FINANCIAL INSTITUTIONS AND MARKETS( LW-2316)

MODULE VI : INSURANCE COMPANIES AND PENSION FUNDS

6.1 Fundamentals of Insurance: Adverse Selection and Moral Hazard

6.2 Types of Insurance
6.3 Types of Pensions, Regulation of Pensions
6.4 Types of Mutual Funds, Hedge Funds
6.5 Managing Credit Risks, Liquidity Risks, Interest Rate Risks and Derivative Risks

INSURANCE

Insurance is a legal agreement between two parties i.e. the insurance company (insurer) and
the individual (insured). In this, the insurance company promises to make good the losses of
the insured on happening of the insured contingency.

The contingency is the event which causes a loss. It can be the death of the policyholder or
damage/destruction of the property. It’s called a contingency because there’s an uncertainty
regarding happening of the event. The insured pays a premium in return for the promise made
by the insurer.

Business Model of Insurance Companies

Like other businesses, insurance companies also thrive on a profit, which in the particular
case of insurance can be classified as follows:

1) Underwriting income: This income is earned from the difference between the amount of
money the insurance company collects for all policies sold (premium) and how much they
pay out in case a claim arises (final settlement) from those policies in any given time frame.

For Instance: Over a Year an insurance company collects Rs 1 Crore in revenue from
premium of policies issued & the amount spent for settling claims is say Rs 50 Lakh then the
underwriting income for that year is Rs 50 lakh.

2) Investment income: The premium money collected by insurance companies from

policyholders is usually invested in bonds, stocks, other businesses, sometimes even in other
insurance companies. Investing premium in capital markets generates a residual income
which is known as investment income.

LIFE INSURANCE

Life insurance is a contract that offers financial compensation in case of death or disability.
Some life insurance policies even offer financial compensation after retirement or a certain
period of time. Life insurance, thus, helps you secure your family’s financial security even in
your absence. You either make a lump-sum payment while purchasing a life insurance policy
or make periodic payments to the insurer. These are known as premiums. In exchange, your
insurer promises to pay an assured sum to your family in the event of death, disability or at a
set time.

Life insurance can help you support your family even after retirement. Depending on what it
covers, Life insurance can be classified into various types:
 - It is the most basic type of insurance.
- It covers you for a specific period.
Term Insurance - Your family gets a lump-sum amount in the case of your death.
- If, however, you survive the term, no money will be paid to you or
your family.

- It covers you for a lifetime.

Whole Life - Your family receives a certain sum of money after your death.
Insurance - They will also be entitled to a bonus that often accrues on such
amount.

- Like a term policy, it is also valid for a certain period.

- A lump-sum amount will be paid to your family in the event of
Endowment Policy your death.
- Unlike a term plan, you get the maturity proceeds after the term
period.

- A certain percentage of the sum assured will be paid to you

periodically throughout the term as survival benefit.
- After the expiry of the term, you get the balance amount as
Money-back Policy maturity proceeds.
- Your family gets the entire sum assured in case of death during the
policy period. This is regardless of the survival benefit payments
made.

- Such products double up as investment tools.

Unit-linked - A part of your premium goes towards your insurance cover.
Insurance Plans - The remaining amount is invested in Debt and Equity.
(ULIPs) - A lump-sum amount will be paid to your family in the event of
your death.

- This ensures your child’s financial security.

- In the event of your death, your child gets a lump-sum amount.
Child Plan - The insurer pays the premium amounts after your death.
- Your child will continue to get a certain sum of money at specific
intervals.

- This helps build your retirement fund.

Pension Plans - You can get a regular pension amount after retirement.
- In the case of your death, your family can claim the sum assured.

Tax Benefits

Life insurance not only ensures the well-being of your family, it also brings tax benefits.The
amount you pay as premium can be deducted from your total taxable income.However, this is
subject to a maximum of Rs 1.5 lakh, under Section 80C of the Income Tax Act.The premium
amount used for tax deduction should not exceed 10% of the sum assured.

GENERAL INSURANCE

A general insurance is a contract that offers financial compensation on any loss other than
death. It insures everything apart from life. A general insurance compensates you for financial
loss due to liabilities related to your house, car, bike, health, travel, etc. The insurance
company promises to pay you a sum assured to cover damages to your vehicle, medical
treatments to cure health problems, losses due to theft or fire, or even financial problems
during travel. Simply put, a general insurance offers financial protection for all your assets
against loss, damage, theft, and other liabilities. It is different from life insurance.

