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Unit I

What do you think should be the objective?

What do a finance manager do? Suppose he makes available the required

funds at an acceptable cost and those funds are suitably invested and

that every thing goes according to plan because of the effective control

measures he uses. If the firm is a commercial or profit seeking then the

results of good performance are reflected in the profits the firm makes.

How are profits utilized? They are partly distributed among the owners as

dividends and partly reinvested in to the business. As this process

continues over a period

“If you don’t know where you are going, it does not matter how you get there”

of time the value of the firm increases. If the share of the organization is

traded on stock exchange the good performance is reflected through the

market price of the share, which shows an upward movement. When the

market price is more a shareholder gets more value then what he has

originally invested thus his wealth increases. Therefore we can say that

the objective of financial management is to increase the value of the firm

or wealth maximization.

Objective: Maximize the Value of the Firm

Brealey & Myers: "Success is usually judged by value: Shareholders are

made better off by any decision which increases the value of their stake in

the firm... The secret of success in financial management is to increase

value."

Copeland & Weston: The most important theme is that the objective of the

firm is to maximize the wealth of its stockholders."

Brigham and Gapenski: Management's primary goal is stockholder wealth

maximization, which translates into maximizing the price of the common

stock.

The Objective in Decision Making

In traditional corporate finance, the objective in decision-making is to

maximize the value of the firm.

A narrower objective is to maximize stockholder wealth. When the stock is

traded and markets are viewed to be efficient, the objective is to

maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value

maximization, or operate as constraints on firm value maximization.

Maximizing stock price is not incompatible with meeting employee needs/objectives. In

particular:

• - Employees are often stockholders in many firms

• - Firms that maximize stock price generally are firms that have treated

employees well.

Maximizing stock price does not mean that customers are not critical to

success. In most businesses, keeping customers happy is the route to

stock price maximization.

Maximizing stock price does not imply that a company has to be a social

outlaw.

Why traditional corporate financial theory focuses on maximizing stockholder wealth?

Stock prices are easily observable and constantly updated (unlike other

measures of performance, which may not be as easily observable, and

certainly not updated as frequently).

If investors are rational, stock prices reflect the wisdom of decisions, short

term and long term, instantaneously. As it is, it is believed that market

discounts all the information in the form of market price of the share.

Why not profit maximization?

Profitability objective may be stated in terms of profits, return on investment, or

profit to-sales ratios. According to this objective, all actions such as increase income

and cut down costs should be undertaken and those that are likely to have adverse

impact on profitability of the enterprise should be avoided. Advocates of the profit

maximisation objective are of the view that this objective is simple and has the in-

built advantage of judging economic performance of the enterprise. Further, it will

direct the resources in those channels that promise maximum return. This, in turn,

would help in optimal utilisation of society's economic resources. Since the finance

manager is responsible for the efficient utilisation of capital, it is plausible to pursue

profitability maximisation as the operational standard to test the effectiveness of

financial decisions.

However, profit maximisation objective suffers from several drawbacks rendering it

an ineffective decisional criterion. These drawbacks are:

(a) It is Vague

It is not clear in what sense the term profit has been used. It may be total

profit before tax or after tax or profitability rate. Rate of profitability may

again be in relation to Share capital; owner's funds, total capital employed or

sales. Which of these variants of profit should the management pursue to

maximise so as to attain the profit maximisation objective remains vague?

Furthermore, the word profit does not speak anything about the short-term

and long-term profits. Profits in the short-run may not be the same as those

in the long run. A firm can maximise its short-term profit by avoiding current

expenditures on maintenance of a machine. But owing to this neglect, the

machine being put to use may no longer be capable of operation after

sometime with the result that the firm will have to defray huge investment

outlay to replace the machine. Thus, profit maximisation suffers in the long

run for the sake of maximizing short-term profit. Obviously, long-term

consideration of profit cannot be neglected in favor of short-term profit.

(b) It Ignores Time Value factor

Profit maximisation objective fails to provide any idea regarding timing of

expected cash earnings. For instance, if there are two investment projects

and suppose one is likely to produce streams of earnings of Rs. 90,000 in

sixth year from now and the other is likely to produce annual benefits of

Rs. 15,000 in each of the ensuing six years, both the projects cannot be

treated as equally useful ones although total benefits of both the projects

are identical because of differences in value of benefits received today and

those received a year two years after. Choice of more worthy projects lies in

the study of time value of future flows of cash earnings. The interest of the

firm and its owners is affected by the time value or. Profit maximisation

objective does not take cognizance of this vital factor and treats all benefits,

irrespective of the timing, as equally valuable.

(c) It Ignores Risk Factor

Another serious shortcoming of the profit maximisation objective is that it

overlooks risk factor. Future earnings of different projects are related with

risks of varying degrees. Hence, different projects may have different

values even though their earning capacity is the same. A project with

fluctuating earnings is considered more risky than the one with certainty

of earnings. Naturally, an investor would provide less value to the former

than to the latter. Risk element of a project is also dependent on the

financing mix of the project. Project largely financed by way of debt is

generally more risky than the one predominantly financed by means of

share capital.

In view of the above, the profit maximisation objective is inappropriate

and unsuitable an operational objective of the firm. Suitable and

operationally feasible objective of the firm should be precise and clear cut

and should give weightage to time value and risk factors. All these factors

are well taken care of by wealth maximisation objective.

That is why we have Wealth Maximisation as an Objective

Wealth maximisation objective is a widely recognised criterion with which the

performance a business enterprise is evaluated. The word wealth refers to the net present

worth of the firm. Therefore, wealth maximisation is also stated as net present worth. Net

present worth is difference between gross present worth and the amount of capital

investment required to achieve the benefits. Gross present worth represents the present

value of expected cash benefits discounted at a rate, which reflects their certainty or

uncertainty. Thus, wealth maximisation objective as decisional criterion suggests that any

financial action, which creates wealth or which, has a net present value above zero is

desirable one and should be accepted and that which does not satisfy this test should be

rejected. The wealth maximisation objective when used as decisional criterion serves as a

very useful guideline in taking investment decisions. This is because the concept of,

wealth is very clear. It represents present value of the benefits minus the cost of the

investment. The concept of cash flow is more precise in connotation than that of

accounting profit. Thus, measuring benefit in terms of cash flows generated avoids

ambiguity.

The wealth maximisation objective considers time value of money. It

recognises that cash benefits emerging from a project in different years

are not identical in value. This is why annual cash benefits of a project are

discounted at a discount rate to calculate total value of these cash

benefits. At the same time, it also gives due weightage to risk factor by

making necessary adjustments in the discount rate. Thus, cash benefits of

a project with higher risk exposure is discounted at a higher discount rate

(cost of capital), while lower discount rate applied to discount expected

cash benefits of a less risky project. In this way, discount rate used to

determine present value of future streams of cash earning reflects both

the time and risk. .

In view of the above reasons, wealth maximisation objective is considered superior profit

maximisation objective. It may be noted here that value maximisation objective is simply

the extension of profit maximisation to real life situations. Where the time period is short

and magnitude of uncertainty is not great, value maximisation and profit maximisation

amount almost the same thing.

Objective redefined :-

Although shareholder wealth maximization is the primary goal, in recent

years many firms have broadened their focus to include the interests of

stakeholders as well as shareholders. Stakeholders are groups such as

employees, customers, suppliers, creditors, and owners who have a direct

economic link to the firm. Employees are paid for their labor, customers

purchase the firm's products or services, suppliers are paid for the

materials and services they provide, creditors provide debt financing, and

owners provide equity financing. A firm with a stakeholder focus

consciously avoids actions that would prove detrimental to stakeholders

by damaging their wealth positions through the transfer of stakeholder

wealth to the firm. The goal is not to maximize stakeholder well being, but

to preserve it. The stakeholder view tends to limit the firm's actions in

order to preserve the wealth of stakeholders. Such a view is often

considered part of the firm's "social responsibility." It is expected to

provide long-run benefit to shareholders by maintaining positive

stakeholder relationships. Such relationships should minimize stakeholder

turnover, conflicts, and litigation. Clearly, the firm can better achieve its

goal of shareholder wealth maximization with the cooperation of- rather

than conflict with-its other stakeholders.

To achieve the objective of financial management there are four

major decisions that a manager takes.

The Four Major Decisions in Corporate Finance/Financial management

The Allocation (Investment) decision

Where do you invest the scarce resources of your business?

What makes for a good investment?

The Financing decision

Where do you raise the funds for these investments?

Generically, what mix of owner’s money (equity) or borrowed money

(debt) do you use?

The Dividend Decision

How much of a firm’s funds should be reinvested in the business and how

much should be returned to the owners?

The Liquidity decision

How much should a firm invest in current assets and what should be the

components with their respective proportions? How to manage the

working capital?

A firm performs finance functions simultaneously and continuously in the

normal course of the business. They do not necessarily occur in a

sequence. Finance functions call for skilful planning, control and execution

of a firm’s activities.

Let us note at the outset hat shareholders are made better off by a financial decision that

increases the value of their shares, Thus while performing the finance function, the

financial manager should strive to maximize the market value of shares. Whatever

decision does a manger takes need to result in wealth maximisation of a shareholder.

Investment Decision

Investment decision or capital budgeting involves the decision of

allocation of capital or commitment of funds to long-term assets that

would yield benefits in the future. Two important aspects of the

investment decision are:

(a) the evaluation of the prospective profitability of new investments, and

(b) the measurement of a cut-off rate against that the prospective return

of new investments could be compared. Future benefits of investments

are difficult to measure and cannot be predicted with certainty. Because

of the uncertain future, investment decisions involve risk. Investment

proposals should, therefore, be evaluated in terms of both expected

return and risk. Besides the decision for investment managers do see

where to commit funds when an asset becomes less productive or non-

profitable.

