Finance Module

Time Value of Money

Q1. A bank is offering a simple annual interest rate of 15% compounded monthly for its monthly recurring deposit. What is the effective yield? What would have been the yield if the interest would have been compounded quarterly and semi-annually respectively?
Ans1-Effective yield in simple terms is how much total interest we would earn assuming that if reinvest our earnings. For example if a bond pays us 6% semi-annually on a face value 100,the return after an year will be greater than 6%(semi-annual) because of the compounding.

Formula= [1+(r/n)]^n-1

a)-when calculated monthly

r=15% n=12

[1+(r/n)]^n-1
Step 1 Step 2 Step 3 Step 4 Answer r/n 0.0125 1 + r/n 1.0125 (1 + r/n)^n 1.160755 (1 + r/n)^n-1 0.160755 16.08%

b)-when calculated quaterly

r=15% n=4

[1+(r/n)]^n-1
Step 1 Step 2 Step 3 Step 4 Answer r/n 1 + r/n (1 + r/n)^n (1 + r/n)^n-1 15.87% 0.0375 1.0375 1.15865 0.15865

c)-when calculated Semi-annually

r=15% n=2

[1+(r/n)]^n-1
Step 1 Step 2 Step 3 Step 4 Answer r/n 0.075 1 + r/n 1.075 (1 + r/n)^n 1.155625 (1 + r/n)^n-1 0.155625 15.56%

So at the end one thing which we see is that as the number of months for compounding increases, the effective yield which we earn increases (Direct relationship between number of months and effective yield) Answer a)Monthly compounding-16.08% b)quarterly compounding-15.87% c)Semi-annually compounding- 15.56%

Q2. If however, the effective annual interest rate offered by the bank is 15% per year, what is the nominal annual interest rate under monthly compounding?
Ans2-This question is just the opposite of the 1st question. In this question we have effective annual rate(EAR) and we need to calculate the nominal interest rate.

FormulaEffective annual interest rate= [1+(Nominal Interest Rate/n)^n]-1

The working is as follows

EAR=15% n=12 r=? EAR=[1+(r/n)]^n-1 Step 1 Step 2 step 3 step 4 Answer EAR + 1 (EAR + 1)^1/n (EAR + 1)^(1/n) - 1 {(EAR + 1)^(1/n) - 1} * n 14.06% 1.15 1.011715 0.011715 0.140579

Q3- If you put Rs. 10,000 in a savings scheme today at 10%, how much would you end up within 20 years?
Ans3Formula =Principal(1 + r%)^n

P=10,000 n=20 r=10% FV=P(1+R%)^n Step 1 Step 2 step 3 1+r% (1+r%)^n (1+r%)^n*P 1.1 6.7275 67,275

Answer

67275.00

Q4- Suppose you would be having Rs. 1,00,000 10 years from now at 8%. How much is it worth today? What is its worth today if the amount is Rs 1,00,000 8 years from now at 10%
Ans 4Formula FV=PV(1+r)^n
FV @ 10 years=1,00,000 r=8% n=10 years PV=? FV=PV(1+r)^n Part a Step 1 Step 2 (1 + r)^n FV/[(1+r)^n] 2.158925 46319.35

Answer Part b FV @ 8 years=1,00,000 r=10% n=8 years PV @ 8 years Step 1 Step 2 Answer

46319.35

(1 + r)^N-n FV@10/(1 + r)^N-n 46650.74

2.143589 46650.74

Q5- Suppose there are two options of savings schemes you can invest in. Scheme A is offered by a bank in which you can put Rs 50,000 at 10% for 15 years. Scheme B offered by a post office savings scheme offers 13% for 21 years for the same Rs 50,000. Which savings scheme would you prefer to invest in?
Ans5-In this question we will compare the FV of both the Schemes A and B, and whichever Scheme gives higher FV. We will invest in it.