You can get almost anything and everything insured. But there are five key types available:

 Health Insurance
 Motor Insurance
 Travel Insurance
 Home Insurance
 Fire Insurance

Health Insurance

This type of general insurance covers the cost of medical care. It pays for or reimburses the
amount you pay towards the treatment of any injury or illness.

It usually covers:
 Hospitalisation
 The treatment of critical illnesses
 Medical bills prior to or post hospitalisation
 Day care procedures like Cataract operations

You can also opt for add-on benefits like:

 Maternity cover: Your health insurance covers you for the costs related to childbirth.
This includes pre-delivery check-ups, hospitalisation during delivery, and post-natal care.

 Pre-existing diseases cover: Your health insurance takes care of the treatment of
diseases you may have before buying the health insurance policy.

 Accident cover: Your health insurance can pay for the medical treatment of injuries
caused due to accidents and mishaps.

Your health insurance can also help you save tax. Your premium payment can reduce your
taxable income.

Tax deduction on the premium

For Total
amount

Rs. 25,000 (Rs. 30,000 if you

Self Rs. 25,000 (or Rs. 30,000)
are a senior citizen)

Parents, who are

Rs. 30,000 Rs. 55,000 (or Rs. 60,000)
senior citizens

Senior citizen = Individual aged 60 or over

Motor Insurance

Motor insurance is for your car or bike what health insurance is for your health.It is a general
insurance cover that offers financial protection to your vehicles from loss due to accidents,
damage, theft, fire or natural calamities.You can also get motor insurance for your
commercial vehicles.

In India, you cannot drive or ride without motor insurance.

Let’s look at the two key types:

1. Car Insurance

It’s precious—your car. You paid lakhs of rupees to buy that beauty. Even a single scratch
can be painful, forget about bigger damages. Car insurance can reduce this pain for a few
thousand rupees.

How it works:

What the insurer will pay for depends on the type of car insurance plan you purchase

2. Two-wheeler Insurance

This is your bike’s guardian angel. It’s similar to Car insurance.You cannot ride a bike or
scooter in India without insurance.

How it works:

As with car insurance, what the insurer will pay depends on the type of insurance and what it
covers.

Types of Motor Insurance:

Third Party Insurance Comprehensive Car Insurance

Compensates for the damages

Covers all kinds of damages and liabilities caused to you or a
caused to another individual,
third party. It includes damages caused by accidents, sabotage,
their vehicle or a third-party
theft, fire, natural calamities, etc.
property.

You can increase your insurance protection with these Add-on covers for your car and bike
insurance:

Travel insurance

A travel insurance compensates you or pays for any financial liabilities arising out of medical
and non-medical emergencies during your travel abroad or within the country.
There are two types of Travel Insurance.
Single Trip Policy Annual Multi Trip

It covers you during a trip that lasts

It covers you for several trips you take within a year.
under 180 days.

What all does travel insurance usually cover?

 Loss of baggage
 Emergency medical expenses
 Loss of passport
 Hijacking
 Delayed flights
 Accidental death

Home Insurance

Home insurance is a cover that pays or compensates you for damage to your home due to
natural calamities, man-made disasters or other threats.
It covers liabilities due to fire, burglary, theft, flood, earthquakes, and sabotage. It not only
offers financial protection to your home, but also takes care of the valuables inside the
property.
Some of the common types of home insurance are:

This covers your home against fire outbreaks and special perils.
The dangers covered are:
- Natural calamities like lightening, flood, storm, earthquake, etc.
Standard fire and
- Damage caused due to overflowing or bursting of water tanks,
special perils policy
pipes, etc.
- Damage caused due to man-made activities such as riots, strikes,
etc.

This protects the structure of your home from any kinds of risks and
Home structure damages.
insurance The cover is also extended to the permanent fixtures within the house
such as kitchen and bathroom fittings.

Public liability The damage caused to another person or their property inside the
coverage insured home can also be compensated.

This covers the content inside the insured home.

Content Insurance What’s commonly covered: Television, refrigerator, portable
equipment, etc.

Fire Insurance

Fire insurance pays or compensates for the damages caused to your property or goods due to
fire.It covers the replacement, reconstruction or repair expenses of the insured property as
well as the surrounding structures.It also covers the damages caused to a third-party property
due to fire.In addition to these, it takes care of the expenses of those whose livelihood has
been affected due to fire.

Types of fire insurance

Some of the common types are:

The insurer firsts value the property and then undertakes to pay
Valued policy
compensation up to that value in the case of loss or damage.

Floating policy It covers the damages to properties lying at different places.

This is known as an all-in-one policy.

Comprehensive
It has a wide coverage and includes damages due to fire, theft,
policy
burglary, etc.

This covers you for a specific amount which is less than the real value
Specific policy
of the property.

HEDGE FUND

To hedge means to safeguard, and in the context of investing, it means to protect against risks.
A hedge fund uses the funds collected from accredited investors like banks, insurance firms,
High Net-Worth Individuals (HNIs) & families, and endowments and pension funds. This is
the reason why these funds often function as overseas investment corporations or private
investment partnerships. They do not need to be registered with SEBI, nor do they need to
disclose their NAV periodically like other mutual funds.

A hedge fund portfolio consists of asset classes such as derivatives, equities, bonds,
currencies, and convertible securities. Hence, they are also considered as alternative
investments. As a collection of assets that strives to ‘hedge’ risks to investor’s money against
market ups and downs, they need aggressive management. Unlike the typical equity mutual
fund, they tend to employ substantial leverage. They hold both long and short positions,
including positions in listed and unlisted derivatives.

Hedge funds are mutual funds that are privately managed by experts. For this reason, they
tend to be a bit on the costlier side. Hence, they are affordable and feasible only for the
financially well-off. You not only have to be someone with surplus funds, but also an
aggressive risk-seeker, this is because the manager buys and sells assets at dizzying speed to
keep up with the market movements.

As you know, higher the structural complexity, more the risks. Hence, the expense ratio (fee
to the fund manager) is way more for hedge funds than regular mutual funds. It can range
from 15% to 20% of your returns. So, we recommend first-time depositors to steer clear from
these funds until you gain considerable experience in the field. Even then, it all depends on
the fund manager. Therefore, unless you have full faith in your fund manager, investing in
hedge funds can give you sleepless nights.

MUTUAL FUNDS

A Mutual Fund (MF) is formed when capital collected by various investors is invested in
purchasing company shares, stocks, or bonds. Shared by thousands of investors, mutual funds
investments are collectively managed by a professional fund manager to earn the highest
possible returns. This is how mutual funds work, not only in India but, anywhere in the world.

Investing in Mutual Funds is the easiest way to grow your wealth. The fund manager’s
expertise is an important factor to consider while choosing the fund. All Mutual Funds are
registered with the Securities Exchange and Board of India (SEBI) and hence, your
investment is safe.

Mutual funds are broadly classified into three categories based on their investment traits and
risks involved. Understand all mutual fund types and analyse them to check if your
requirements would be served by investing in a particular type of mutual fund. Following are
the types of mutual funds:

Equity Funds

Equity funds primarily invest in shares of different companies. Your equity funds investment
would make a profit when the share prices surge, while they suffer a loss when the share
prices fall. Investing in equity funds is apt for those who stay invested for an extended period
and are comfortable with moderate to high risk.

Debt Funds

Debt funds primarily invest in fixed income government securities such as treasury bills and
bonds, or reputed corporate deposits. Investing in debt funds is less risky than equity funds.
Debt Funds are apt for those who are risk-averse and looking for a short-term investment.

Balanced or Hybrid funds

As the name suggests, balanced or hybrid funds invest in both equity and debt instruments to
balance the risk and maintain a specific rate of return. The fund manager decides the ratio to
reap the best of both debt and equity instruments.

PENSION

Planning for retirement is a crucial aspect of everybody’s lives. Considering the rising
inflation level and limited social security initiatives for senior citizens, it is vital that you start
planning your retirement early. Pension or retirement plans offer the dual benefit of
investment and insurance cover. By investing a certain amount regularly towards your
pension plan, you will accumulate a considerable sum in a phase-by-phase manner. This will
ensure a steady flow of funds once you retire. Public Provident Fund is one of the most
popular retirement planning schemes in India.
When you start contributing to your retirement early, the funds build a secure golden year
money-wise over the years. A well-chosen retirement plan can help you rise above inflation,
thanks to the power of compounding.

Every individual should invest in pension plans to secure their retired life financially. Section
80C of the Income Tax Act, 1961, covers several retirement plans and taxpayers are eligible
for tax deductions of up to Rs.1.5 lakh.

Example:

Priyanka is 32 years old with an expected lifespan of 80 years. Her current salary is Rs.50,000
and she wishes to retire at the age of 60. She is looking for a monthly pension of Rs.30,000
post-retirement. How much do you think she should invest until the age of 60 to meet her
investment goals?

Priyanka will need a corpus of Rs.4.05 crores to receive an income of Rs.30,000. Let us
assume a long-term return of 12% till age 60 and 5% after that, with 6% inflation rate. Based
on these figures, she must invest Rs.14,820 monthly for the next 28 years. If all goes
according to plan, Priyanka is going to lead financially secure golden years. You may also use
this retirement planning calculator to arrive at a number.

ANNUITY

An annuity is a contract aimed at generating steady income during retirement, where in lump
sum payment is made by an individual to obtain certain amounts immediately or at some
point of future.

How Does An Annuity Work

 The individual begins by making a lumpsum investment in the annuity plan.

 The annuity then makes payments to the individual on a future date or series of dates.
The income can be doled out monthly, quarterly, annually or even as a lump sum
payment.
 The income payout is determined by a number of factors, including the tenure of the
annuity.
 The individual can opt to receive the income payments for the rest of his life or for a
fixed period of time.
 The income depends on whether he has opted for a guaranteed payout (fixed annuity) or
a payout stream determined by the performance of the annuity's underlying

Types Of Annuities

There are types of annuities – essentially two ways in which the individual receives the
annuity payout:

Immediate annuity

The investor begins to receive payments soon after the initial investment. This is ideal for
someone approaching retirement age.

Investment

Deferred annuity

In this type , money gets accumulated and is paid as a lump sum in future date or as a stream
of payments spread over a period or a stream of payments over a life time.Many times it
includes the life of the survivor spouse as well.

Ordinary annuities

An ordinary annuity makes (or requires) payments at the end of each period. For example,
bonds generally pay interest at the end of every six months.

Annuities due

With an annuity due, by contrast, payments come at the beginning of each period. Rent,
which landlords typically require at the beginning of each month, is a common example.
FUTURE VALUE OF ANNUITY

Calculation of FV in manual method

Year 2015 2016 2017 2018 2019

1st 31st 1st 31st 1st 31st 1st 31st 1st 31st
Future Value of Annuity April Mar April Mar April Mar April Mar April Mar
Ordinary Annuity 100 100 100 100 100
FV Growth Period(years) 4 3 2 1 0
Annuity Due 100 100 100 100 100
FV Growth Period(years) 5 4 3 2 1
FV of Ordinary
Annuity=100*(1.08^4)+100*(1.08^3)+100*(1.08^2)+100*(1.08^1)+100*(1.08^0)=586.66
FV of Annuity
Due=100*(1.08^5)+100*(1.08^4)+100*(1.08^3)+100*(1.08^2)+100*(1.08^1)=633.59

The above values can also be calculated using formulae:

Future Value of an ordinary annuity=FV

=A*[ (1+r)^n - 1)]/r
=100*(1.08^5-1)/0.08=586.66

Future Value of an annuity due=FV

=A*[(1+r)^n -1]*(1+r)/r
=100*(1.08^5-1)*1.08/0.08=633.59

The above values can also be calculated using annuity Table:

Future Value of an ordinary annuity= A*Ordinary Annuity FV factor(n=5,r=8%)=

Future Value of an annuity due=A*Annuity due FV factor(n=5,r=8%)=

PRESENT VALUE OF ANNUITY

Year 2015 2016 2017 2018 2019

1st 31st 1st 31st 1st 31st 1st 31st 1st 31st
Present Value of Annuity April Mar April Mar April Mar April Mar April Mar

Ordinary Annuity 100 100 100 100 100

PV Discount Period(years) 1 2 3 4 5
Annuity Due 100 100 100 100 100
PV Discount Period(years) 0 1 2 3 4
PV of Ordinary
Annuity=100/(1.08^1)+100/(1.08^2)+100/(1.08^3)+100/(1.08^4)+100/(1.08^5)=399.27
PV of Annuity Due=100+100/(1.08^1)+100/(1.08^2)+100/(1.08^3)+100/(1.08^4)=431.21
The above values can also be calculated using formulae:

Present Value of an ordinary annuity=PV=

PV= A*[ (1+r)^n -1]/[(1+r)^n* r]
=100*(1.08^5-1)/(1.08^5*0.08)=399.27

Present Value of an annuity due=PV=

=A*[(1+r)^n - 1]*(1+r)/[(1+r)^n)*r]*(1+r)
=100*(1.08^5-1)/(1.08^5*0.08)*(1.08)=431.21

The above values can also be calculated using annuity Table:

Present Value of an ordinary annuity= A*Ordinary Annuity PV factor(n=5,r=8%)=

Present Value of an annuity due=A*Annuity due PV factor(n=5,r=8%)=

GROWING ORDINARY ANNUITY

Year 2015 2016 2017 2018 2019

Future Value of Growing 1st 1st 1st 1st 1st 31st
Annuity April 31st Mar April 31st Mar April 31st Mar April 31st Mar April Mar
Ordinary Annuity 100 100 100 100 100
Growing Annuity @6% 100.00 106.00 112.36 119.10 126.25
FV Growth Period(years) 4 3 2 1 0
FV of Ordinary Annuity
(growing)=100*(1.08^4)+106*(1.08^3)+112.36*(1.08^2)+119.10*(1.08^1)+126.25*(1.08^0)=655.51

Year 2015 2016 2017 2018 2019

Present Value of Growing 1st 1st 1st 1st 1st 31st
Annuity April 31st Mar April 31st Mar April 31st Mar April 31st Mar April Mar
Ordinary Annuity 100 100 100 100 100
Growing Annuity @6% 100.00 106.00 112.36 119.10 126.25
PV Discount Period(years) 1 2 3 4 5
PV of Ordinary
Annuity(growing)=100/(1.08^1)+106/(1.08^2)+112.36/(1.08^3)+119.10/(1.08^4)+126.25/(1.08^5)=446.13

The above values can also be calculated using formula:

FV = A x [ (1 + r)^n - (1 + g)^n ] / (r-g)

=100*(1.08^5-1.06^5)/(0.08-0.06)
=655.51
PV =A*(1-((1+g)/(1+r))^n)/(r-g)
=100*(1-(1.06/1.08)^5)/(0.08-0.06)
=446.13
PERPETUITY

Although perpetuity is somewhat theoretical (can anything really last forever?), classic
examples include businesses, real estate, and certain types of bonds.

One of the examples of a perpetuity is the UK’s government bond that is known as a
Consol. Bondholders will receive annual fixed coupons (interest payments) as long as they
hold the amount and the government does not discontinue the Consol.

The second example is in the real-estate sector when an owner purchases a property and then
rents it out. The owner is entitled to an infinite stream of cash flow from the renter as long as
the property continues to exist (assuming the renter continues to rent).

Another real-life example is preferred stock, where the perpetuity calculation assumes the
company will continue to exist indefinitely in the market and keep paying dividends.

Present Value of a Perpetuity=PV

=A/r
=100/0.08=1250

Present Value of a constantly growing Perpetuity=PV

=A/(r-g)
=100/(0.08-0.06)=5000

SOLVED -PROBLEMS ON ANNUITY

1.What is the future value (as of 10 years from now) of an annuity that makes 10 annual
payments of Rs. 5,000, if the interest rate is 7% per year compounded quarterly?
Ans: 286,170.67

Solution:

Future Value of an ordinary annuity=FV

=A*[ (1+r)^n - 1)]/r
Here A=5000
r= 7/4=1.75%
n= 10*4=40
FV=5000*(1.0175^40-1)/0.0175= 286,170.67

2. Suppose that you start a savings plan by depositing Rs. 1,000 at the beginning of every
year into an account that offers 8% per year. If you make the first deposit today, and then
three additional ones, how much will have accumulated after four years?
Ans : 4863.60

Solution:

Future Value of an annuity due=FV

=A*[(1+r)^n -1]*(1+r)/r=1000*(1.08^4-1)*(1.08)/0.08=4866.60
This problem cal also be solved using the Annuity Table.
3. If at the end of each year a deposit of Rs. 500 is made in an account that pays 8%
compounded half yearly, what will the final amount be after five years by factor formula and
table?
Ans: 6003.0

Solution:

Future Value of an annuity=FV

=A*[(1+r)^n -1]/r
Here , A=500
r= 8/2=4%
n=5*2=10 half years
FV=500*(1.04^10-1)/0.04=6003.05

4. Your client is 40 years old and wants to begin saving for retirement. You advise the client
to put Rs. 5,000 a year into the stock market. You estimate that the market’s return will be
on average of 12% a year. Assume the investment will be made at the end of the year. How
much money will she have by age 65?
Ans:666,670.00

Solution:

Future Value of an annuity =FV

=A*[(1+r)^n -1]/r
Here , A=5000
r=12%
n=(65-40)=25 years
FV=5000*(1.12^25-1)/0.12=666,670.00

5. If you put Rs. 100 in the market at the end of every year for 20 years at 10%, how much
would you end up with? What if you put the Rs. 100 in at the beginning of every year?
Ans: 5,727.50/6,300.25

Solution:

Future Value of an annuity =FV

=A*[(1+r)^n -1]/r
Here , A=100
r=10%
n=20 years
FV=100*(1.10^20-1)/0.10=5,727.50

In the second case, it is an Annuity due

Future Value of an annuity due =FV

=A*[(1+r)^n -1]*(1+r)/r
=100*(1.10^20-1)*(1.10)/0.10=6,300.25

6. You decide to work for next 20 years before an early-retirement. For your
post-retirement days, you plan to make a monthly deposit of Rs. 1,000 into a retirement
account that pays 12% p.a. compounded monthly. You will make the first deposit one
month from today. What will be your account balance at the end of 20 years?
Ans: 572,749.99

Solution:

Future Value of an annuity =FV

=A*[(1+r)^n -1]/r
Here , A=1000
r=12/12=1% per month
n=20 years=20x12=240 months
FV=1000*(1.01^240-1)/0.01=989255.35

7. You are making car payments of $315/month for the next 3 years, you know that your car
loan has an interest rate of 12.4%, discounted monthly, what was the initial price of the car?
Ans: 9,429.53

Solution:

Present Value of an ordinary annuity=PV=

PV= A*[ (1+r)^n -1]/[(1+r)^n* r]
Here A=315
r=12.4/12=1.0333
N=3x12 months=36 months
PV=315*(1.010333^36-1)/(1.010333^36*0.010333)=9,429.58

8. What is the present value of an annuity of $2,000 per year, with the first cash flow
received three years from today and the last one received 8 years from today? Use a
discount rate of eight percent.
Ans: 7,926.75

Solution:

Present Value of an ordinary annuity=PV=

PV= A*[ (1+r)^n -1]/[(1+r)^n* r]
PV at the beginning of the 3rd years=2000*(1.08^6-1)/(1.08^6*0.08)=9245.75
PV = 9245.75/(1+r)^2=9245.75/(1.08^2)=7,926.74

9. Mr. Mohammad Ali has received a job offer from a large investment bank as an
accountant. His base salary will be $35,000 constant to date of retirement. He will receive
his first annual salary payment one year from the day he begins to work. In addition, he will
get an immediate $10,000 bonus for joining the company. Mr. Ali is expected to work for
25 years. What is the present value of the offer if the discount rate is 12 percent?
Ans: 284,509.87

Solution:

Present Value of an ordinary annuity in this case=PV=

= A*[ (1+r)^n -1]/[(1+r)^n* r] + 10000 ( because he gets 10000 at the beginning of the first
year)
PV=35000*(1.12^25-1)/(1.12^25*0.12)+10000=284,509.9
10. A 10-year annuity pays $900 four times in year. The first $900 will be paid five years
from now. If the stated interest rate is eight percent, discounted quarterly, what is the
present value of this annuity?
Ans: 12,400

Solution:

Present Value of an ordinary annuity=PV=

= A*[ (1+r)^n -1]/[(1+r)^n* r]
In the above case, A=900
r=8/4=2% per quarter
n=period=6yearsx4=24 quarter
Present value at the beginning of 4th year=900*(1.02^24-1)/(1.02^24*0.02)=17022.53
This amount has to be discounted by 3 years i.e. 12 quarter.
Present Value=14716.3/(1+r)^n=17022.53/(1.02)^12=12,400.

11. You have won the lottery! The lottery officials offer you two choices for collecting
your winnings. You may take four payments of $250,000 over the next four years or, you
may take a one-time payment of $750,000 today. If the interest rate is 10% annual
compounding , which would you take?
Ans: 792,466.36

Solution:

Present Value of an ordinary annuity=PV=

= A*[ (1+r)^n -1]/[(1+r)^n* r]
=250000*(1.10^4-1)/(1.10^4*0.10)=792,466.36
So the instalment payment is a better option.

12. Now that you are finished school, you also have to start paying back your student loans.
You borrowed a total of Rs. 12,500. You plan to pay back the loan over 10 years at an interest
rate of 9.4% interest, compounded monthly. How much will your monthly payments be?
Ans: 161.06

Solution:

Present Value of an ordinary annuity=PV=

= A*[ (1+r)^n -1]/[(1+r)^n* r]
Here the PV amount = 12500
n= 10x12=120 months
r=9.4/12=0.7833
So, 12500=A*(1.007833^120-1)/(1.007833^120*0.007833)=77.61A
Or, A=Monthly instalment=12500/77.61=161.06

13. A firm wants to open a new coal mine. The price of coal is very volatile and the projected
profits over the next five years are : Rs. 100,000 , Rs. 250,000 , Rs. 10,000 , Rs.
200,000 and Rs. 50,000 respectively. After that profits will be a constant Rs. 150,000 per
year for next 20 years at which time the mine closes. If 7% is the appropriate discount rate for
the first five years and is 8% after that, what is the present value of the mine?
Ans: 1,558,234.4
Solution:
PV of the cash flow for the first five years=

=100000/(1.07^1)+250000/(1.07^2)+10000/(1.07^3)+200000/(1.07^4)+50000/(1.07^5)

= 508208.95

PV of the cash flow of the next 20years at beginning of 6th yea

r= A*[ (1+r)^n -1]/[(1+r)^n* r]
=150000*(1.08^20-1)/(1.08^20*0.08)
=1472722.11
PV of the above amount= 1472722.11/(1.07^5)=1050030.51

Total PV=508208.95+=1050030.51=1558239.46

14.Suppose you have just won the first prize in a lottery. The lottery offers you two
possibilities for receiving your prize. The first possibility is to receive a payment of $10,000
at the end of the year, and then, for the next 15 years this payment will be repeated, but it will
grow at a rate of 5%. The interest rate is 12% during the entire period. The second
possibility is to receive $100,000 right now. Which of the two possibilities would you take?
In case the annuity payment is made at the beginning of the years , will your decision change?

Solution:

PV of a growing annuity=A*(1-((1+g)/(1+r))^n)/(r-g)
A=10000
n= 16
g=5%
R=12%
(1+g)/(1+r)=1.05/1.12=0.9375
PV=10000*(1-0.9375^16)/(0.12-0.05)=91989.41
So it is a better option to go for a lump sum payment now.
In case the payment start at the beginning of the year=PV=91989.41*1.12=103028.13
In such a case taking installment payment will be better.

15.What would you be willing to pay (given that you could live forever, and hence could
receive all the cash flows) for a preferred share of stock in the University of Pittsburgh, that
promises you to pay a cash dividend to you at the end of the year of $25, which will increase
every year by 1%, forever. The interest rate is fixed at 4.75%. What would you be willing to
pay if the share of stock paid out its first $25 right now, and everything else being the same?

Solution:

PV of a perpetuity= A/(r-g) = 25 / (0.0475 - 0.01) = $666.67

PV of a perpetuity= A/(r-g)+25=[(25 * 1.01) / (0.0475 - 0.01)] + 25 = $673.33 + $25 =

$698.33
Other Points:

In annuity problems , if there is compounding other than annual , first convert that to
Effective Annual Rate and then calculate the rate as per the frequency of payment (Monthly ,
Quarterly , Half yearly etc)

Example:

Ram deposits 100/- every month for two years and the amounts are compounded quarterly
Interest Rate is 12% per annum. What will be the Final Value?
.
Solution : A= 100 , n=2*12=24
Effective Interest Rate=(1.02^12-1)=12.68%
r=12.68/12=1.05666
FV of the Annuity=100*(1.0105666^24-1)/(0.0105666)=2715.54