There is a broad agreement that the correct cut-off rate is the required

rate of return or the opportunity cost of capital. However, there are

problems in computing the opportunity cost of capital in practice from the

available data and information. A decision maker should be aware of

capital in practice from the available data and information. A decision

maker should be aware of these problems.

Financing Decision

Financing decision is the second important function to be performed by

the financial manager. Broadly, her or she must decide when, where and

how to acquire funds to meet the firm’s investment needs. The central

issue before him or her is to determine the proportion of equity and debt.

The mix of debt and equity is known as the firm’s capital structure. The

financial manager must strive to obtain the best financing mix or the

optimum capital structure for his or her firm. The firm’s capital structure is

considered to be optimum when the market value of shares is maximised.

The use of debt affects the return and risk of shareholders; it may

increase the return on equity funds but it always increases risk. A proper

balance will have to be struck between return and risk. When the

shareholders’ return is maximised with minimum risk, the market value

per share will be maximised and the firm’s capital structure would be

considered optimum. Once the financial manager is able to determine the

best combination of debt and equity, he or she must raise the appropriate

amount through the best available sources. In practice, a firm considers

many other factors such as control, flexibility loan convenience, legal

aspects etc. in deciding its capital structure.

Dividend Decision

Dividend decision is the third major financial decision. The financial

manager must decide whether the firm should distribute all profits, or

retain them, or distribute a portion and retain the balance. Like the debt

policy, the dividend policy should be determined in terms of its impact on

the shareholders’ value. The optimum dividend policy is one that

maximises the market value of the firm’s shares. Thus if shareholders are

not indifferent to the firm’s dividend policy, the financial manager must

determine the optimum dividend – payout ratio. The payout ratio is equal

to the percentage of dividends to earnings available to shareholders. The

financial manager should also consider the questions of dividend stability,

bonus shares and cash dividends in practice. Most profitable companies

pay cash dividends regularly. Periodically, additional shares, called bonus

share (or stock dividend), are also issued to the existing shareholders in

addition to the cash dividend.

Liquidity Decision

Current assets management that affects a firm’s liquidity is yet another

important finances function, in addition to the management of long-term

assets. Current assets should be managed efficiently for safeguarding the

firm against the dangers of illiquidity and insolvency. Investment in current

assets affects the firm’s profitability. Liquidity and risk. A conflict exists

between profitability and liquidity while managing current assets. If the firm

does not invest sufficient funds in current assets, it may become illiquid. But

it would lose profitability, as idle current assets would not earn anything.

Thus, a proper trade-off must be achieved between profitability and liquidity.

In order to ensure that neither insufficient nor unnecessary funds are

invested in current assets, the financial manager should develop sound

techniques of managing current assets. He or she should estimate firm’s

needs for current assets and make sure that funds would be made available

when needed.

It would thus be clear that financial decisions directly concern the firm’s

decision to acquire or dispose off assets and require commitment or

recommitment of funds on a continuous basis. It is in this context that finance

functions are said to influence production, marketing and other functions of

the firm. This, in consequence, finance functions may affect the size, growth,

profitability and risk of the firm, and ultimately, the value of the firm. To

quote Ezra Solomon

The function of financial management is to review and control decisions to

commit or recommit funds to new or ongoing uses. Thus, in addition to

raising funds, financial management is directly concerned with production,

marketing and other functions, within an enterprise whenever decisions are

about the acquisition or distribution of assets.

Various financial functions are intimately connected with each other. For

instance, decision pertaining to the proportion in which fixed assets and

current assets are mixed determines the risk complexion of the firm.

Costs of various methods of financing are affected by this risk. Likewise,

dividend decisions influence financing decisions and are themselves

influenced by investment decisions.

In view of this, finance manager is expected to call upon the expertise of

other functional managers of the firm particularly in regard to investment

of funds. Decisions pertaining to kinds of fixed assets to be acquired for

the firm, level of inventories to be kept in hand, type of customers to be

granted credit facilities, terms of credit should be made after consulting

production and marketing executives.

However, in the management of income finance manager has to act on

his own. The determination of dividend policies is almost exclusively a

finance function. A finance manager has a final say in decisions on

dividends than in asset management decisions.

Financial management is looked on as cutting across functional even

disciplinary boundaries. It is in such an environment that finance manager

works as a part of total management. In principle, a finance manager is

held responsible to handle all such problem: that involve money matters.

But in actual practice, as noted above, he has to call on the expertise of

those in other functional areas to discharge his responsibilities effectively.

You have studied separate legal entity concept in financial

accounting the following paragraph is extension of the same.

In large businesses separation of ownership and management is a

practical necessity. Major corporations may have hundreds of thousands

of shareholders. There is no way for all of them to be actively involved in

management: Authority has to be delegated to managers.

The separation of ownership and management has clear advantages. It

allows share ownership to change without interfering with the

operation of the business. It allows the firm to hire professional

managers. But it also brings problems if the man-agers' and owners'

objectives differ. You can see the danger: Rather than attending to the

wishes of shareholders, managers may seek a more leisurely or

luxurious working lifestyle; they may shun unpopular decisions, or they

may attempt to build an empire with their shareholders' money.

Such conflicts between shareholders and managers' objectives

create principal agent problems. The shareholders are the principals;

the managers are their agents. Shareholders want management to

increase the value of the firm, but managers may have their own axes to

grind or nests to feather. Agency costs are incurred when (1) managers do

not attempt to maximize firm value and (2) shareholders incur costs to

monitor the managers and influence their actions. Of course, there are no

costs when the shareholders are also the managers. That is one of the

advantages of a sole proprietorship. Owner-managers have no conflicts of

interest.

Conflicts between shareholders and managers are not the only principal-

agent problems that the financial manager is likely to encounter. For

example, just as shareholders need to encourage managers to work for

the shareholders' interests, so senior management needs to think about

how to motivate everyone else in the company. In this case senior

management are the principals and junior management and other

employees are their agents.

Think of the company's overall value as a pie that is divided among a

number of claimants. These include the management and the

shareholders, as well as the company's workforce and the banks and

investors who have bought the company's debt. The government is a

claimant too, since it gets to tax corporate profits.

All these claimants are bound together in a complex web of contracts and

un-derstandings. For example, when banks lend money to the firm, they

insist on a formal contract stating the rate of interest and repayment

dates, perhaps placing restrictions on dividends or additional borrowing.

But you can't devise written rules to cover every possible future event. So

written contracts are incomplete and need to be supplemented by

understandings and by arrangements that help to align the interests of

the various parties.

Principal-agent problems would be easier to resolve if everyone had

the same information. That is rarely the case in finance. Managers,

shareholders, and lenders may all have different information about the

value of a real or financial asset, and it may be many years before all the

information is revealed. Financial managers need to recognize these

information asymmetries and find ways to reassure investors that there

are no nasty surprises on the way.

The control of the modern corporation is frequently placed in the hands of

professional non-owner managers. We have seen that the goal of the

financial manager should be to maximize the wealth of the owners of the

firm and given them decision-making authority to manage the firm.

Technically, any manager who owns less than 100 percent of the firm is to

some degree an agent of the other owners.In theory, most financial

managers would agree with the goal of owner wealth maximization. In

practice, however, managers are also concerned with their personal

wealth, job security, and fringe benefits, such as country club

memberships, limousines, and posh offices, all provided at company

expense. Such concerns may make managers reluctant or unwilling to

take more that, moderate risk if they perceive that too much risk might

result in a loss of job and damage to personal wealth. The result is a less-

than-maximum return and a potential loss of wealth for the owners.

How do we resolve the agency problem?

From this conflict of owners and managers arises what has been called

the agency problem-the likelihood that managers may place personal

goals ahead of corporate goals. Two factors-market forces and agency

costs-act to prevent or minimize agency problems.

Market Forces One market force is major shareholders, particularly large

institutional investors, such as mutual funds, life insurance companies,

and pension funds. These holders of large block of a firm's stock have

begun in recent years to exert pressure on management to perform.

When necessary they exercise their voting rights as stockholders to

replace under performing management.

Another market force is the threat of takeover by another firm that

believes that it can enhance the firm's value by restructuring its

management, operations, and financing. The constant threat of takeover

tends to motivate management to act in the best interest of the firm's

owners by attempting to maximize share price.

Agency Costs To minimize agency problems and contribute to the

maximization of owners' wealth, stockholders incur agency costs. These

are the costs of monitoring management behavior, ensuring against

dishonest acts of management, and giving managers the financial

incentive to maximize share price. The most popular, powerful, and

expensive approach is to structure management compensation to

correspond with share price maximization. The objective is to compensate

managers for acting in the best interests of the owners. This is frequently

accomplished by granting stock options to management. These options

allow managers to purchase stock at a set market price; if the market

price rises, the higher future stock price would result in greater

management compensation. In addition, well-structured compensation

packages allow firms to hire the best managers available. Today more

firms are tying management compensation to the firm's performance.

This incentive appears to motivate managers to operate in a manner

reasonably consistent with stock price maximization.

Social Responsibility

Maximizing shareholder wealth does not mean that management should

ignore social responsibility, such as protecting the consumer, paying fair

wages to employees, maintaining fair hiring practices and safe working

conditions, supporting education, and becoming involved in such

environmental issues as clean air and water .It is appropriate for

management to consider the interests of stakeholders other than

shareholders. These stakeholders include creditors, employees,

customers, suppliers, communities in which a company operates, and

others. Only through attention to the legitimate concerns of the firm’s

various stakeholders can the firm attain its ultimate goal of maximizing

shareholder wealth.

Is stock price maximization the same as profit

maximization?

No, despite a generally high correlation amongst stock

price, EPS, and cash flow.

