1.2. Recap of Previous Lecture

So in the previous lecture I have introduced to you what are all the components of the ownership cost. We have discussed about the different depreciation accounting methods. Then we worked out a problem on how to estimate the ownership cost using average annual investment method.

In the last lecture, we focused on understanding the ownership costs associated with equipment. This includes all the necessary expenses that arise from owning equipment, such as depreciation, which reflects the reduction in value over time. Different methods for accounting for this depreciation were introduced, allowing students to calculate how much value an asset loses year over year. Additionally, an actual example was worked out using the average annual investment method, which helps in estimating the yearly cost of owning equipment by factoring in how investments fluctuate over time.

Think of ownership cost like taking care of a car. Just like you have to consider fuel, insurance, and maintenance as costs of owning a car, you also have to think about how a car depreciates. As time goes on, its value decreases, just like the equipment we discussed. The depreciation methods help you estimate just how much value the car loses each year.

In today’s presentation I will just introduce to you what is the time value of money?

Time value of money (TVM) is a fundamental financial principle that asserts money available now is worth more than the same amount in the future due to its potential earning capacity. This means that if you have a certain amount of money today, you could invest it and earn interest, making it grow over time. Understanding TVM is vital as it affects how we make financial decisions regarding investments and loans.

Imagine you have a choice: your friend offers you ₹100 today or ₹100 a year from now. If you take the ₹100 today, you can invest it in a bank that gives you 10% interest. By next year, you’d have ₹110. Therefore, taking the money now is a better option because it gives you more value over time.

So the thing we have to keep in mind is all these three values are equivalent. The 100 rupees today and rupees 108 after 1 year and rupees 116.64 after 2 years, all these are equivalent. They are not equal but economically they are equivalent.

The concept of equivalence in the time value of money conveys that while absolute values may not be the same, they hold equivalent economic value when accounting for interest earned. Over time, the interest compounds on the principal amount, leading to differing amounts at various future dates that can ultimately represent the same economic impact. This forms the basis for evaluating cash flows that occur at different times.

Consider a balloon that you blow air into. Initially, it’s small, but the more air (or value) you add over time, the bigger it gets. Similarly, your money grows over time when invested wisely. While the amounts you have at various points (now, after 1 year, after 2 years) aren't the same numbers, they all demonstrate the growth of value over time.

So this shows the typical cash flow diagram. Cash flow diagram is nothing but a graphical representation of the cash flows which are occurring at different point of time.

A cash flow diagram visually represents the flow of cash within a business over time, identifying points of cash inflow and outflow. The diagram helps highlight important periods (like the present value point) and distinguish between cash coming into the business (inflows) and cash going out (outflows). This tool is essential for tracking how financial resources are allocated and the timing of transactions.

Think about a monthly budget as a cash flow diagram. You might receive a salary (inflow) at the beginning of the month and then spend money on rent, groceries, and entertainment (outflows) throughout the month. Visualizing this flow helps you understand when you’ll have money available and when you need to be careful about spending.

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