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Aim

The aim of this chapter is to:

Objectives

The objectives of this chapter are to:

Learning outcome

At the end of this chapter, you will be able to:

1/uts

Financial Management

Financial management "is the operational activity of a business that is responsible for obtaining and effectively

utilising the funds necessary for efficient operations".

Financial management is concerned with three key activities namely:

Traditionally, financial management was considered as a branch of knowledge with focus on the procurement of

funds. Instruments of financing, formation, merger and restructuring of firms, legal and institutional frame work

involved therein occupied the prime place in this approach.

Modern approach to financial management

Modern phase has shown the commendable development with combination of ideas from economic and statistics

that led the financial management more analytical and quantitative. The key work area of this approach is rational

matching of funds to their uses, which leads to the maximisation of shareholders' wealth.

Goal of financial management of a firm is maximisation of economic welfare of its shareholders. Shareholders' wealth

maximisation is reflected in the market value of the firms' shares. A firms' contribution to the society is maximised

when it maximises its value. Two widely accepted goals of financial management are:

Profit maximisation

Profit is primary motivating force for any economic activity. Firm is essentially being an economic organisation,

it has to maximise the interest of its stakeholders. To this end the firm has to earn profit from its operations. The

overall objective of business enterprise is to earn at least satisfactory return on the funds invested, consistent with

maintaining a sound financial position.

Limitations of Profit Maximisation

The term profit is vague and it doesn't clarify what exactly it means. It has different interpretations

for different people.Time value of money refers a rupee receivable today is more valuable than a

rupee, which is going to be receivable in future period. The profit maximisation goal does not help in

distinguishing between the returns receivable in different periods.The concept of profit maximisation

fails to consider the fluctuation in the profits from year to year.

Wealth maximisation:

Wealth maximisation refers to maximising the net wealth of the company's share holders. Wealth maximisation is

possible only when the company pursues policies that would increase the market value of shares of the company.

The functions performed by a finance manager are known as finance functions. In the course of following these

functions finance manager takes the following decisions:

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Financial

Decisions

Investment

Decisions

Financing

Decisions

Dividend

Decisions

Investment decisions

It begins with a determination of the total amount of assets needed to be held by the firm. It relates to the selection

of assets, on which a firm will invest funds. The required assets fall into two groups namely:

Long-term assets: This involves huge investment and yield a return over a period of time in future. It is also

termed as 'capital budgeting' and can be defined as the firm's decision to invest its current funds most efficiently

in fixed assets with an expected flow of benefits over a series of years.

Short-term assets: These are the current assets that can be converted into cash within a financial year without

diminution in value. Investment in current assets is termed as 'working capital management'.

Financing decisions

Financing decisions relate to the acquisition of funds at the least cost. The cost has two dimensions which have been

illustrated in the below mentioned table.

Explicit cost

Implicit cost

coupon rate, cost of floating and

issuing the securities and so on

but it may seriously affect the company's

operations especially when it is exposed to

business and financial risk

The challenge before the finance manager is to arrive at a combination of debt and equity for financing decisions

which would attain an optimal structure of capital.

Dividend decisions

Dividend decision is a major decision made by the finance manager on the formulation of dividend policy. Since

the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands

the managerial attention on the impact of its policy on dividend on the market value of shares. Optimum dividend

policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio

means what portion of earnings per share is given to the shareholders in the form of cash dividend.

3/uts

Financial Management

Financial management has relationship with almost all functional departments. But it has close relationship with

economics and accounting.

Relationship to economics

The relationship between finance and economics is studied under two prime areas of economics. They are

macroeconomics and microeconomics:

Macroeconomics: It is the environment in which an industry operates, which is not controllable. It is important

for financial managers to understand changes in macroeconomics and their impact on the firm's operating

performance. External environment analysis helps in identifying opportunities and threats.

Microeconomics: It is concerned with the determination of optimum operational strategies. All financial decisions

of a firm are made on the basis of marginal cost, and marginal revenue. Therefore it is necessary to understand

the relationship between finance and economics.

Relationship to accounting

Accounting and finance are closely related. For computation of return-on-investment, earnings per share of various

ratios for financial analysis, the data base will be accounting information. Without proper accounting system, an

organisation cannot administer effectively function of financial management. The purpose of accounting is to report

the financial performance of the business for the period under consideration.

Relationship to HR (Human Resource)

HR activities include recruitment, training, development, fixing compensation and so on for which we need finance.