Scheme A

Scheme B

Q6- If you borrow Rs. 2,00,000 for a car loan at a 14% simple annual interest rate, what would be your monthly payment on a 5 year loan? If the interest is compounded annually what is your monthly interest payment?
Ans6Simple Interest Amount=P(1+rt/100) Annual Inst=Amt/no of years

P=2,00,000 i=14% t=60 Amount=P(1+rt/100) Step 1 Step 2 Installment (1+rt/100) p*(1+rt/100) {p*(1+rt/100)}/t 1.7 340000 5666.667

Compound Interest

Q7- You are getting payments of Rs 8000 at the beginning of every year and they are to last another five years. At 6%, what is the value of this annuity?
Ans7-

Pmt=8000 n=5 years r=6% At time t0 t1 t2 t3 t4 Pmt 8000 8000 8000 8000 8000 PV of Pmt 8000 7547.17 7119.972 6716.954 6336.749 35720.84

Answer

35720.845

Q8- If you put Rs. 5000 in the market at the beginning of every year for 20 years at 10%, how much would you end up with? What if you put the Rs. 5000 in at the end of every year?
Ans8-

Part a Pmt t r

Beginning 5000 20 10%

jasdeep:In calculating the FV of beginning Pmt,there will be an extra compounding,when comapred to ending Pmt.

Time @beg t1 t2 t3 t4 t5 t6 t7 t8 t9 t10 t11 t12 t13 t14 t15 t16 t17 t18 t19 t20

Pmt 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

(1+r)^t 6.7275 6.115909 5.559917 5.05447 4.594973 4.177248 3.797498 3.452271 3.138428 2.853117 2.593742 2.357948 2.143589 1.948717 1.771561 1.61051 1.4641 1.331 1.21 1.1

FV 33637.5 30579.55 27799.59 25272.35 22974.86 20886.24 18987.49 17261.36 15692.14 14265.58 12968.71 11789.74 10717.94 9743.586 8857.805 8052.55 7320.5 6655 6050 5500 315012.5

20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1

Answer

315012.4972

Part b Pmt t r

Beginning 5000 20 10%

Time @end t1 t2 t3 t4 t5 t6 t7 t8 t9 t10 t11 t12 t13 t14 t15 t16 t17 t18 t19 t20

Pmt 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

(1+r)^t 6.115909 5.559917 5.05447 4.594973 4.177248 3.797498 3.452271 3.138428 2.853117 2.593742 2.357948 2.143589 1.948717 1.771561 1.61051 1.4641 1.331 1.21 1.1 1

FV 30579.55 27799.59 25272.35 22974.86 20886.24 18987.49 17261.36 15692.14 14265.58 12968.71 11789.74 10717.94 9743.586 8857.805 8052.55 7320.5 6655 6050 5500 5000 286375

19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Answer

286374.9975

Q9-You are considering the purchase of two different insurance annuities. Annuity A will pay you Rs 16,000 at the beginning of each year for 8 years. Annuity B will pay you Rs 12,000 at the end of each year for 12 years. Assuming your money is worth 7%, and each costs you Rs 75,000 today, which would you prefer?
Ans9-In this question we can not compare the PV of both the annuities because of the unequal lives. So we will use the LCM of the lives for both the annuities . LCM of lives=24 years In question we assume that we reinvest annuity A thrice (8 x 3=24 years) and reinvest annuity B(12 x 2=24 years) twice . And whichever has a highest PV after reinvestment , we will select that annuity.

Annuity A Cost at t0= Rs 75,000 Pmt=Rs 16,000 T @ beg=8 years R=7% Here we have the PV if we reinvested it thrice at t=16 . PV at t0=9,223

3rd reinvestment

2nd reinvestment

Here we have the PV if we reinvested it twiceat t=8 PV at t0=13,614

1st investment

Here we have the PV at t0,no further discounting needed. PV at t0=27,229

Total Pv = 9,223 + 13,614 + 27,229 = 50,066

Annuity B Cost at t0= Rs 75,000 Pmt=Rs 12,000 T @ end=12 years R=7%

Here we have the PV if we reinvested it thrice at t=16 .

2nd PV at t0=9,019 reinvestment

Here we have the PV if we reinvested it twiceat t=8 PV at t0=20,312 2nd reinvestment

Total Pv = 9,019 + 20,312= 29,330 So we should select annuity A(50,066) as it gives us higher PV than annuity B(29,330).

Q10-If you want a Rs. 81,00,000 for retirement in 30 years, how much would you have to save by the end of each year if you could make 10% per year? How much would you have to set aside each year if you could put money away starting now?

A10Part a fv=8,100,000 t=30 years r=10% Pmt=? At end

fv=pmt1(1+r)^30 + pmt2(1+r)^29 ++ pmt(1+r)^n Solving for pmt Answer pmt=Rs49,242

Part a fv=8,100,000 t=30 years r=10% Pmt=?

At beg
jasdeep:when we are calculating pmt at beg, we will have an extra compounding, as compared to pmt at end.

fv=pmt1(1+r)^31 + pmt2(1+r)^30 ++ pmt (1+r)^n Solving for pmt Answer pmt=Rs44,765

Q11-If you are to live 20 years after the retirement, how much you would be able to draw each year if you draw the money at the beginning of the year? (Assume you have been able to save the Rs 81,00,000 you wanted to save at the time of retirement)
Ans11Pv=8,100,000 N=20 years @ beg R=10% Pmt (each year withdrawal)=? It is the same way as calculating the pv of all the payments if we pay at beg for 20 years. So PV of all the PMTs should equal to 8,100,000.

PMT=864,930
Proving as under
At t 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Yearly payment 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 864929.96 Discounting factor 0.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.14 2.36 2.59 2.85 3.14 3.45 3.80 4.18 4.59 5.05 5.56 6.12 PV of all the payments Discounted PMT 864929.96 786299.9636 714818.1488 649834.6807 590758.8006 537053.4551 488230.4137 443845.8307 403496.2097 366814.7361 333467.9419 303152.6745 275593.3404 250539.4004 227763.0913 207057.3557 188233.9597 171121.7816 155565.256 141422.96 8100000

0 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

We would be able to withdraw Rs 864,930 for next 20 years.

Q-12 You can deposit $4000 per year into an account that pays 12% interest. If you deposit such amounts for 15 years and start drawing money out of the account in equal annual installments, how much could you draw out each year for 20 years?
Ans-12 PV=$4000 R=12% N=15 years Step1-Calculate FV of $4000 at T15

Fv=4000(1.12)^15 =21,894.26 Now this Fv will be our PV and we will calculate PMT(the amount which we can withdraw each year). Assuming withdrawals are year end. We can withdraw Rs2931.17 for 20 years. Pv of Rs 2931.17 will be equal to 21,894.26.Working as followsPMT 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 2931.17 T 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Discounting factor 1.12 1.25 1.40 1.57 1.76 1.97 2.21 2.48 2.77 3.11 3.48 3.90 4.36 4.89 5.47 6.13 6.87 7.69 8.61 9.65 Pv of PMT 2617.12 2336.71 2086.35 1862.81 1663.22 1485.02 1325.91 1183.85 1057.01 943.76 842.64 752.36 671.75 599.78 535.51 478.14 426.91 381.17 340.33 303.86 21894.21

Q13-If you put Rs. 10,000 in the stock market, how many years would it take you to triple your money if the market is making 14% a year?
Ans13Pv= Rs 10,000 Fv= Rs 30,000 r = 14% n=? Fv=pv(1+r)^n 30,000=10,000(1.14)^n

N=8.38 years
Proving:
Fv=pv(1+r)^n fv=Rs 30,000 pv= Rs 10,000 r = 14% n=8.38 Step 1 Step 2 (1+r)^n P * (1+r)^n 2.99821 Approx= 29982.1418 Rs 30,000

Q14- Ramesh will receive Rs.25000 & Rs. 15000 at the end of 14 & 15 year respectively. If the rate of return is 6%. Compute the present value of the amount.
Ans14Fv at 14= Rs25,000 Fv at 15= Rs15,000

Fv at 14= 25,000 Fv at 15= 15,000 r=6% Discounting factors Pv of 14 2.26 of 15 2.40 11057.52 6258.98 17316.50

Answer Pv=Rs 17,316.50

Q-15 An investment that Kiran is considering offers the following cash flows given below: What is the internal rate of return that this investment offers?

Ans-15 Initial investment=Inflow at 1/(1+r) + Inflow at 2/(1+r)^2 +...+ Inflow at n/(1+r)^n IRR=11.64%

AMT -10,000 2,000 1,500 -5,000 2,000 2,200 1,500 1,000 1,200 17,000

IRR

11.64%

Case study

Q1- What are the areas of financial concerns that the Seymores are currently facing?
Ans1-Currently Seymores are not facing any financial concerns. Their children are small, they may have financial difficulties arranging funds for their children but currently they are not in any excess funds. Also we see that Johns mother is ill may need to move in the future, currently she is managing on her own. So this also not an area of concern. Then we see Lily is also sending her parents money, which she is able to afford with her current salary (no reference is given that she is not able to fund her parents)

Q2- The Seymores are making some financial decisions that will help them in the future. In your estimation, what are the sound decisions theyve already made?

Some of the sound financial decisions taken by the Seymores are-

A)They already own a house, so they dont have to pay rent which can be cumbersome to support with other major expenses. B)They have Rs 500,000 as saving which will help them during the rainy days.
c) They are also invested in their new pension scheme at their respective working places, which will provide funds in the future plus accrued interest.

d)Mrs Lilly is pursuing her doctorate which is a professional stream, and after attaining such education she can become a lecturer in reputed institute like LBSIM which will provide good salary to her.

Q3-College education is increasing at a rate of 3% per year. If college cost is running at Rs 10,00,000 for a 4-year course today, what will the Seymores need to have saved up for Lucy in 11 years and for Joe in 16 years? Assume that the Seymores are in the 30% tax bracket. You can assume that the Seymores earn 9% on their investments. Assume that the Seymores can only save Rs 5000 a month towards each childs educational funding. Is this amount of savings per month sufficient? Ans3-

For Lucy
Current college cost= Time lest for lucy to join college= r= College cost at the end of 11 years= Net savings after deducting tax= r on savings= Number of months= fv of annuity= 10,00,000 11 years 0.0300 Rs. 13,84,233.87 5000 0.53% 132 Rs. 9,48,651.34

For Joe
Current college cost= Time lest for lucy to join college= r= College cost at the end of 11 years= Net savings after deducting tax= r on savings= Number of months= fv of annuity= 10,00,000 16 years 0.0300 Rs. 16,04,706.44 5000 0.53% 192 Rs. 16,50,380.71

So we can conclude that for JOE they will be able to save.

Q4-What is the opportunity cost for the family while Lily is pursuing her Doctorate in Psychology? Ans4-The opportunity cost of the family while Lily is pursuing her Doctorate in Psychology is lily could have worked full time and earned a lot more income. Which her family could have invested some where else and earned good return.

Capital Budgeting
Q1- Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:
Project A Project B Year Cash Flow Cash Flow 0 ($100,000) ($100,000) 1 39,500 0 2 39,500 0 3 39,500 133,000

Ans1One way to do the problem Here we can select a project by calculating IRR but as we have give that these projects are mutually exclusive, we need to calculate NPV. But we are no provided with rate of interest, so the answer is inconclusive. As we can have a problem of multiple IRR Second way if we rely on IRR
Project A Cash Flow -1,00,000 39,500 39,500 39,500 8.99% Project B Cash Flow -1,00,000 0 0 1,33,000 9.97%

Year 0

1 2
3 IRR

. So we should select project B as it has a higher IRR (9.97%) vs project A (8.99).

Q2- Plan Ltd is considering to purchase a new equipment to replace its existing equipment that has book value of zero and market value of Rs 7,50,000. New equipment costs Rs 45,00,000 and is expected to provide production savings and increased profits of Rs 10,00,000 per year for the next 10 years. New equipment has expected useful life of 10 years, after which its estimated salvage value would be Rs 5,00,000. Straight-line depreciation Effective tax rate: 35% Cost of capital: 14% Should Plan Ltd replace the current equipment?
Ans2-

If the NPV of the new project has a positive NPV, then we should replace the current equipment. Initial Investment= cost of new equipment cash inflow after selling the old equipment +tax to paid on cash inflow after selling old equipment. = = 45,00,000 7,50,000 + 7,50,000(.35) 44,512,500

Incremental cash flow for next 10 years=10,00,000 Terminal cash flow=Salvage value - ( salvage value - book value) x Tax rate = 5,00,000 (5,00,00 0).35 =3,25,000 Wacc=14% Working as follows

t0 t1 t2 t3 t4 t5 t6 t7 t8 t9

t10

-45,12,500 Initial investment 10,00,000 10,00,000 10,00,000 10,00,000 Incremental 10,00,000 cashflow 10,00,000 10,00,000 10,00,000 10,00,000 Initial investment and Incremental 13,25,000 cashflow

NPV=

Rs. -2,96,071.43

As we see the NPV from the new project is -2,96,071.43. According to the NPV rule we should not take this project as it has a negative NPV.