Current stock price relies upon current earnings, as well

as future earnings and cash flow.

Some actions may cause an increase in earnings, yet

cause the stock price to decrease (and vice versa).

Questions

1. Contrast the objective of maximizing earnings with that of

maximizing wealth.

2. What is financial management all about?

3. In large corporations, ownership and management are

separated. What are the main implications of this separation?

4. What are agency costs & what causes them?

1. __________ is concerned with the acquisition, financing, and

management of assets with some overall goal in mind.

a) Financial management

b) Profit maximization

c) Agency theory

d) Social responsibility

taxes.

a) Shareholder wealth maximization

b) Profit maximization

c) Stakeholder maximization

d) EPS maximization

a) Shareholder wealth maximization

b) Profit maximization

c) Stakeholder maximization

d) EPS maximization.

maximization as the primary goal of the firm?

a) Profit maximization considers the firm's risk level.

b) Profit maximization will not lead to increasing short-term profits at the

expense of lowering expected future profits.

c) Profit maximization does consider the impact on individual

shareholder's EPS.

d) Profit maximization is concerned more with maximizing net income

than the stock price.

5. __________ is concerned with the branch of economics relating the

behavior of principals and their agents.

a) Financial management

b) Profit maximization

c) Agency theory

d) Social responsibility

6. A concept that implies that the firm should consider issues such as

protecting the consumer, paying fair wages, maintaining fair hiring

practices, supporting education, and considering environmental issues.

a) Financial management b) Profit maximization

c) Agency theoryd) Social responsibility

7. The __________ decision involves determining the appropriate make-up

of the right-hand side of the balance sheet.

a) Asset management

b) Financing

c) Investment

d) Capital budgeting

8. You need to understand financial management even if you have no

intention of becoming a financial manager. One reason is that the

successful manager of the not-too-distant future will need to be much

more of a __________ who has the knowledge and ability to move not just

vertically within an organization but horizontally as well. Developing

__________ will be the rule, not the exception.

a) Specialist; specialties

b) Generalist; general business skills

c) Technician; quantitative skills

d) Team player; cross-functional capabilities

9. The __________ decision involves a determination of the total amount of

assets needed, the composition of the assets, and whether any assets

need to be reduced, eliminated, or replaced.

a) Asset management.

b) Financing

c) Investment

d) Accounting

10.How are earnings per share calculated?

a) Use the income statement to determine earnings after taxes (net

income) and divide by the previous period's earnings after taxes. Then

subtract 1 from the previously calculated value.

b) Use the income statement to determine earnings after taxes (net

income) and divide by the number of common shares outstanding.

c) Use the income statement to determine earnings after taxes (net

income) and divide by the number of common and preferred shares

outstanding.

d) Use the income statement to determine earnings after taxes (net

income) and divide by the forecasted period's earnings after taxes. Then

subtract 1 from the previously calculated value.

11. What is the most important of the three financial management

decisions?

a) Asset management decision

b) Financing decision

c) Investment decision

d) Accounting decision

12. The __________ decision involves efficiently managing the assets on

the balance sheet on a day-to-day basis, especially current assets.

a) Asset management

b) Financing

c) Investment

d) Accounting

13. Which of the following is not a perquisite (perk)?

a) Company-provided automobile

b) Expensive office

c) Salary

d) Country club membership

14. All constituencies with a stake in the fortunes of the company are

known as __________.

a) Shareholders

b) Stakeholders

c) Creditors

d) Customers

15. Which of the following statements is not correct regarding earnings

per share (EPS) maximization as the primary goal of the firm?

a) EPS maximization ignores the firm's risk level.

b) EPS maximization does not specify the timing or duration of expected

EPS.

c) EPS maximization naturally requires all earnings to be retained.

d) EPS maximization is concerned with maximizing net income.

16. __________ is concerned with the maximization of a firm's stock price.

a) Shareholder wealth maximization

b) Profit maximization

c) Stakeholder welfare maximization

d) EPS maximization

Answers to above

1. Financial management

2. Profit maximization

3. Shareholder wealth maximization

4. Profit maximization is concerned more with maximizing net income

than the stock price.

5. Agency theory

6. Social responsibility

7. Financing

8. Team player; cross-functional capabilities

9. Investment

10. Use the income statement to determine earnings after taxes (net

income) and divide by the number of common shares outstanding.

11. Investment decision

12. Asset management

13. Asset management

14. Stakeholders

15. EPS maximization is concerned with maximizing net income.

16. Shareholder wealth maximization

The time value of money

You all instinctively know that money loses its value with time. Why does this happen?

What does a Financial Manager have to do to accommodate this loss in the value of

money with time? In this section, we will take a look at this very interesting issue.

Why should financial managers be familiar with the time value of money?

The time value of money shows mathematically how the timing of cash flows, combined

with the opportunity costs of capital, affect financial asset values. A thorough

understanding of these concepts gives a financial manager powerful tool to maximize

wealth.

The time value of money serves as the foundation for all other notions in finance. It

impacts business finance, consumer finance and government finance. Time value of

money results from the concept of interest.

This overview covers an introduction to simple interest and compound

interest, illustrates the use of time value of money tables, shows a

approach to solving time value of money problems and introduces the

concepts of intra year compounding, annuities due, and perpetuities. A

simple introduction to working time value of money problems on a

financial calculator is included as well as additional resources to help

understand time value of money.

Time value of money

The universal preference for a rupee today over a rupee at some future time is because of

the following reasons: -

Alternative uses/ Opportunity cost

Inflation

Uncertainty

The manner in which these three determinants combine to determine the rate of interest

can be represented symbolically as

Nominal or market rate of interest rate = Real rate of interest + Expected rate of

Inflation + Risk of premiums to compensate uncertainty

Basics Evaluating financial transactions requires valuing uncertain future cash flows.

Translating a value to the present is referred to as discounting. Translating a value to the

future is referred to as compounding .The principal is the amount borrowed. Interest is

the compensation for the opportunity cost of funds and the uncertainty of repayment of

the amount borrowed; that is, it represents both the price of time and the price of risk.

The price of time is compensation for the opportunity cost of funds and the price of risk

is compensation for bearing risk.

Interest is compound interest if interest is paid on both the principal and any accumulated

interest. Most financial transactions involve compound interest, though there are a few

consumer transactions that use simple interest (that is, interest paid only on the principal

or amount borrowed).Under the method of compounding, we find the future values

(FV) of all the cash flows at the end of the time horizon at a particular rate of

interest. Therefore, in this case we will be comparing the future value of the initial

outflow of Rs. 1,000 as at the end of year 4 with the sum of the future values of the yearly

cash inflows at the end of year 4. This process can be schematically represented as

follows:

PROCESS OF DISCOUNTING

Under the method of discounting, we reckon the time value of money now, i.e. at

time 0 on the time line. So, we will be comparing the initial outflow with the sum of the

present values (PV) of the future inflows at a given rate of interest.

Translating a value back in time -- referred to as discounting -- requires determining

what a future amount or cash flow is worth today. Discounting is used in valuation

because we often want to determine the value today of future value or cash flows.

The equation for the present value is:

Present value = PV = FV / (1 + i) n

Where:

PV = present value (today's value), FV = future value (a value or cash flow sometime in

the future), i = interest rate per period, and n = number of compounding periods

And [(1 + i) n] is the compound factor.

We can also represent the equation a number of different, yet equivalent ways:

Where PVIFi,n is the present value interest factor, or discount factor.

In other words future value is the sum of the present value and interest:

Future value = Present value + interest

From the formula for the present value you can see that as the number of discount

periods, n, becomes larger, the discount factor becomes smaller and the present value

becomes less, and as the interest rate per period, i, becomes larger, the discount factor

becomes smaller and the present value becomes less.

Therefore, the present value is influenced by both the interest rate (i.e., the discount rate)

and the numbers of discount periods.

Example

Suppose you invest 1,000 in an account that pays 6% interest, compounded annually.

How much will you have in the account at the end of 5 years if you make no

withdrawals? After 10 years?

Solution

FV5 = Rs 1,000 (1 + 0.06) 5 = Rs 1,000 (1.3382) = Rs 1,338.23

FV10 = Rs 1,000 (1 + 0.06) 10 = Rs 1,000 (1.7908) = Rs 1,790.85

What if interest was not compounded interest? Then we would have a lower balance in

the account:

FV5 = Rs 1,000 + [Rs 1,000(0.06) (5)] = Rs 1,300

FV10 = Rs 1,000 + [Rs 1,000 (0.06)(10)] = Rs 1,600

Simple interest is the product of the principal, the time in years, and the annual interest

rate. In compound interest the principal is more than once during the time of the

investment.Compound interest is another matter. It's good to receive compound interest,

but not so good to pay compound interest. With compound interest, interest is calculated

not only on the beginning interest, but also on any interest accumulated in the meantime.

I hope you have understood the concept of simple interest and compound interest. It is

explained with the help of a graph, which is self-explanatory. Now let us solve a problem

for Compound Interest vs. Simple Interest

Example Suppose you are faced with a choice between two accounts,

Account A and Account B. Account A provides 5% interest, compounded

annually and Account B provides 5.25% simple interest. Consider a

deposit of Rs 10,000 today. Which account provides the highest balance

at the end of 4 years?

Solution

Account A: FV4 = Rs 10,000 (1 + 0.05) 4 = Rs 12,155.06

Account B: FV4 = Rs 10,000 + (Rs 10,000 (0.0525)(4)] = Rs 12,100.00

Account A provides the greater future value.

Present value is simply the reciprocal of compound interest.

Another way to think of present value is to adopt a stance out on the time

line in the future and look back toward time 0 to see what was the

beginning amount.