HR managers need to consult finance managers. Finance managers take decision after studying the impact of HR

activity on organisation.

Relationship to production

Production department is another functional area that involves huge investment on fixed assets. The production

manager and the finance manager need to work closely for effective investment on plant and machinery.

Relationship to marketing

Marketing functions involves selection of distribution channel and promotion policies. These two are the primary

activities of marketing department and involves huge cash outflows. Therefore finance and marketing managers

need to work with coordination to maximise value of the firm.

Financial Planning is a process by which funds required for each course of action is decided. A financial plan has

to consider capital structure, capital expenditure and cash flow. Financial planning generates financial plan which

indicates:

Formulation of polices for giving effect to the financial plans under consideration

Develop procedures

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Formulation of policies and instituting procedures for elimination of all types of wastages in the process of

execution of strategic plans.

Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for

plant and machinery and other fixed assets.

Flexibility

Government policy

1.6 Capitalisations

Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the firm.

It has two components, viz., debt and equity.

After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive

at the value at which the company has to be capitalised. The two theories of Capitalisation are:

1.6.1 Cost Theory

According to the cost theory of capitalisation, the value of a company is arrived at by adding up the cost of fixed

assets like plants, machinery patents, the capital that regularly required for the continuous operation of the company

(working capital), the cost of establishing business and expenses of promotion. The original outlays on all these

items become the basis for calculating the capitalisation of company.

Merits of cost approach

of capital required for various activities like

incorporation of company, conducting market

surveys and so on.

inflated prices; productivity of the firm will be

less than that of the industry.

successful initiation of the working of the firm.

investors by the earnings of a company. Earning

capacity based net worth helps a firm to arrive

at the total capital in terms of industry specified

yardstick cost theory fails in this respect.

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Financial Management

The earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise depends

upon its earnings and earning capacity. According to it, the value or capitalisation of a company is equal to the

capitalised value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and

loss account. For the first few years of its life, the sales are forecast and the manager has to depend upon his/her

experience for determining the probable cost. The earnings so estimated may be compared with the actual earnings

of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study

the rate at which other companies in the same industry similarly situated are earning. The rate is then applied to the

estimated earnings of the company for finding out the capitalisation.

Merits of earnings theory

the least chances of neither under nor over

capitalisation.

deciding on capitalisation and its division thereof

into various procurement sources.

approach will make the management to be

cautious in negotiating the technology and

cost of procuring and establishing the new

business.

task because the investors' perception of established

companies cannot be really representative of what

investors perceive of the earning power of new

company.

1.7 Over-capitalisation

A company is said to be overcapitalised, when its total capital exceeds the true value of its assets. The correct

indicator of overcapitalisation is the earnings capacity of the firm. If the earnings of the firm are less then that of

the market expectation, it will not be in position to pay dividends to its shareholders as per their expectations. It is

a sign of overcapitalisation.

Effects of over-capitalisation

Market value of company's share falls, and company loses investors confidence

Restructuring the firm is to be executed to avoid the situation of company becoming sick. It involves the

following:

Initiating merger with well managed profit making companies interested in taking over ailing company

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1.8 Under-capitalisation

A company is considered to be under-capitalised when its actual capitalisation is lower than its proper capitalisation

as warranted by its earning capacity.

Causes of under-capitalisation

Maintaining very high efficiency through improved means of production of goods or rendering of services

Effects of under-capitalisation

Encouragement to competition

It encourages the management of the company to manipulate the company's share prices

High margin of profit may create among consumers an impression that the company is charging high prices

for its product

Remedies

Splitting up of the shares- This will reduce the dividend per share

Issue of bonus share This will reduce both the dividend per share and earnings per share.

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Financial Management

Summary

Financial management "is the operational activity of a business that is responsible for obtaining and effectively

utilising the funds necessary for efficient operations.

Wealth maximisation refers to maximising the net wealth of the company's share holders.

Financial Planning is a process by which funds required for each course of action is decided.

A financial plan has to consider capital structure, capital expenditure and cash flow.

Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the

firm. It has two components, viz., debt and equity.

The earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise

depends upon its earnings and earning capacity.

A company is said to be overcapitalised, when its total capital exceeds the true value of its assets.

References

Correia, C., Flynn, D. K., Uliana, E. & Wormald, M., 2012. Financial Management, 6th ed., Juta and Company

Ltd.

Financial Planning - Definition, Objectives and Importance, [Online] Available at: <http://www.

managementstudyguide.com/financial-planning.htm> [Accessed 27 May 2013].

