Module 2: Time Value of Money and Capital Budgeting

 

Section B: Short Answer Questions

1. What is the Time Value of Money (TVM)? Explain with an example.
Answer: The Time Value of Money (TVM) refers to the idea that money available today is worth more than the same amount in the future due to its potential earning capacity.
Example: If you have ₹1,000 today and invest it at 10% annual interest, it will become ₹1,100 after one year. Hence, ₹1,000 now is more valuable than ₹1,000 a year later.

2. Differentiate between Traditional and Modern Methods of Capital Budgeting.
Answer:

Basis	Traditional Methods	Modern Methods
Focus	Liquidity	Profitability
Techniques	Payback Period, Accounting Rate of Return (ARR)	NPV, IRR, PI
Time Value	Ignored	Considered
Decision-making	Simpler but less accurate	More complex but realistic

 

3. Define the Payback Period method. Give one limitation.
Answer: The Payback Period is the time it takes for a project to recover its initial investment from cash inflows.
Limitation: It ignores the time value of money and cash flows after the payback period.

Section C: Long Answer / Essay Questions

1. Explain the concept of NPV and its importance in Capital Budgeting. Solve with a case study.
Answer: Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over time.

Case Study Example:

Year	Cash Flow	PV Factor (10%)	Present Value
0	-₹10,000	1.000	-₹10,000
1	₹4,000	0.909	₹3,636
2	₹4,000	0.826	₹3,304
3	₹4,000	0.751	₹3,004
			Total = ₹9,944

NPV = ₹9,944 – ₹10,000 = -₹56
Decision: Since NPV is negative, the project should not be accepted.

2. What is Internal Rate of Return (IRR)? How is it different from NPV?
Answer: IRR is the discount rate that makes the NPV of a project zero.

Difference from NPV:

Basis	IRR	NPV
Meaning	Rate at which NPV = 0	Present value of future cash flows minus investment
Decision Rule	IRR > required rate ⇒ Accept	NPV > 0 ⇒ Accept
Complexity	Iterative and complex	Straightforward if rate known

 

3. Discuss the concept of Profitability Index (PI) with a solved example.
Answer: Profitability Index = PV of Cash Inflows / Initial Investment

Example:
Initial Investment = ₹5,000
PV of inflows = ₹6,500
PI = 6,500 / 5,000 = 1.3
Decision: Since PI > 1, the project is profitable.