the viability of the project.

“I now understand how to compare different cash flow occurring at different time intervals. It was interesting to know that money cannot be compared on absolute terms in isolation with time. Indeed “Time is Money”, said Apurva. I wished her all the luck for her upcoming exams and ended the call on that note.

Image Reference: http://www.aziende-news.com/valore-del-tempo/

Islamic Banking

It was time for the weekly Skype session with Apurva and as promised I had to take her to the world where there is no concept of Interest Rates. “How is it possible that the banks would lend out money but would not charge interest on it, what is in it for banks then, how will they survive?”, the questions came like bullets from the machine gun. “Islamic Banking is a concept which works on the principal of Non-Interest”, I started explaining her.

Islamic banks work on the Islamic principles where it is not allowed to lend out money to others on interest. Does that mean that banks lend out this money without any profit? No, obviously not!! Every entity is required to generate profits for its survival and that is the prime reason for its existence. But generating profit through interest is not the only way of generating profit. Islamic banking also has profit generating mechanism but it is devoid of the interest component and certainly not the compounding aspect of it. To understand how Islamic Baking works, we need to first understand how the regular commercialize banking with interest and compounding works. Let us say, you want to buy a Tata Nano which costs Rs. 1, 00,000. You go to a Bank, say RBM bank and ask for money. If the interest on the car-loan is 10%. At the end of 2 years, you would have to payback Rs 1, 21,000([1, 00,000 *(1.1)]*(1.1)). The fact that component of 1.1 (1+10%) appeared twice in the calculation is because the interest gets compounded over the tenure of the loan which is two years in this case. You will have to pay a total interest of Rs. 21000 at the end of two years. Alternatively, RBM bank can give you option of making equal payment based on the predefined frequency of payment which can be either Monthly, Semi-Annually or Annually.  

The above method of lending is based on the principle of Risk Transferring. In the above case the ownership of the Tata Nano car is with you till the time you make payment to the bank as decided with the banks. In case you fail to make the payment, the bank will sell off the car and keep the amount with it to recover the loss. This type of lending also has inbuilt issue of money multiplication creating artificial money. Suppose RBM bank lends you Rs. 100000 @10% for 1 year. You find a borrower which is ready to pay interest of 12% but can’t finance his loan through bank due to compliance issue. You decide to take the additional risk for getting 2% on Rs 100000 (i.e. 2000). The borrower who agreed to pay 12% to you finds another borrower who is willing to pay 15%. Like you, he also lends money to him to get 3% on 100000 (i.e. 3000). Though the amount of money in the system is Rs. 1, 00,000 it has changed 3 hands causing money multiplication. The chain of risk transferring will be shattered as soon the last hand in the chain defaults causing entire chain to collapse. This principle of Risk Transferring was the prime reason was 2008 sub-prime crisis which we will discuss some other day. This is not possible with Islamic banking because money is always lent for buying real assets such as home, car, metal etc.

Unlike the commercial banking which works on the principle of risk transferring, the Islamic banking works on the principle of Risk Sharing. The Islamic banking allows charging the predefined fix profit percentage which does not get compounded.  There are different ways of lending under the Islamic Banking that includes Istisna, Musawamah, Murabahah, Musharakah etc. I would try to explain “Musharakah” which is the most used of all and how it is different from the conventional banking. Suppose your father wants to buy a house in which is worth Rs. 14, 00,000. He has Rs. 4, 00, 000 and needs financing of Rs. 10, 00,000.

Consider the case where your father borrows it from conventional commercial bank which charges 10% interest compounded annually. The repayment is to be done as 5 annual payments.

Commercial_Bank_Loan_Repayment_Schedule

The above diagram shows the calculations for payments for Rs. 10, 00,000 loan from the commercial bank.  As it can be seen that the yearly payment to be made to the bank is constant every year. The principal to be paid as part of that payment increases over the years while the interest component to be paid reduces over the years as per the principal outstanding. Bank does not assume any risk such as natural disaster and risk is entirely bared by the borrower. In case of default, bank has the right to sell off the property and recover the money.