299&substcode=19&stcode=10> [Accessed 27 May 2013].

[Accessed 27 May 2013].

2011. Financial Management - Lecture 01, [Video online] Available at: <http://www.youtube.com/

watch?v=iDlFPm3fqbs> [Accessed 27 May 2013].

Recommended Reading

Brigham, E. F., 2010. Financial Management: Theory & Practice. 13th ed., South-Western College Pub.

Shim, J. K., 2008. Financial Management (Barrons Business Library). 3rd ed., Barrons Educational Series.

Brigham, E. F., 2009. Fundamentals of Financial Management. 12th ed., South-Western College Pub.

8/uts

Self Assessment

1. Wealth maximisation refers to maximising the ___________ of the company's share

a. profit

holders

b. net wealth

c. assets

d. liabilities

2. A company is said to be ____________, when its total capital exceeds the true value of its assets.

a. under-capitalised

b. capitalised

c. overcapitalised

d. profit maximisation

3. Which of the following statements is false?

a. Capitalisation of a firm refers the composition of its short-term funds.

b. A financial plan has to consider Capital structure, Capital expenditure and cash flow.

c. Wealth maximisation refers to maximising the net wealth of the company's share holders

d. Goal of financial management of a firm is maximisation of economic welfare of its shareholders

4. The earnings theory of Capitalisation recognises the fact that the _________ of an enterprise depends upon its

earnings and earning capacity.

a. false value

b. total value

c. true value

d. half value

5. Which of the following cost is not visible but it may seriously affect the company's operations especially when

it is exposed to business and financial risk.

a. Explicit cost

b. Implicit cost

c. Direct cost

d. Indirect cost

6. Match the following

Concept

A. Explicit cost

B. Financial Planning

C. Long-term assets

D. Short-term assets

a. A-2, B-1, C-4, D-3

Description

1. A process by which funds required for each course of action is decided

2. This involves huge investment and yield a return over a period of time in

future.

3. The current assets that can be converted into cash within a financial year

without diminution in value

4. The cost in the form of coupon rate, cost of floating and issuing the securities

c. A-4, B-1, C-2, D-3

d. A-1, B-2, C-3, D-4

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Financial Management

7. ___________ is the operational activity of a business that is responsible for obtaining and effectively utilising

the funds necessary for efficient operations.

a. Financial planning

b. Financial management

c. Asset management

d. Budget management

8. ______________is a major decision made by the finance manager on the formulation of dividend policy.

a. Investment decision

b. Financing decision

c. Dividend decision

d. Accounting decision

9. Financing decisions relate to the acquisition of funds at the _________ cost.

a. maximum

b. less

c. more

d. least

10. Which among the following is the primary goal of financial management of a firm?

a. Maximisation of economic welfare of its shareholders

b. Encouragement to competition

c. Fall in dividend rates

d. Effective utilisation of funds

10/uts

Chapter II

Time Value of Money

Aim

The aim of this chapter is to:

Objectives

The objectives of this chapter are to:

Learning outcome

At the end of this chapter, you will be able to:

describe the sinking fund factor with its formula for calculation

11/uts

Financial Management

One of the most fundamental concepts in finance is that money has a time value. That is to say that money in

hand today is worth more than money that is expected to be received in the future. This leads us to summarise the

concept of time value: A Rupee today is worth more than a Rupee tomorrow."

Concept - Time value of money

A rupee, which is received today, is more valuable than a rupee receivable in future. The amount that is received

earlier period can be reinvested and it can earn an additional amount. Therefore, people prefer to receive the rupee

that is receivable at the earliest.

Rationale of time preference for money

Individual prefers value opportunity to receive money now rather than waiting for one or more years to receive the

same. It is referred to as an individual's time preference for money. There are three reasons that may be attributed

to the individual's time preference for money:

Uncertainty: Future is uncertain and it involves risk. An individual is not certain about future cash inflows.

Hence, the individual would prefer to receive cash toady instead of future.

Current consumption: Most of the people prefer to use the present money for satisfying existing present

needs.

Possibility of investment opportunity: The reason why individuals prefer present money is due to the possibility

of investment opportunity through which they can earn additional cash.

Simple interest is the interest paid on only the original amount, or principle borrowed. Simple amount is a function

of three components such as principle amount borrowed or lent, interest per annum and the number of years for

which the interest rate is calculated. Symbolically:

SI = Po (I) (n)

Where,

SI= Simple interest, Po= Principle amount at year '0', I= Interest rate per annum

n=Number of year for which interest is calculated

For instance

Mr. Dorabjee has deposited Rs.1,00,000 in a Savings bank account at 7 per cent simple interest and interest and

interested to keep the deposit for a period of 5 years. He requested you to give accumulated interest end of the

years.

Solution: SI = Po (I) (n) = Rs.1, 00,000 X 0.07 X 5 years= Rs. 35,000

If an investor wants to know his total future value at the end of 'n' years. Future value is the sum of accumulated

interest and the principal amount. Symbolically:

FVn = Po + Po (I) (n) OR SI + Po

For instance

Manish annual savings are Rs. 1000, which is invested in a bank saving fund account that pays a 5 % simple interest.

Krishna wants to know his total future value or terminal value at the end of 8 years period.

Solution: FVn = Po + Po (I) (n) OR SI + Po

FVn = Rs. 1000 + Rs. 1000 (0.05) (8) = Rs. 1,400

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Here the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found,

interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the

first compounding period.

There is no difference between simple interest and compound interest when there is only one time investment yearly

compounding, and for only one year maturity. But the difference can be seen only when the investment is made for

more than two years. Compounding interest is also referred as future value (FV).

2.3.1 Compounding Value of a Single Amount

Compound value or future value on an account can be calculated by the following formula.

CV = Po (1 + I) n

Where,

CV = Compound value, Po = Principal amount, I = Interest per annum,

n = Number of years for which compound is done

(1 + I) n = CVIF I..n or future value inter factor for interest and 'n' years.

For instance: Suppose you have Rs. 10, 00,000 today and you deposit it with a financial institute, which pay 8 %

compound interest for a period of 5 years. Show how the deposit will grow.

Solution: CV = Po (1 + I) n

CV5 = 10, 00,000(1+0.08)5

= 10, 00,000 (1.469*)

CV5 = Rs. 14, 69,000

Note: * See compound value of one rupee Table for 5 years at 8 % rate of interest.

2.3.2 Variable Compounding Periods

Generally compounding is done once in a year. In the above problem, we assumed that the compounding is done

annually. If the investor promised to pay compound interest for variable periods, compound value with variable

compound periods is determined with the following formula.

Where,

CVn = Compound value at the end of year 'n', Po = Principal amount at the year '0', I = Interest per annum,

m = Number of times per year compounding is done

n = Maturity period

For instance (Semi compounding): How much does a deposit of Rs. 40,000 grow to at the end of 10 year at the rate

of 6 % interest and compounding is done semi-annually. Determine the amount at the end of 10 years.

Solution:

= Rs. 40,000 [*1.86] = Rs. 72,240

Note: * See compound value of one rupee Table for 20 years at 3 % rate of interest.

For Instance (Quarterly compounding): Suppose that a firm deposits Rs. 50 lakhs at the end of each year for 4 years

at the rate of 8 % interest and compounding is done on quarterly basis. What is the compound value at the end of

4 year?

Solution:

= Rs. 50, 00,000 x 1.373 = Rs. 68, 65,000

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Financial Management

Compound growth rate can be calculated with the following formula:

gr:

Where gr= Growth rate in percentage

V= Variable for which the growth rate is needed to found (i.e. sales, revenue, dividend at the end of year '0')

Vo = Variable value at the end of year 1

Vn = Variable value (amount) at the end of year 'n'

For instance:

From the following dividend data of a company calculate compound rate of growth for period (1998-2003).

Year

Dividend per share (Rs.)

1998

21

1999

22

2000

25

2001

26

2002

28

2003

31

Solution:

gr= 8%

Note

See compound one rupee Table for 5 years (total years one year) till you find closest value to the compound factor,

at closest value see upward to the table to get growth rate.

Compound Value of Series of cash Flows

Annuity means a series of cash flows (inflow or outflow) of a fixed amount for a specified number of years. Compound

value of a series of cash flows can be calculated by the following formula (uneven cash flows)

Where CVn= Compound value at the end of' 'n' year

P1 = Payment at the end of year 1, P2 = Payment at the end of year 2

Pn = Payment at the end of year 'n', I = Interest rate

CVn = P1 (CVIF I.1) + P2 (CVIF I.2) + Pn (1+I I.n)

For instance

Mr. Shyam deposits Rs. 5,000, Rs. 10,000, Rs. 15,000, Rs. 20,000 and Rs. 25,000 in his savings bank account in

year 1,2,3,4 and 5 respectively. Interest rate of 6 %, he wants to know his future value of deposits at the end of 5

years.

Solution:

= Rs. 81,280

Compound Value of Annuity (Even Cash Flow)

Annuity is a series of even cash flows for a specified duration. It involves a regular cash outflow or inflow. For

instance like the payment of LIC premium, depositing in a recurring deposit account, and the like. Cash flows may

happen either at the end of year or beginning of the year. If cash flows happen at the beginning of the year, it is called

as an annuity due, where as when the cash flows happen at the end it is called as a regular or deferred annuity.

14/uts

For instance: Mr. Ram deposits Rs. 500 at the end of every year for 6 years at 6 % interest. Determine Ram's money

value at the end of 6 years.

Solution:

+

= 669 + 631 + 595.5 + 562 + 530 + 500

= Rs. 3487.5

Short cut formula for the above is:

Where,

P = Fixed periodic cash flow, I Interest rate

n = duration of the amount

= (CVIFA I.n)

(CVIFA I.n) = Future value for interest fact or annuity at 'I' interest and for 'n' years.

For the example above this formula can be used as below.

= 500(6.975)

= Rs. 3,487.5

Note: See compound value interest factor annuity Table of one rupee Table for 6 years at 6 % interest.

Compound Value of Annuity Due

When the cash flows involves at the beginning of the year compound value of annuity is calculated with the following

formula:

OR

For instance

Suppose you deposit Rs. 2,500 at the beginning of every year for 6 years in a saving bank account at 6 % compound

interest. What is your money value at the end of 6 years?

Solution:

= 2,500 (6.975) (1+0.06)

= Rs. 18, 4863.75

Doubling period is the period required to double the amount invested at a given rate of interest.

Doubling period can be computed by adopting two rules:

Rule of 72: To get doubling period, 72 is dividend by interest rate.

Doubling period (DP) = 72 I

Where I = Interest rate, (%)

DP = Doubling period in years

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Financial Management

For instance:

If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?

Solution: DP = 72 I = 72 10 = 7.2 years (approx.)

Rule of 69

Rule of 72 may not give exact doubling period, but rule of 69 gives a more accurate doubling period. The formula

to calculate doubling period is

DP =0.35 + 69/I

For instance: If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?

Solution: 035 + 69/10 = 7.25 years

Effective rate of interest (ERI) in case of doubling period

Effective rate of interest can be defined with the use of following formula.

In case of rule of 72

ERI = 72 Doubling period (DP)

Where ERI = effective rate of interest, DP = Doubling period

In case of rule of 69

For instance

A financial institute has come with an offer to the public, where the institute pays double the amount invested in

the institute at the end of 8 years. Mr. A who is interested to deposit with institute wants to know the effective rate

of interest that will be given by institute.

Solution as per rule of 72: 72 8 years = 9 %

Solution as per rule of 69:

= 9 % (approx.)

The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value to the

present value. The processes of determining present value of future cash flows are called discounting. It is concerned

with determining the present value of a future amount, assuming that the decision maker has an opportunity to earn a

certain return on individual's money. This return is referred as discount rate, cost of capital or an opportunity cost.

Present value of a single amount

Present value can be calculated by the following formula:

PV = Present value

OR

I = Interest rate or discounting factor or cost of capital

n = Duration of the cash flow

= present value interest facts at 'I' interest and for 'n' years

For instance

An investor wants to find the present value of Rs. 40,000 due 3 years. His interest rate is 10 %.

Solution:

= Rs. 40,000 [1

= Rs. 40,000 (0.751*)

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= Rs. 30,040

Note: * Present value of one rupee Table at 3 years for the arte of 10 %

Present value of a series of cash flows

We have calculated the present value of a single amount to be received after a specified period. In many cases, we

may need to calculate present value of series cash flows. For example, in capital budgeting decisions, there is a need

to convert the future cash inflows into present values to take decision and in case of raising funds through debt also

needs to convert the future cash outflows into present values. Cash flows over a period may be even or uneven.

Present Value of Uneven Cash Flows

OR

+ +

PV = Present value

I = Interest rate or discounting factor or cost of capital

n = Duration of the cash inflows stream

t = Year in which cash inflows are receivable

For instance

From the following information, calculate the present value at 10% interest rate.

Year

Cash inflow (Rs.)

2,000

3,000

4,000

5,000

4,500

5,500

Solution:

= 2,000+ 2,727 + 3,304 + 3,755 + 3,073.5 + 3,415.5

= Rs. 18,275

Present Value of even Cash Flows (annuity)

I = Interest rate or discounting factor

n = Duration of the annuity

CIF = Cash inflows

For instance

Mr. Ram wishes to determine the PV of the annuity consisting of cash flows of Rs. 40,000 per annum for 6 years.

The rate of interest he can earn from his investment is 10 %.

Solution:

= Rs. 40,000 X

= Rs. 4000 X * 4.355 = Rs. 17,420

*See present value of annuity for 6 years at 10 %

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Financial Management

(1+I)

For instance: Mr. Krishna has to receive Rs. 500 at the beginning of each year for 4 years. Calculate present value

of annuity due assuming 10 % rate of interest.

Solution:

= Rs. 1,743.5

Nominal rate of interest or rate of interest per year is equal. Effective and nominal rate are equal only when the

compounding is done yearly once, but there will be a difference, that is effective rate is greater than the nominal

rate for shorter compounding periods. Effective rate of interest can be calculated with the following formula.

m = Frequency of compounding per year.

For instance

Mr. Y deposited Rs. 1,000 in a bank at 10% of rate of interest with quarterly compounding. He wants to know the

effective rate of interest.

Solution:

= 1.1038-1

= 0.1038 OR 10.38 %

Financial manager may need to estimate the amount of annual payments so as to accumulate a predetermined

amount after a future date to purchase assets or to pay a liability. The following formula is useful to calculate the

annual payment.

For instance: Finance manager of a company wants to buy an asset costing Rs. 1, 00,000 at the end of 10 years. He

Requests you to find out the annual payment required, if the savings earn an interest rate of 12% per annum.

Solution:

= 1, 00,000 (0.12/2.1058)

= Rs. 5.689

Present Value of Perpetuity

Perpetuity is an annuity of infinite duration. It may be expressed as:

Where: PV = Present value of a perpetuity

CIF = Constant annual cash inflow

= PV interest factor for perpetuity

= CIF/I

For instance: Mr. X an investor expects a perpetual amount of Rs. 1000 annually from his investment. What is his

present value of perpetuity if the interest rate is 8 %?

Solution: = CIF/I

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Loan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is known

as amortisation. Financial manager may take loan and may be interested to know the amount of equal installment

to be paid every year to repay the complete loan amount including interest. Installment can be calculated with the

following formula.

OR LI

Where: LI = Loan installment, = Principal amount, I = Interest, n = Loan repayment period at specified interest

rate.

For instance: ABC company raised Rs. 10, 00,000 lakhs for an expansion program from IDBI at 7% interest per

year. The amount has to be repaid in 6 equal annual installments. Calculate the installment amount.

Solution:

= 10, 00,000 7.767

= Rs. 1, 28,750

Present Value of Growing Annuity

Growing annuity means the cash flows that grow at a constant rate for a specified period of time.

Steps involved in calculation of growing annuity:

Convert the series of cash flows into present values at a given discount factor

Add all the present values of series of cash flows to get total PV of a growing annuity

Formula:

PVGA= PV of growing annuity

CIF = Cash inflows

g= Growth rate

I = discount factor

n= Duration of the annuity

For instance: A Real estate Agency has rented out one of their apartment for 5 years at an annual rent of Rs. 6,00,000

with the stipulation that rent will increase by 5% in every year. If the agency's required rate at return is 14%. What

is the PV of expected (annuity) rent?

Solution: Calculate on series of annual rent

Year Amount of Rent (Rs.)

1

6,00,000

2

6,00,000 X (1+0.05) 6,30,000

3

6,30,000 X (1+0.05) 6,61,500

4

6,61,500 X (1+0.05) 6,94,575

5

6,94,575 X (1+0.05) 7,29,303.75

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Financial Management

Generally cash flows are discounted once a year, but some times cash flows have to be discounted less than one

(year) time, like, semi-annually, quarterly, monthly or daily. The general formula used for calculating the PV in the

case of shorter discounting period is:

Where, PV = Present vale, = Cash inflow after 'n' year, m= No. of times per year discounting is done

I= Discount rate

For instance: Mr. P expected to receive Rs. 1, 00,000 at the end of 4 years. His required rate of return is 12% and

he wants to know PV of Rs. 1, 00,000 with quarterly discounting.

Solution:

= 1, 00,000 X

= 1, 00,000 X 0.623

= Rs. 62,300

20/uts

Summary

One of the most fundamental concepts in finance is that money has a time value. That is to say that money

in hand today is worth more than money that is expected to be received in the future.

Simple interest is the interest paid on only the original amount, or principle borrowed.

Simple amount is a function of three components such as principle amount borrowed or lent, interest per annum

and the number of years for which the interest rate is calculated.

Doubling period is the period required to double the amount invested at a given rate of interest.

The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value

to the present value.

Effective and nominal rate are equal only when the compounding is done yearly once, but there will be a

difference, that is effective rate is greater than the nominal rate for shorter compounding periods.

Loan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is

known as amortisation.

References

Introduction to the Time Value of Money, [Online] Available at: <https://www.boundless.com/accounting/timevalue-money/introduction-to-time-value-money/> [Accessed 27 May 2013].

[Accessed 27 May 2013].

Paramasivan, C. & Subramanian, T., 2009. Financial Management, New Age International.

2013. Financial Management: Lecture 2, Chapter 5: Part 1 - Time Value of Money, [Video online] Available

at: <http://www.youtube.com/watch?v=vpJszYCLH3o> [Accessed 27 May 2013].

Prof. Ahmed, M., 2010. Time Value of Money, [Video online] Available at: <http://www.youtube.com/

watch?v=CnRJ6Jypsj4> [Accessed 27 May 2013].

Recommended Reading

Drake, P. P., 2009. Foundations and Applications of the Time Value of Money. Wiley

Benninga, S., 2006. Principles of Finance with Excel. Oxford University Press, USA

Block, S., 2008. Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in

card. 13th ed., McGraw-Hill/Irwin.

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Financial Management

Self Assessment

1. Individual prefers ________opportunity to receive money now rather than waiting for one or more years to

receive the same

a. value

b. money

c. interest

d. principle

2. ________ is an amount raised from outsiders at an interest and repayable at a specified period

a. Money

b. Loan

c. Principle

d. Value

3. ________ rate of interest or rate of interest per year is equal

a. Sinking

b. Present value

c. Nominal

d. Principle

4. The present value of a future cash inflow (or outflow) is the amount of _________ cash that is of equivalent

value to the present value

a. current

b. future

c. past

d. lost

5. Which of the following statements is false?

a. Annuity is a series of odd cash flows for a specified duration

b. Simple interest is the interest paid on only the original amount

c. Growing annuity means the cash flows that grow at a constant rate for a specified period of time

d. The processes of determining present value of future cash flows are called discounting

6. Compounding interest is also referred as __________.

a. future value

b. current value

c. asset value

d. amount value

7. ________ period is the period required to double the amount invested at a given rate of interest.

a. Compounding

b. Growth

c. Discounting

d. Doubling

22/uts

a. Annuity due

b. Deferred annuity

c. Regular annuity

d. Mixed annuity

9. A rupee, which is received today, is more valuable than a rupee receivable in ______.

a. past

b. present

c. future

d. today

10. The process of determining present value of future cash flows is called?

a. Sinking

b. Billing

c. Discounting

d. Amounting

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Financial Management

Chapter III

Valuation of Bonds and Shares

Aim

The aim of this chapter is to:

Objectives

The objectives of this chapter are to:

Learning outcome

At the end of this chapter, you will be able to:

24/uts

Valuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset depends

on the cash flow it is expected to provide over the holding period. The fact is that, as on date there is no method by

which prices of shares and bonds can be accurately predicted. It should be kept in mind by an investor before one

decides to take an investment decision.

Book value: It is an accounting concept. Assets are recorded in balance sheet at their book values. Book value

of an asset is cost of acquisition less accumulated depreciation. It is determined by the formula below.

Market value: Market value of an asset is the price at which the asset is bought or sold in the market. Market

value per share is generally higher than the book value per share for profitable and growing firms.

Going concern value: It is the value that a firm can be realised if it sells its business as a continuing operating

business. This value would be higher than the liquidation and book value. Valuation of securities is always

considered as going concern, because if the firm is not running, investors would not invest in securities

Liquidation value: Liquidation value is the actual amount that can be realised when an asset is sold. Liquidation

value of a equity stock is the actual amount that would be received if all of the firm's assets were sold at their

market value, liabilities were paid, and the remaining proceeds were by number of equity shares outstanding.

Intrinsic value: Investors invest on equity stock with an expectation of intrinsic cash inflow stream. The present

value of the cash inflows expected from a security over its holding period. Present value is computed by

discounting future cash inflows at an appropriate rate. It is also called economic value.

A bond is a legal document issued by the issuing company under is common seal acknowledging a debt and setting

forth the terms under which they are issued and are to be paid. Bond is also known as 'debenture'. Bonds are issued

by different types of organisations like the government, financial institutions, public sector undertaking and private

sector organisations.

Few important terms in bond valuation are as follows:

Par value: The par value (Face Value) is stated on the face of the bond. It is the amount at which a bond is issued

to public, and promises to pay either at the end of maturity period or in pre-decided installments.

Coupon rate: Coupon rate is the interest rate with which a bond is issued. The interest payable at regular intervals

is the product of the par value and the coupon rate broken down to the relevant time horizon.

Maturity period: Refers to the number of years after which the par value becomes payable to the bond-holder.

Redemption value: It is the amount the bond-holder gets on maturity. A bond may be redeemed at par, at a

premium (bond-holder gets more than the par value of the bond) or at a discount (bond-holder gets less than

the par value of the bond)

Market value: It is the price at which the bond is traded in the stock exchange. Market price is the price at which

the bonds can be bought and sold and this price maybe different from par value and redemption value.

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Financial Management

Following are the types of bonds:

Redeemable Bond

A bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. The appropriate

discount rate is cost of debt (kd) required rate of return on bond (debenture).

OR

Where,

BVo = Value of bond (debenture) at time 'zero'

I = Annual interest paid per year

M = Maturity of bond

N = Number of years to maturity

kd= Required rate of return, or cost of debt

PVIF = Present value interest factor

PVIFA = Present value interest factor annuity

For instance: AB company issues Rs. 1,000 par value bond at 12%. The bond is redeemable after 10 years. Determine

value of bond assuming required rate of return is 14%.

Solution:

BVo = (Rs.120 X 5.216) + (Rs. 1,000 X 0.270)

BVo = Rs. 625.92 + Rs. 270

BVo = Rs. 895.92

Bond values with semi-annual interest

With the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with

annual interest payments. Hence the bond valuation equation can be modified as:

OR

For instance: MNC company issues bonds with face value of Rs. 1,000 each, at 12% per coupon rate with interest

payable semi-annually. The bonds are redeemable after 5 years. Determine value of bond if required rate of return

on this type of bond is 14%.

Solution:

BVo = (Rs. 60 X 7.024) + (Rs. 1,000 X 0.508

= Rs. 421.44 + Rs. 508

= Rs. 929.44

Irredeemable Bond

Irredeemable bond is the bond which is not repaid till closing of the firm. It is the bond without maturity period.

Value of perpetual bond is determined by the following formula.

OR

For instance: A company has issued 12 % perpetual bond of Rs. 1,000 each. Determine value of bond assuming 15

% cost of debt.

Solution: BVo =

26/uts

= Rs.120/.015 = Rs.800

In India Zero coupon bonds are also known as Deep discount bonds. These bonds have no coupon rate, that is, there

is no interest to be paid out. Instead, these bonds are issued at a discount to their face value, and the face value is

the amount payable to the holder of the instrument on maturity. The difference between the discounted issue price

and face value is effective interest earned by the investor. These are called deep discount bonds because these bonds

are long term bonds whose maturity some time extends up to 25 to 30 years.

Along with the bond value, investors are also interested in knowing the yield on bonds. Yields on bonds can be

measured by applying various measures. They are:

Yield to Maturity (YTM)

It is the rate of return that an investor earns if they buy a bond at a specific price and hold it until maturity.

If bond is sold at par and realised par value fully then yield to maturity equals to interest rate YTM is computed

by using the following formulae.

Where,

SP = Sales proceeds a bond (price of bond)

I = Annual Interest payment (Rs.)

M = Maturity value of bond

n= Maturity period

Kd= Yield to maturity

Illustration: XYZ company bond, currently sells for Rs.1, 000 (Face value 900) it has a 10% interest rate, and with

a maturity period of 10 years.

OR

Alternatively

Years

CIFs (Rs.)

DF

10%

6%

1 to 10

90

6.145

7.360

10

900

0.386

0.558

PV (Rs.)

10%

553.05

347.40

900.45

1000.00

(-)99.55

6%

662.4

502.2

1164.6

1000.00

164.6

Yield to maturity:

=

= 6% +

= 6% + 2.49

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Financial Management

= 8.49 %

Yield to Call (YTC)

Yield to call is exactly similar to YTM, but here yield is found till the call of the bond. Some corporate issues bonds

with call feature that allows the company call back the bond before maturity period. In such cases bond holder would

not have the option of holding the bond until the maturity period. