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Financial management notes :-

Unit I

What is the objective of financial management?


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.

The Criticism of 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.

Separation of Ownership and Management


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 Agency Issue


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?

Multiple Choice Questions


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

2. __________ is concerned with the maximization of a firm's earnings after


taxes.
a) Shareholder wealth maximization
b) Profit maximization
c) Stakeholder maximization
d) EPS maximization

3. What is the most appropriate goal of the firm?


a) Shareholder wealth maximization
b) Profit maximization
c) Stakeholder maximization
d) EPS maximization.

4. Which of the following statements is correct regarding profit


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.

What is the time value of money?


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

Using Tables to Solve Future Value Problems


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

�Cannot tell from this information


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

In what period of time money will be doubled?


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:

where r = effective rate of interest


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

Annuity as discussed just now is the term used to describe a series of


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

Interest factor for Annuity (FVIFA, hereafter) and it represents the


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(120
= 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.

PRESENT VALUE OF AN ANNUITY


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:

(a) The cash flows are equal; and

(b) The cash flows occur at the end of every year.


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

Capital Recovery Factor


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.

Year Equated Interest Capital Loan


(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 --

Time Value of Money Numerical:-


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.

viii. The Rule of 72


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

Solution to Section (B)

3.1 d 3.2 c 3.3 c 3.4 d 3.5 c 3.6 a 3.7 d 3.8 e


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

MULTIPLE CHOICE QUESTIONS

1. Compare the interest earned by Rs750 for 8 years at 6% simple


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

Factors that affect stock price


 Projected cash flows to shareholders
 Timing of the cash flow stream
 Riskiness of the cash flows

Basic Valuation Model


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