Present Value = P0 = Fn / (1+I) n

Table A-3 shows present value factors: Note that they are all less than one. Therefore,

when multiplying a future value by these factors, the future value is

discounted down to present value. The table is used in much the same

way as the other time value of money tables. To find the present value of

a future amount, locate the appropriate number of years and the

appropriate interest rate, take the resulting factor and multiply it times

the future value.

How much would you have to deposit now to have Rs 15,000 in 8 years if

interest is 7%?

= 15000 X .582 = 8730 Rs

Consider a case in which you want to determine the value today of $

1,000 to be received five years from now. If the interest rate (i.e., discount

rate) is 4%,

Problem Suppose that you wish to have Rs 20,000 saved by the end of

five years. And suppose you deposit funds today in account that pays 4%

interest, compounded annually. How much must you deposit today to

meet your goal?

Solution Given: FV = Rs 20,000; n = 5; i = 4%

PV = Rs 20,000/(1 + 0.04) 5 = Rs 20,000/1.21665

PV = Rs 16,438.54

Q. If you want to have Rs 10,000 in 3 years and you can earn 8%, how

much would you have to deposit today?

�Rs

7938.00

�Rs 25,771

�Rs 12,597

A-1 for future value at the end of n yrs

A-3 for present value at the beginning of the year

Compound Interest tables have been calculated by figuring out the (1+I) n

values for various time periods and interest rates. Look at Time Value of

Money Future Value Factors.

This table summarizes the factors for various interest rates for various

years. To use the table, simply go down the left-hand column to locate the

appropriate number of years. Then go out along the top row until the

appropriate interest rate is located. For instance, to find the future value

of Rs100 at 5% compound interest, look up five years on the table, and

then go out to 5% interest. At the intersection of these two values, a

factor of 1.2763 appears. Multiplying this factor times the beginning value

of Rs100.00 results in Rs127.63, exactly what was calculated using the

Compound Interest Formula. Note, however, that there may be slight

differences between using the formula and tables due to rounding errors.

An example shows how simple it is to use the tables to calculate future

amounts.

You deposit Rs2000 today at 6% interest. How much will you have in 5

years?

=2000*1.338=2676

The following exercise should aid in using tables to solve future value

problems. Please answer the questions below by using tables

1. You invest Rs 5,000 today. You will earn 8% interest. How much will you

have in 4 years? (Pick the closest answer)

�Rs 6,802.50

�Rs 6,843.00

Rs 3,675

�

2.You have Rs 450,000 to invest. If you think you can earn 7%, how much

could you accumulate in 10 years? ? (Pick the closest answer)

�Rs 25,415

Rs 722,610

�Rs 722,610

�

3.If a commodity costs Rs500 now and inflation is expected to go up at

the rate of 10% per year, how much will the commodity cost in 5 years?

�Rs 805.25

�Rs 3,052.55

Now we will talk about the cases when the interest is given semi

annually, quarterly, monthly….

The interest rate per compounding period is found by taking the annual

rate and dividing it by the number of times per year the cash flows are

compounded. The total number of compounding periods is found by

multiplying the number of years by the number of times per year cash

flows is compounded. The formula for this shorter compounding period is

= PV0 (1+i/m)n*m

Consider the following example. You deposited Rs 1000 for 5 yrs in a bank

that offers 10% interest p.a. compounded semiannually, what will be the

future value.

=1000 (1+. 10/2) 5*2

For instance, suppose someone were to invest Rs 5,000 at 8% interest,

compounded semiannually, and hold it for five years.

The interest rate per compounding period would be 4%, (8% / 2)

The number of compounding periods would be 10 (5 x 2)

To solve, find the future value of a single sum looking up 4% and 10

periods in the Future Value table.

FV = PV (FVIF)

FV = Rs 5,000(1.480)

FV = Rs 7,400

Now let us solve a problem for Frequency of Compounding FVn

Problem Suppose you invest Rs 20,000 in an account that pays 12%

interest, compounded monthly. How much do you have in the account at

the end of 5 years?

Solution FV = Rs 20,000 (1 + 0.01) 60 = Rs 20,000 (1.8167) = Rs

36,333.93

Investor most of the times wants to know that in what period of time his

money will be doubled. For this the “rule of 72” is used.

Suppose the rate of interest is 12%, the doubling period will be 72/12=6

yrs.

Apart from this rule we do use another rule, which gives better results, is

the “rule of 69”

= .35 + 69

int rate

= .35 + 69

12

= .35 + 5.75 = 6.1 yrs

Practice Problems

What is the balance in an account at the end of 10 years if Rs 2,500 is

deposited today and the account earns 4% interest, compounded

annually? Quarterly?

If you deposit Rs10 in an account that pays 5% interest, compounded

annually, how much will you have at the end of 10 years? 50 years? 100

years?

How much will be in an account at the end of five years the amount deposited today is Rs

10,000 and interest is 8% per year, compounded semi-annually?

Answers

1.Annual compounding: FV = Rs 2,500 (1 + 0.04) 10 = Rs 2,500 (1.4802)

= Rs 3,700.61

Quarterly compounding: FV = Rs 2,500 (1 + 0.01) 40 = Rs 2,500 (1.4889)

= Rs3,722.16

2.

10 years: FV = Rs10 (1+0.05) 10 = Rs10 (1.6289) = Rs16.29

50 years:FV = Rs10 (1 + 0.05) 50 = Rs10 (11.4674) = Rs114.67

100 years: FV = Rs10 (1 + 0.05) 100 = Rs10 (131.50) = Rs 1,315.01

3. FV = Rs 10,000 (1+0.04) 10 = Rs10,000 (1.4802) = Rs14,802.44

For example, assume you deposit Rs. 10,000 in a bank, which offers 10%

interest per annum compounded semi-annually which means that interest

is paid every six months.

Now, amount in the beginning = Rs. 10,000

Rs.

Interest @ 10% p.a. for first six = 500

Months 10000 x 21.0 =10500

Interest for second

6 months = 10500 x 21.0 = 525

Amount at the end of the year = 11,025

Instead, if the compounding is done annually, the amount at the end of

the year will be 10,000 (1 + 0.1) = Rs, 11000. This difference of Rs. 25 is

because under semi-annual compounding, the interest for first 6 moths

earns interest in the second 6 months.

The generalized formula for these shorter compounding periods is

The generalized formula for these shorter compounding periods is

FVn = PV(1+k/m) mxn

Where

FVn = future value after ‘n’ years

PV = cash flow today

K = Nominal Interest rate per annum

M = Number of times compounding is done during a year

N = Number of years for which compounding is done.

Example

Under the Vijaya Cash Certificate scheme of Vijaya Bank, deposits can be

made for periods ranging from 6 months to 10 years. Every quarter,

interest will be added on to the principal. The rate of interest applied is

9% p.a. for periods form 12 to 13 months and 10% p.a. for periods form

24 to 120 months.

An amount of Rs. 1,000 invested for 2 years will grow to

Where m = frequency of compounding during a year

= 1000 (1.025)8

= 1000 x 1.2184 = Rs. 1218

Effective vs. Nominal Rate of interest

We have seen above that the accumulation under the semi-annual

compounding scheme exceeds the accumulation under the annual

compounding scheme compounding scheme, the nominal rate of interest

is 10% per annum, under the scheme where compounding is done semi

annually, the principal amount grows at the rate of 10.25 percent per

annum. This 1025 percent is called the effective rate of interest which is

the rate of interest per annum under annual compounding that produces

the same effect as that produced by an interest rate of 10 percent under

semi – annual compounding.

The general relationship between the effective an nominal rates of

interest is as follows:

k = nominal rate of interest

m = frequency of compounding per year.

Example

Find out the effective rate of interest, if the nominal rate of interest is 12%

and is quarterly compounded? Effective rate of interest

= (1 + mk)m – 1

= (+ 412.0)4 – 1

= (1 + 0.03)4 -1 = 1.126 -1

= 0.126 = 12.6% p.a. compounded quarterly

�A-1

The Compound Sum of one rupee FVIF

�A-3 The Present Value of one rupee PVIF

IMPORTANT

The inverse of FVIF is PVIF i.e. inverse of FVIF is PVIF.

Types AnnuitiesTypes of Annuities

Ordinary AnnuityOrdinary Annuity: Payments or receipts occur at the endof each period.

Annuity DueAnnuity Due: Payments or receipts occur at the beginningof each period

ANNUITY

Till now we talked about the future value of single payment made at the

time zero (PV0). Now we will speak about annuities. An annuity is an equal

annual series of cash flows. Annuities may be equal annual deposits,

equal annual withdrawals, equal annual payments, or equal annual

receipts. The key is equal, annual cash flows. Note that the cash flows occur at

the end of the year. This makes the cash flow an ordinary annuity. If the

cash flows were at the beginning of the year, they would be an annuity

due.

Annuity = Equal Annual Series of Cash Flows

Assume annual deposits of Rs 100 deposited at end of year earning 5%

interest for three years

Year 1: Rs100 deposited at end of year = Rs100.00 Year 2: Rs100 x .05 =

Rs5.00 + Rs100 + Rs100 = Rs205.00 Year 3: Rs205 x .05 = Rs10.25 +

Rs205 + Rs100 = Rs315.25

Translating a series of cash flows into a present value is similar to

translating a single amount to the present; we discount each cash flow to

the present using the appropriate discount rate and number of discount

periods. Translating a series of cash flows into a future value is also

similar to translating a single sum: simply add up the future values of

each cash flow.

Again, there are tables for working with annuities. Future Value of Annuity

Factors is the table to be used in calculating annuities due. Basically, this

table works the same way as Table 1. Just look up the appropriate number

of periods, locate the appropriate interest, take the factor found and

multiply it by the amount of the annuity.

We use table A-2 for FVIFA For instance, on the three-year, 5% interest

annuity of Rs100 per year. Going down three years, out to 5%, the factor

of 3.152 is found. Multiply that by the annuity of Rs100 yields a future

value of Rs315.20. another example of calculating the future value of an

annuity is illustrated.

You deposit Rs 300 each year for 15 years at 6%. How much will you have

at the end of that time?

= 300 X 23.276 = 6982.8

The following exercise should aid in using tables to solve annuity

problems. Use table A-2. FVIFA

1.You deposit Rs 2,000 in recurring account each year for 5 years. If

interest on this recurring account is 4%, how much will you have at the

end of those 5 years?

�Rs 10,000

�Rs 10,832.60

�Rs 8,903.60

2.If you deposit Rs 4,500 each year into an account paying 8% interest,

how much will you have at the end of 3 years?

�Rs 13,500

�Rs 14,608.80

�Rs 11,596.95

To find the present value of an annuity, use Table A-4. Find the

appropriate factor and multiply it times the amount of the annuity to find

the present value of the annuity.

For instance

Find the present value of a 4-year, Rs 3,000 per year annuity at 6%.

Using the present value of annuity table, going down the left column for 4

yrs and to 6% the corresponding factor is 3.465

=3000 X 3.465 = 10395 Rs

FUTURE VALUE OF ANNUITY

periodic flows of equal amounts. These flows can be either receipts or

payments. For example, if you are required to pay Rs. 200 per annum

as life insurance premium for the next 20 years, you can classify this

stream of payments as an annuity. If the equal amounts of cash flow

occur at the end of each period over the specified time horizon, then

this stream of cash flows is defined as a regular annuity or deferred

annuity. When cash flows occur at the beginning of each period the

annuity is known as an annuity due.

Which reduces to

FVAn = A −+KKn1)1(

Where A = amount deposited/ invested at the end of every year for n

years.

K = rate of interest (expressed in decimals)

N = time horizon

FVAn = accumulation at the end of n

The future value of a regular annuity for a period of n years at a rate of

interest ‘k’ is given by the formula:

FVAn = A (1 +K)n-1 + A ( 1+ K)n-2 + A( 1 + k)n-3 + ..+ A

accumulation of Re. 1 invested or paid at the end of every year for a period of n years at

the rate of interest ‘k’. As in the case of the future value of a single flow,

this expression has also been evaluated for different combinations of

‘k’ and ‘n’ and tabulated in table A.2 at the end of this book. So, given

the annuity payment, we have to just multiply it with the appropriate

FVIFA value and determine the accumulation.

Example

Under the recurring deposit scheme of the Vijaya Bank, a fixed sum is

deposited every month on or before the due date opted for 12 to 120

months according to the convenience and needs of the investor. The

period of deposit however should be in multiples of 3 months only. The

rate of interest applied is 9% p.a. for periods from 12 to 24 months and

10% p.a. for periods form 24 to 120 months and is compounded at

quarterly intervals.

Based on the above information the maturity value of a monthly

installment of Rs. 12 months can be calculated as below:

Amount of deposit = Rs. 5 per month

Rate of interest = 9% p.a. compounded quarterly

Effective rate of interest per annum

= 0931.01409.14=−0+

Rate of interest per month = 120931.0 =n 0.78%

Alternative method

Rate of interest per month

= (r + 1 )1/m - 1

= (1 + 0.0931)12 - 1

= 1.0074 - 1 = .0074 = .74%

Maturity value cab be calculated using the formula

FVAn = A −+kkn1)1(

= 5 −+0078.01)0078.1(120

= 5 x 12.53 = Rs. 62.65

If the payments are made at the beginning of every year, then the value

of such an annuity called annuity due is found by modifying the formula

for annuity regular as follows.

FVAn (due) = A (1 + k) FVIFAK,n

Example

Under the Jeevan Mitra plan offered by Life insurance Corporation of India,

if a person is insured for Rs. 10,000 and if he survives the full term, then

the maturity benefits will be the basic sum of Rs. 10,000 assured plus

bonus which accrues on the basic sum assured. The minimum and

maximum age to propose for a policy is 18 and 50 years respectively.

Let us take two examples, one of a person aged 20 and another a person

who is 40 years old to illustrate this scheme.

The person aged 20, enters the plan for a policy of Rs. 10,000. The term

of policy is 25 years and the annual premium is Rs. 41.65. The person

aged 40, also proposes for the policy of Rs. 10,000 and for 25 years and

the annual premium he has to pay comes to Rs. 57. What is the rate of

returns enjoyed by these two persons?

Solution:

Rate of Return enjoyed by the person of 20 years of age

Premium = Rs. 41.65 per annum

Term of policy = 25 years

Maturity value = Rs. 1,000 + bonus which can be neglected as it is a

Fixed amount and does not vary with the term of policy.

We know that the premium amount when multiplied by FVIFA factor will

give us the value at maturity.

i.e., P X (1 X k)* FVIFA (k,n) = MV

Where

P = Annual premium

n = Term of policy in years

k = Rate of return

MV = Maturity Value

Therefore 41.65 x (1 + k) FVIFA (k, 25) = 10,000

(1 + k) FVIFA (k, 25) =240.01

From the table A.2 at the end of the book, we can find that

(1 + 0.14) FVIFA (14,25) = 207.33

i.e., (1.14) FVIFA (15,25)

= 1.15 X 212.793

= 244.71

By Interpolation

K = 14% + (15% - 14%) x 33.20771.24433.20701.240−−

= 14% + 1% X 38.3768.32

= 14% + 0.87% = 14.87%

Rate of return enjoyed by the person aged 40

Premium = Rs. 57 per annum

Term of policy = 25 years

Maturity value = Rs. 10,000

Therefore 57 X ( 1 + k) FVIFA (k,25) = 10,000

(1 + k) FVIFA (k, 25) = 175.87

i.e., (1.13) (155.62) = 175.87

i.e., k. = 13% (appr.)

Here we find that the rate of return enjoyed by the 20-year-old person is

greater than that of the 40-year-old person by about 2% in spite of the

latter paying a higher amount of annual premium for the same period of

25 years and for the same maturity value of Rs. 10,000. This is due to the

coverage for the greater risk in the case of the 40 year old person.

Now that we are familiar with the computation of future value, we will get

into the mechanics of computation of present value.

SINKING FUND FACTOR

Here is the equation

FVA = A −+kKn1)1(

We can rewrite it as

A = FVA −+1)1(nKK

The expression −+1)1(nKK is called the sinking Fund factor. It

represents the amount that has to be invested at the end of every year

for a period of “n” years at the rate of interest “k”, in order to accumulate

Re. 1 at the end of the period.

The present value of an annuity ‘A’ receivable at the end of every year for

a period of n years at a rate of interest K is equal to

PVAn = )1(...)1()1()1(32KAKAKAKA+++++++

Which reduces to

PVAn =A X ()()+−+nnkkK1(11

The expression

()()+−+nnkkK1(11

is called the PVIFA (Present Value Interest Factor Annuity ) and it represents the present

value of regular annuity of Rs. 1 for the given values of k and n. The values of PVIFA (k,

n) for different combinations of ‘k’ and ‘n’ are given in Appendix A.4 given at the end of

the book.

It must be noted that these values can be used in any present value

problem only if the following conditions are satisfied:

Example

The Swarna Kailash Yojana at rural and semi-urban branches of SBI is a

scheme open to all individuals /firms. A lump sum deposit is remitted and

the principal is received with interest at the rate of 12% p.a. in 12 or 24

monthly installments. The interest is compounded at quarterly intervals.

The amount of initial deposit to receive a monthly installment of Rs. 100

for 12 months can be calculated as below:

Firstly, the effective rate of interest per annum has to be calculated.

11−+=mmkr

%55.12114=−+=mk

After calculating the effective rate of interest per annum, the effective

rate of interest per month has to be calculated which is nothing but

ALWAYS REMEMBER

It must also be noted that PVIFA (k, n) is not the inverse of FVIFA

(k, n,)although PVIF (k, n) is the inverse of FVIF (k, n).

01046.0121255.0=

The initial deposit can now be calculated as below:

()()+−+=nnkkkAPVAn111

+−+=1212)01046.01(01046.01)01046.01(100

=01185.0133.0100

1122.22.11100Rsx==

Example

The annuity deposit scheme of SBI provides for fixed monthly income for

suitable periods of the depositor’s choice. An initial deposit has to be

made for a minimum period of 36 months. After the first month of the

deposit, the depositor receives monthly installments depending on the

number of months he has chosen as annuity period. The rate of interest is

11% p.a., which is compounded at quarterly intervals.

If an initial deposit of Rs. 4,549 is made for an annuity period of 60

months, the value of the monthly annuity can be calculated as below:

Firstly, the effective rate of interest per annum has to be calculated.

11−+=mmkr

= %46.111411.14=−+0

After calculating the effective rate of interest per annum, the effective

rate of interest per month has to be calculated which is nothing but

00955.0121146.0=

The monthly annuity can now be calculated as

PVAn = A +−+nnkkK)1(1)1(

4549 = A −+6060)00955.1(00955.01)00955.01(

4549 = A X 0169.07688.0

A = Rs. 100

Manipulating the relationship between PVAn, A, K & n we get an equation:

A = PVAn −++1)1()1(nnkkk

−++1)1()1(nnkkk is known as the capital recovery factor.

Example

A loan of Rs. 1,00,000 is to be repaid in five equal annual installments. If

the loan carries a rate of interest of 14% p.a. the amount of each

installment can be calculated as below:

If R is defined as the equated annual installment, we are given that

R X PVIFA (14.5) = Rs. 1,00,000

There fore R = )5.14(000,00,1.PVIFARs

= 433,3000,00,1.Rs

= Rs. 29,129

Notes:

We have introduced in this example the application of the inverse of the PVIFA factor,

which is called the capital recovery factor. The application of the capital recovery factor

helps in answering questions like:

KEEP IN MIND *Inverse of FVIFA factor is Sinking Fund Factor

*Inverse of PVIFA factor is Capital Recovery Factor

�What

should be the amount that must be paid annually to liquidate a

loan over a specified period at a given rate of interest?

�How much can be withdrawn periodically for a certain length of time, if

a given amount is invested today?

2. In this example, the amount of Rs. 29,129 represents the sum of the

principal and interest components. To get an idea of the break-up of each

installment between the principal and interest components, the loan-

repayment schedule is given below.

(A) annual content of content of outstanding

installment (b) (B) after

(Rs.) (Rs.) (Rs.) payment

(B) (C) [(D) = (B – (Rs.)

C)] (E)

0 - - - 1,00,000

1 29,129 14,000 15,129 84,871

2 29,129 11,882 17,247 67,624

3 29,129 9,467 19,662 47,962

4 29,129 6,715 22,414 25,548

5 29,129 3,577 25,552 --

State whether the following statements are True (T) or false (F)

i. Financial analysis requires an explicit consideration of the time value of

money because many financial problems involve cash flows occurring at

different points of time.

ii. A regular annuity in a series of periodic cash flows of equal amounts occurring at the

beginning of each period.

iv. The inverse of the FVIFA factor is" equal to the PVIFA factor.

v. The inverse of the PVIFA factor is called the capital recovery- factor.

vi. A bank that pays 10.5 percent interests compounded annually provides a

higher effective rate of interest than a bank that pays 10 percent

compounded semi-annually.

vii. The sinking fund factor is used to determine the amount that must be

deposited periodically to accumulate a specified sum at the end of a

given period at a given rate of interest.

viii. The nominal rate of interest is equal to the effective rate of interest

when interest is compounded annually.

ix. When debt is amortized in equal periodic installments, the total debt-

servicing burden (consisting of interest payment and principal

repayment) declines over time.

x. The present value interest factor for annuity is equal to the product of the

future value interest factor for annuity and the present value interest

factor.

xi. The present value of an uneven cash flow stream can be calculated using

the PV1FA tables.

xii. The rule of 72 is useful in determining the future value of an annuity for

6 years at an interest rate of 12% p.a.

xiii. One of the reasons for attributing time value to money is that individuals prefer future

consumption to current consumption.

Ans:-3.1 T 3.2 F 3.3 F 3.4 T 3.5 T 3.6 T 3.7 T 3.8 F 3.9 T 3.10 F 3.11 F 3.12 F

Section (B)

Choose the right answer from the' alternatives given.

i. Money has time value because

a. Money in hand today is more certain than money to be got tomorrow.

b. The value of money -gets discounted as time goes by.

c. The value of money gets compounded as time goes by.

d. Both (a) and (b) above.

e. Both (a) and (c) above.

ii. Given an investment of Rs 1,000 to be invested for 9 months and

interest is credited annually

a. It is better to -invest in a scheme, which earns compound interest at

12%.

b. It is better to invest in a scheme, which earns simple interest at 12%.

c. It is better to invest in a scheme, which earns simple interest at 15%.

d. It is better to invest in a scheme, which earns compound interest at

14%.

e. The interest rate does not matter.

iii. In order to find the value in 1995 of a sum of Rs 100 invested in 1993

at X% interest

a. The FVIFA table should be used.

b. The PVIFA table should be used.

c. The FVIF table should be used.

d. The PVIF table should be used.

e. Both FVIFA and FVIF tables can be used.

iv. The real rate of interest or return is nothing but

a) Nominal or market interest rate

b) Market interest rate to which expected rate of inflation and risk

premium for uncertainty has been added

c) Market interest rate, which has been adjusted for inflation

d) Nominal interest rate from which expected rate of inflation and risk

premium for uncertainty has been deducted.

e) None of the above.

v. The relationship between effective rate of interest (r) and nominal rate of interest (i) is best

represented by

a) i = (1 + 1)−mmr

b) r = (1 + 1)−nnr

c) r = (1 + 1)−mmr

d) Both (a) and (c) above

f) None of the above.

vi. Which of the following statement is /are true?

a) Present value interest factor Annuity (PVIFA) is the product of future

value interest factor Annuity (FVIFA) and present value interest factor

(PVIF)

b) PVIFA ( i,n ) = nniin)1(1)1(+−+

c) PVIFA ( i,n) = iin)1(1+

d) PVIFA is the inverse of FVIFA

e) None of above.

vii. If P= initial amount, i = interest rate, m = frequency of compounding

per year, n= number of years and S = accumulation at the end of year n,

which of the following expressions are correct.

a) S = P mnni)1+(

b) P = S mnmi)1+(

c) S = [P (1+ nmmi])

d) S= P (mnmi)1+(

e) None of the above.

a) Is used to find the doubling period

b) Makes use of the PVIFA tables

c) Applies the formula rateerestint72

d) Both (b) and (c) above

e) Both (a) and (c) above

Section (C)

1. If you invest Rs. 10,000 today for a period of 5 years, what will be the

maturity value if the interest rate is?

(a) 8% (b) 10% (c) 12% (d) 15%

2. How many years will it take for Rs. 5,000 invested today at 12% rate of

interest to grow to Rs. 1,60,000? Use the rule of 72.

3. Amount invested today = Rs. 1,000; maturity value = Rs. 8,000; time

period = 12 years. Use rule of 69 to calculate the implied interest rate.

4. If you invest Rs. 3,000 a year for 3 years and Rs. 5,000 a year for 7

years therefore at a rate of 12%, what will be the maturity value at the

end of 10 years?

5. Sunita expects an expenditure of Rs. 2,00,000 after a period of 10

years. How much should she save annually to have the required sum after

10 years, if she invests her savings at a rate of 12%.

6. Annual payment = Rs. 1,500; maturity value = Rs. 12,500, period = 5

years. Find out the implied interest rate.

7. You invest Rs. 3,000 today and get Rs. 10,000 after 6 years. What is

the implied interest rate?

8. What will be the present value of Rs. 12,000 receivable after 10 years if

the rate of discount is (i) 10% (ii) 12% (iii) 15%

9. What is the present value of an 5 year annuity of Rs. 3,000 at 12%

10. Mr. Srinivas is going to retire after 6 months. He has a choice between

(a) an annual pension of Rs. 8,000 as long as he lives, and

(b) A lump sum amount of Rs. Amount of Rs. 50,000. If he expects to live

for 20 years and the interest rate is 10% which option would you suggest

him to go for?

11. Sunil has deposited Rs. 2,00,000 in a bank, which pays interest @8%.

How much can he withdraw every year for a period of 25 years, so that

there is no balance left at the end?

12. You invest Rs. 1,500 at the end of year one, Rs. 2,000 at the end of

the second year, and Rs. 5,000 each year form the third year to the tenth.

Calculate the present value of the stream if the discount rate is 10%.

13. You receive Rs. 1,000 a year for the first 8 years, and Rs. 4,000 a year

forever therefore. Calculate the present value if the discount rate is 12%.

14. Suman is due to retire 20 years form now. She wants to invest a lump

sum now so as table to withdraw Rs. 10,000 every year, beginning from

the end of the 20th year. How much should she invest now if the deposit

earns a return of 12%?

15. A company is offering to pay Rs. 10,000 annually for a period of 10

years if you deposit Rs. 50,000 now. What is the implied interest rate?

16.Using a discount rate of 10%, calculate the present value of the

following cash flow streams.

End of year Stream A Stream B Stream C

1 1,000 10,000 5,000

2 2,000 9,000 5,000

3 3,000 8,000 5,000

4 4,000 7,000 5,000

5 5,000 6,000 5,000

interest with that earned by the same amount for 8 years at 6%

compounded annually.

(A) Simple Interest: I = Rs350; Compound Interest: I = Rs529.48

(B) Simple Interest: I = Rs360; Compound Interest: I = Rs445.39

(C) Simple Interest: I = Rs400; Compound Interest: I = Rs579.46

(D) Simple Interest: I = Rs370; Compound Interest: I = Rs469.25

2. You are considering investing Rs 1,500 at an interest rate of 5%

compounded annually for 2 years or investing the Rs1,500 at 7% per year

simple interest rate for 2 years. Which option is better?

(A) Simple Interest by Rs56.25

(B) Compound Interest by Rs114.05

(C) Compound Interest by Rs52.75

(D) Simple Interest by Rs75.19

3. Suppose you have the alternative of receiving either Rs4,000 at the

end of 2 years or P dollars today. Having no current need for the money,

you would deposit the

P dollars in a bank that pays 7% interest compounded annually. What

value of P would make you indifferent in your choice between P dollars

today and the promise of Rs 4,000 at the end of 2 years?

(A) P = Rs 3,397.48

(B) P = Rs 3,200.39

(C) P = Rs 3,518.86

(D) P = Rs 3,493.75

4. Suppose that you are obtaining a personal loan from your uncle in the

amount of Rs 6,000 for three years to cover your college expenses. If your

uncle always earns 10% interest (compounded annually) on his money

invested in various sources, what minimum lump-sum payment three

years from now would make your uncle happy?

(A) F = Rs 8,520

(B) F = Rs 7,395

(C) F = Rs 7,784

(D) F = Rs 7,986

5. What will be the amount accumulated by Rs 9,000 in 9 years if it is

compounded at a rate of 9% per year?

(A) F = Rs 18,229.30

(B) F = Rs 19,547.04

(C) F = Rs 20,978.22

(D) F = Rs 19,055

6. In 7 years, we will have accumulated Rs 17,000. What is the present

worth of Rs 17,000 if it is compounded annually at 11%?

(A) P = Rs 8,188.19

(B) P = Rs 8,563.05

(C) P = Rs 7,892.46

(D) P = Rs 250.29

7. For an interest rate of 7% compounded annually, find how much can be

loaned now if Rs 4,000 will be repaid at the end of 4 years?

(A) P = Rs 2,896.22

(B) P = Rs 3,190.55

(C) P = Rs 3,051.58

(D) P = Rs 3,789.22

8. For an interest rate of 7% compounded annually, find how much will be

required in 3 years to repay Rs 3,000 loan now?

(A) F = Rs 3,780.56

(B) F = Rs 3,675.13

(C) F = Rs 4,005.67

(D) F = Rs 3,600.13

9. If you desire to withdraw the following amounts over the next 5 years

from a savings account that earns a 9% interest compounded annually,

how much do you need to deposit now?

n Amount

2 Rs 1,000

3 Rs 1,500

4 Rs 3,000

5 Rs 5,000

(A) P = Rs 6,982.30

(B) P = Rs 7,074.89

(C) P = Rs 7,958.22

(D) P = Rs 7,374.89

10. If Rs300 is invested now, Rs500 two years from now, and Rs700 four

years from now at an interest rate of 3% compounded annually, what will

be the total amount in 10 years?

(A) F = Rs 1,872.40

(B) F = Rs 1,540.27

(C) F = Rs 1,975.11

(D) F = Rs 1,801.36

11. How much invested now at 7% compounded annually would be just

sufficient toprovide three withdrawals with the first withdrawal in the

amount of Rs1500 occurring three years hence, Rs3000 six years hence,

and Rs5000 eight years hence?

(A) P = Rs 4606.13

(B) P = Rs 5392.17

(C) P = Rs 6027.51

(D) P = Rs 6133.35

12. What is the future worth at t=7 of a series of equal year-end deposits

of Rs750 for 7 years in a savings account that earns 8% compound annual

interest?

(A) F = Rs 6655.23

(B) F = Rs 6692.10

(C) F = Rs 7582.13

(D) F = Rs 6529.05

13. What equal annual series of payments beginning at t=1 must be paid

into a sinking fund to accumulate Rs 13,000 in 20 years at 8%

compounded annually?

(A) A = Rs419.29

(B) A = Rs485.35

(C) A = Rs284.70

(D) A = Rs387.28

14. An individual deposits an annual bonus into a savings account that

pays 5% interest compounded annually. The size of the bonus increases

by Rs200 each year and the initial bonus amount at t=1 was Rs250.

Determine how much will be in the account immediately after the fifth

deposit.

(A) F = Rs3019.59

(B) F = Rs3483.89

(C) F = Rs2953.94

(D) F = Rs2752.95

15. Five annual deposits in the amounts beginning at t=1 of (Rs800,

Rs700, Rs600, Rs500, and Rs400) are made into a fund that pays interest

at a rate of 10% compounded annually. Determine the amount in the fund

immediately after the fifth deposit.

(A) F = Rs2969.52

(B) F = Rs1127.15

(C) F = Rs3778.99

(D) F = Rs2752.95

16. What is the equal-payment series for 10 years that is equivalent to a

payment series of Rs 15,000 at the end of the first year (t=1) decreasing

by Rs300 each year over 10 years? Interest is 9% compounded annually.

(A) A = Rs 7120.85

(B) A = Rs 10,118.72

(C) A = Rs 12,929.01

(D) A = Rs 13,860.66

17. Suppose that an oil well is expected to produce 10,000 barrels of oil

during its first production year. However, its subsequent production (yield)

is expected to decrease by 10% over the previous year's production. The

oil well has a proven reserve of 100,000 barrels. Suppose that the price of

oil is expected to be Rs30 per barrel for the next several years. What

would be the present worth of the anticipated revenue stream at an

interest rate of 15% compounded annually over the next 7 years?

(A) P = Rs 948,629.78

(B) P = Rs 955,013.95

(C) P = Rs 984,228.58

(D) P = Rs 875,629.00

18. If a bank pays you 8% compound annual interest on your balance,

how much do you have to deposit now so that you will be able to

withdraw Rs75 at the end of the first year, Rs75 at the end of the second

year, Rs100 at the end of the third and fourth years, and Rs200 at the end

of the fifth and final year.

(A) P = Rs509.52

(B) P = Rs419.08

(C) P = Rs422.75

(D) P = Rs352.75

19. Consider the following positive cash flows: Rs400 at t=0, Rs400 at the

end of year 1, Rs400 at the end of year 2, Rs400 at the end of year 3,

Rs400 at the end of year 4, Rs500 at the end of year 5, Rs500 at the end

of year 6, and Rs500 at the end of year 7. At an interest rate of 12 percent

compounded annually, what equivalent cash flow series makes the inflow

series equivalent to the outflow series between t=2 to t=9.

(A) C = Rs397.45

(B) C = Rs428.99

(C) C = Rs500.63

(D) C = Rs536.17

20. Consider the following cash flow: Rs500 at the end of year 0, Rs1000

at the end of year 1, Rs1000 at the end of year 2, Rs1000 at the end of

year 3, Rs1000 at the

end of year 4, and Rs1000 at the end of year 5. In computing F at the

end of year 5 at an interest rate of 10% compounded annually,

which of the following statements is correct?

(A) F = 1000(F/A, 10%, 4) + 500(F/P, 10%, 5)

(B) F = 500(F/A, 10%, 6) + 500(F/A, 10%, 5)

(C) F = [500 + 1000(P/A, 10%, 5)] x (F/P, 10%, 5)

(D) F = [5000(A/P, 10%, 5) + 1000] x (F/A, 12%, 5)

21. Using a 12% interest rate compounded annually, solve for the present

worth of the following cash flow series: -Rs30 @ t=1, Rs30 @ t=3, Rs60 @

t=4, Rs90 @ t=5, -Rs30 @ t=6, -Rs30 @ t=7, -Rs30 @ t=8, -Rs30 @ t=9,

-Rs90 @ t=10, Rs60 @ t=10, -Rs90 @ t=11, Rs60 @ t=11, -Rs90 @ t=12

and Rs60 @ t=12.

(A) Rs6

(B) Rs18

(C) Rs13

(D) Rs9

22. Consider the first cash flow series: Rs200 @ t=1, Rs150 @ t=2, Rs400

@ t=3, Rs150 @ t=4 and Rs400 @ t=5; and the second series: Rs100 @

t=1, Rs X at t=2, Rs X @ t=3, -Rs200 @ t=4 and Rs X @ t=5. Find the

value of X in the second series so that the two cash flows are equivalent

for an interest rate of 12% compounded annually.

(A) X = Rs545

(B) X = Rs454

(C) X = Rs465

(D) X = Rs525

23. What single amount at the end of the fourth year is equivalent to a

uniform annual series of Rs7000 per year starting at t=1 and ending at

t=10, if the interest rate is 7% compounded annually?

(A) X = Rs 62,798

(B) X = Rs 46,445

(C) X = Rs 60,564

(D) X = Rs 64,446

24. At an interest rate of 7% compounded annually, which equation from

the list below would correctly compute either the equivalent present

worth (P) at t=0 or

future worth (F) at t=5 for the following cash flow series: Rs A @ t=0, Rs A

@ t=1, Rs A @ t=2, Rs A @ t=3, Rs A @ t=4 and Rs A @ t=5.

(1) P = A (P/A, 7%, 6); F = A (F/A, 7%, 6)

(2) P = A + A (P/A, 7%, 5); F = A (F/A, 7%, 5) + A (F/P, 7%, 6)

(3) P = A + A (P/A, 7%, 5); F = A (F/A, 7%, 6)

(4) P = A (P/A, 7%, 6); F = A (F/A, 7%, 5) + A (F/F, 7%,5)

(A) (1)

(B) (2)

(C) (3)

(D) (4)

25. Consider the first cash flow series: -Rs20 @ t=0, Rs20 @ t=2, Rs40 @

t=3, Rs60 @ t=4 and Rs80 @ t=5; and the second series: Rs A @ t=2, Rs

A at t=3, Rs A @ t=4 and Rs A @ t=5. Find the equivalent equal-cash-flow

series (A), such that the two aforementioned cash flows are equivalent at

10% compounded annually.

(A) A = Rs41

(B) A = Rs81

(C) A = Rs51

(D) A = Rs21

26. How much would you have to deposit in a savings account today,

earning 8% compound annual interest, such that you will be able to make

5 equal end of year withdrawals of Rs10,000 beginning 6 years from

today, with your last withdrawal bringing your savings account balance to

zero?

(A) P = Rs 25,321

(B) P = Rs 27,174

(C) P = Rs 29,559

(D) P = Rs 24,785

27. A professional hockey player free agent is trying to decide which of

two teams he should play for based on economic considerations. Both

teams have offered him a signing bonus, which he will receive today, and

an annual salary (assume that the salary is paid out at the end of each

year). His total salary from Team A will be Rs 6,000,000 over 3 years

whereas the total salary from Team B will be Rs 6,250,000 also over 3

years. The structure of each team's offer is summarized below.

Team A: Rs 500,000 initial signing bonus, Rs 1,500,000 for year 1, Rs

2,000,000 for year 2 and Rs 2,000,000 for year 3.Total = Rs 6,000,000.

Team B: Rs 350,000 initial signing bonus, Rs 400,000 for year 1, Rs

2,000,000 for year 2 and Rs 3,500,000 for year 3.

Total = Rs 6,250,000.

Assuming the player uses a 15% interest rate compounded annually to

evaluate his options, which team offers do you recommend?

(A) Team A

(B) Team B

28. Woods Manufacturing Company, a small toothpick fabricator, needs to

purchase a molding machine for Rs 200,000. Woods will borrow money

from a bank at an interest rate of 9% compounded annually over 5 years.

Woods expects its product sales to be slow during the first year but to

increase subsequently at an annual rate of 10%. Woods therefore

arranges with the bank to pay off the loan with increasing payments, with

the lowest payment at the end of first year, each subsequent payment to

be just 10% more than the previous one. Determine the fifth annual

payment.

(A) A = Rs 52,660

(B) A = Rs 62,660

(C) A = Rs 72,660

(D) A = Rs 82,760

29. ACB Inc. has invested Rs1.5 million in new technology. The entire

investment was financed with a loan bearing interest of 15% compounded

annually. The new technology will increase the net cash flow per unit of

product sold by Rs250. Assuming that the same number of units will be

sold each year over the six year life (assume end of year sales) of the

technology, how many units have to be sold each year to recover the

Rs1.5 million investment and interest on the loan?

(A) X = Rs 1,285 units per year

(B) X = Rs 1,385 units per year

(C) X = Rs 1,485 units per year

(D) X = Rs 1,585 units per year

30. You have Rs 10,000 to invest and you expect it to double in 8 years.

Using the Rule of 72, what compound annual interest rate do you have to

earn on your investment.

(A) i = 11%

(B) i = 8%

(C) i = 10%

(D) i = 9%

ANSWERS TO ABOVE

Question 1: 'b' is the correct answer! Simple interest: I = iPN = (0.06)(Rs

750)(8) = Rs 360; Compound interest: I = P[(1+ i)^N - 1] = Rs

750[(1.06)^8 - 1] = Rs 445.39

Question 2: Rs 'a' is the correct answer. Compound interest: F = Rs

1,500(1 + 0.05)^2 = Rs 1653.75; Simple interest: F = Rs 1,500(1 +

0.07(2)) = Rs 1710

Question 3: Rs 'd' is the correct answer.: P = Rs 4,000/(1 + 0.07)^2 = Rs

3493.75

Question 4: Rs 'd' is the correct answer.: F = Rs 6,000(1 + 0.1)^3 = Rs

7986

Question 5: Rs 'b' is the correct answer.: F = Rs 9,000(1 + 0.09)^9 = Rs

19547.04

Question 6: Rs 'a' is the correct answer.: P = Rs 17,000/(1 + 0.11)^7 =

Rs 8188.19

Question 7: Rs 'c' is the correct answer.: P = Rs 4,000/(1 + 0.07)^4 = Rs

3051.58

Question 8: Rs 'b' is the correct answer.: F = Rs 3,000(1 + 0.07)^3 = Rs

3675.13

Question 9: 'd' is the correct answer!: P = [Rs 1,000/(1 + 0.09)^2 ] + [Rs

1,500/(1 + 0.09)^3 ] + [Rs 3,000/(1 + 0.09)^4 ] + [Rs 5,000/(1 +

0.09)^5 ] = Rs 7374.89

Question 10: Rs 'a' is the correct answer.: F = Rs 300(1 + 0.03)^10 + Rs

500(1 + 0.03)^8 + Rs 700(1 + 0.03)^6 = Rs 1872.40

Question 11: 'd' is the correct answer.: P = Rs 1500(P/F,7%,3) + Rs

3000(P/F,7%,6) + Rs 5000(P/F,7%,8) = Rs 6133.35

Question 12: 'b' is the correct answer!: F = Rs 750(F/A,8%,7) = Rs

6692.10

Question 13: 'c' is the correct answer!: A = Rs 13,000(A/F,8%,20) = Rs

284.70

Question 14: 'b' is the correct answer.: F = F1 + F2 = Rs 250(F/A,5%,5)

+ Rs 200(F/G,5%,5) = Rs 250(F/A,5%,5) + Rs 200(A/G,5%,5)(F/A,5%,5) =

Rs 3483.89

Question 15: 'c' is the correct answer.: F = Rs 800(F/A,10%,5) - Rs

100(F/G,10%,5) = Rs 800(F/A,10%,5) - Rs 100(P/G,10%,5)(F/P,10%,5) =

Rs 3778.99

Question 16: 'd' is the correct answer.: A = Rs 15,000 - Rs

300(A/G,9%,10) = Rs 13,860.66

Question 17: 'c' is the correct answer: g = -10% and P = Rs

300,000(P/A1, -10%, 15%,7) = Rs 984,228.58

Question 18: 'c' is the correct answer.: P = Rs 75(P/A,8%,2) + Rs

100(P/A,8%,2)(P/F,8%,2) + Rs 200(P/F,8%,5) = Rs 422.75

Question 19: 'd' is the correct answer: P (Inflow at t=0) = Rs 400 + Rs

400(P/A, 12%, 4) + Rs 500(P/A, 12%, 3)(P/F, 12%, 4) = Rs 2,378.14 P

(Inflow at t=1) = Rs 2,378.14(F/P,12%,1) = Rs 2,663.52 = P (Outflow at

t=1) Outflow series: A at t=2, A at t=3, ..., A at t=9. A = P (A/P, 12%,8) =

2,663.52 (A/P, 12%,8) = Rs 536.17 Note: N=8 since between t=2 and t=9

there are only 8 consecutive cash outflow of Rs A

Question 20: 'c' is the correct answer.: F = [500 + 1000(P/A,10%,5)] x

(F/P,10%,5)

Question 21: 'a' is the correct answer!: P = [ Rs 30(P/G,12%,3) + Rs

30(P/A,12%,3)](P/F,12%,2) - Rs 30(P/F,12%,1) - Rs 30(P/A,12%,7)

(P/F,12%,5) P = [ Rs 30(2.2208) + Rs 30(2.4018)](0.7972) - Rs 30(0.8929)

- Rs 30(4.5638)(0.5674) P = Rs 110.55 - Rs 26.79 - Rs 77.68 = Rs 6.08

Question 22: 'b' is the correct answer.: P = Rs 150(P/A,12%,5) + Rs

50(P/F,12%,1) + Rs 250(P/F,12%,3) + Rs 250(P/F,12%,5) = Rs 540.72 +

Rs 44.65 + Rs 177.95 + Rs 141.85 = Rs 905.17 P = Rs 100(P/F,12%,1) +

X(P/A,12%,2)(P/F,12%,1) - Rs 200(P/F,12%,4) + X(P/F,12%,5) Rs 905.17 =

Rs 89.29 + 1.5091X - Rs 127.10 + 0.5674X X = Rs 454.12

Question 23: 'd' is the correct answer.: Computing the equivalent worth

at n = 4, X = Rs 7000(F/A,7%,4) + Rs 7000(P/A,7%,6) = Rs 64,446

Question 24: 'b' and 'c' are both correct answers!: (2) P = A +

A(P/A,7%,5); F = A(F/A,7%,5) + A(F/P,7%,5) or (3) P = A + A(P/A,7%,5); F

= A(F/A,7%,6)

Question 25: 'a' is the correct answer.: P0 = -Rs 20 + [ Rs 20(P/G,10%,4)

+ Rs 20(P/A,10%,4)](P/F,10%,1) = -Rs 20 + [Rs 20(4.3781) + Rs

20(3.1699)]0.9091 = Rs 117.24 A = Rs 117.24(F/P,10%,1)(A/P,10%,4) =

Rs 117.24(1.1)(0.3155) = Rs 40.49

Question 26: 'b' is the correct answer!: P = Rs 10,000(P/A,8%,5)

(P/F,8%,5) = Rs 27,174

Question 27: 'a' is the correct answer!: Team A; P = Rs 500,000 + Rs

1,500,00(P/F,15%,1) + Rs 2,000,000(P/F,15%,2) + Rs

2,000,000(P/F,15%,3) = Rs 4,631,6000 Team B; P = Rs 350,000 + Rs

400,000(P/F,15%,1) + Rs 2,000,000(P/F,15%,2) + Rs

3,500,000(P/F,15%,3) = Rs 4,511,230

Question 28: 'b' is the correct answer.: Rs 200,000 = A1(P/A1,10%,9%,5)

Rs 200,000 = A1[(1 - (1 + g)^N(1 + i)^(-N))/(i - g)] Rs 200,000 = A1[(1 -

(1 + 0.1)^5(1 + 0.09)^(-5))/(0.09 - 0.10)] A1 = Rs 42,798 The fifth

payment = Rs 42,798(1 + 0.1)^4 = Rs 62,660

Question 29: 'd' is the correct answer.: Rs 1,500,000 = Rs

250X(P/A,15%,6) Rs 6000 = X(3.7845) X = Rs 1,585 units/year

Question 30: 'd' is the correct answer.: Rule of 72: 72/i = N to double

Therefore, i = 72/N = 72/8 = 9%

Some more practice problems

1.Complete the following, solving for the present value, PV:

Num

Futur Inter Prese

ber

Case e estra ntval

ofper

value te ue

iods

Rs

A 5% 5

10,000

Rs

B 4% 20

563,000

C Rs 5,000 5.5% 3

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

CF1 CF2 CFn

Value = + + +

(1 + k) 1

(1 + k) 2

(1 + k) n

n

CFt

=∑ .

t =1 (1 + k)

t

To estimate an asset’s value, one estimates the cash flow for each period t

(CFt), the life of the asset (n), and the appropriate discount rate (k)

Throughout the course, we discuss how to estimate the inputs and how

financial management is used to improve them and thus maximize a firm’s

value.

Factors that Affect the Level and Riskiness of Cash Flows

Decisions made by financial managers:

Investment decisions

Financing decisions (the relative use of debt financing)

Dividend policy decisions

The external environment

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