Unlike commercial banks, Islamic banks work on the principal of Diminishing Partnership in which share of the bank reduces gradually till the time it is transferred to the borrower. It is based on the principal of risk sharing which in turn corresponds to sharing of profits or sharing of loss. As discussed it does not include interest and works on the basis of fix, predefined profit rate. Islamic bank typically have both internal and external Sharia compliance officer to ensure that the money is lent in accordance with the Sharia principals (e.g. Lending money for alcohol, arms is prohibited). The Islamic bank receives funds from the investors to lend out to which bank gives the expected profit rate. The rate to the investors in expected as it depends on the investment made by the bank to the customers in terms of landings.

Islamic_Banking_Repayment_Structure

The above diagram shows the similar housing loan and payment structure under the Islamic Banking. Borrower makes an yearly payment to bank like that of the commercial banks but the yearly payment made by the borrower reduces every year as with each passing year the borrower increases the ownership stake in the property owned. The part of the annual payment includes the equity payment made by the borrower to regain additional ownership in the property and other part includes the profit paid to the Islamic bank for the equity still owned by the bank). In case of natural disaster or any other issue the borrower forgoes only the part of the equity owned by him and banks bares the risk for part of owned by it. The borrower can sell off his ownership to other borrower who will then continue the payments to the Islamic bank.

“I now understand how Islamic Banking works!! On face of it looks like a better model of lending. I wonder what will happen when it will gain more popularity and entire world will work on the non interest principal”, said Apurva. “There is still long way to go for that, “Musharakah” that we discussed is just part of Islamic banking. We would cover the other parts sometime later.” we ended the Skype call on that note.

Budget Simplified

Unlike the regular weekly Saturday Skype session, the Skype session was planned on Sunday this time owing to the request by Apurva. The Union Budget for financial year FY16 (1^st April 2015 to 31^st March 2016) was presented on the Saturday by the finance minister and she wanted to listen and understand the budget and then discuss the same with me. “There was too much talked about and written about this year’s budget, since this was going to be the first full fledge budget by the newly elected government. I watched the entire budget speech by the finance minister but honestly could not understand much of it. Can you please explain?” the curiosity on the face of Apurva was clearly evident and was obvious too. For most of the common man, budget and terms used in the budget are too technical and their connection with the budget is only through next day’s newspaper, which explains things that will get cheaper and other things that will get costlier for them. But I always felt the need of simplifying the budget for common man, as everyone should understand it from the macro level and know the economic environment, opportunities and challenges in front of the country. “The Budget prepared by Finance Minister is no different than what your mother prepares monthly, budget in simple term corresponds to future planning.”, I started explaining her.

It is a very tough task for the finance minister to plan for the entire year’s receipts that the government will generate and expenditure the government should incur so as to have growth oriented, healthy economy. “How does one quantify growth for a country?” asked Apurva. Like for individuals, the way we assess their growth from their income and increase in the income year over year, the country’s growth can be calculated using a parameter called as GDP, Gross Domestic Product. It is calculated as the total amount of goods and services produced in the country. There are different methods of calculating GDP, such as Production method, Income method etc. India adopts production method, but this year there is a slight change in the way GDP of the country would be calculated. Unlike the method used traditionally where the total amount of Goods and services produced were quantified using factor cost, i.e. the cost at which the goods and services were produced, now it will be calculated using the market price. This new method adopted by India is in sync with the international standards of calculating GDP. In FY15 (ending on March 31^st 2015) the total size of India economy is expected to be $2.1 trillion----| Rs. 12600 (000 cr). This real GDP number also indicates growth of 7.4% as compared to the previous year. As per the economic survey of India 2015 presented before the budget day, the growth in the GDP for India, is expected to be 8.5% in FY16 which mean the real GDP for the country will be $2.28 trillion ----| Rs. 136.71 (000 Cr).

“The budget was full of Jargon with terms such as fiscal deficit, revenue deficit, planned expenditure, unplanned expenditure, revenue expenditure/receipts, capital expenditure/receipts etc., can you please explain them to me in simple terms?” asked Apurva. This is when it gets too technical for the common man to decode these jargon and they prefer staying away from it and concentrate on what impacts them. My task was very challenging, I had to keep it as simple as possible.

The diagram above shows over all summary for Outflow and Inflow of rupees for India. Both the inflow and outflow are categorized into Revenue and Capital receipts/expenditure.

The revenue and capital expenditure and further classified into planned and unplanned expenditure.

All the figures are in Rs. crore.

Planned Expenditure

Earlier India had a planning commission, which is now replaced by NITI (National Institute of Transforming India) Aayog which lays down the 5 year central plan for India. The planned expenditure allocation both in revenue as well as capital sector corresponds to amount allocated to implement various schemes detailed in the plan. The planned expenditure also corresponds to grant/assistance to state and union territories.

FY 16: 465003

Unplanned Expenditure

Unplanned Expenditure correspond to amount allocated for expenses required for activities other than one present as part of 5 year central plan.

Non-plan revenue expenditure is accounted for by subsidies, and wage and salary payments to government employees, pensions, police, and economic services in various sectors, other general services such as tax collection, social services, and grants to foreign governments.

Non Plan revenue expenditure also includes interest payments on the previous debt. This debt arises because India has been running fiscal deficit traditionally.

FY16 : 1312471

Fiscal Deficit

Fiscal deficit is total expected outflow (Revenue+ Capital Expenditure) minus total expected inflow (Total Non-debt Capital Receipt + Revenue Receipt for the center). It is important to note that the revenue receipt include those of the center only and revenue receipts for the states are not included. States would include these revenue receipts in their state budget.

It is also important to know that fiscal deficit is different than the Revenue deficit.

FY16: 3.9% of GDP

Revenue Deficit

Revenue deficit refers to the excess of revenue expenditure over revenue receipts and does not include capital expenditure and non-debt capital receipts.

FY16: 2.8% of GDP

Primary Deficit

Primary Deficit = Fiscal Deficit – Interest Payment on the loan raised due to previous deficits.

Primary deficit indicates the absolute deficit in the financial year generated which is devoid of the impact of the loans raised for funding fiscal deficits of the previous years.

Current Account Deficit

Current account deficit as we already know corresponds to different between imports and exports

All the deficits i.e. current account deficit, revenue deficit and fiscal deficit are reported as % of GDP

Revenue Expenditure

Revenue expenditure is for the normal running of the government's department and various services, interest charged on debt incurred by government, subsidies etc.

FY16: 1536045

Capital Expenditure

Expenditure incurred to acquire, build assets, infrastructure or to upgrade existing infrastructure facilities.

FY16: 241429

Revenue Receipts

Revenue receipts corresponds total tax and non-tax receipts collected by the central government.

FY16: 1141574

Tax Receipt

Tax receipts can be income based which is known as direct tax or additional amount to be paid for availing a particular set of services at predefined rate known as indirect tax.

Center FY16: 919842

Direct Tax are for Individual as well for the corporate. In this budget the finance minister has proposed to reduce the corporate tax from 30% to 25% over next four years by discontinuing the exemption present earlier which used to reduce 30% tax to effective 23%. For individuals there is no change in the tax slabs.

Indirect Tax corresponds to different set of taxes such as excise duty, custom duty, service tax, value added tax etc. The indirect tax structure is very complex and government has announced all the different indirect taxes with a single tax known as Goods and Service Tax GST applicable from 1^st April 2016.

Non Tax Receipt                                                      

Apart from Tax receipt, government can also generate revenues through means such as auctioning of Telecom Spectrum, Coal Mine Blocks etc.

FY 16: 221732

Capital Receipt

Non Debt Capital Receipts

Capital receipts consists of Non Debt receipts which corresponds to recovery of loan by the Center to State governments & Union Territories and proceeds or by diluting part of (selling off) its stake in public sector companies.

FY 16: 80252

Borrowing

The other part of capital receipts are required to fund the fiscal deficit. This is done by raising of loans the market by means of Bonds, government borrowings from the RBI (raises inflation) & other parties, and loans received from foreign governments.

FY 16: 543607

FY16_India_Inflow_Overview_Data

The above diagram shows the total receipts and expenditures categories wise allocated by the finance minister of India Shri. Arun Jaitley in his budget for FY16.

“I now understand the components of the budget and its significance. I have realized that preparing a budget is not a simple task. I would now be in the position to appreciate my mother who does this exercise monthly for running of our house, Of course running the country would be more difficult I understand! Let us connect next Saturday, I eagerly waiting for you to take me to the world where there are no interest rates, as you had promised during last call, Good Night.”, with those words we ended the Skype call to connect once again next Saturday…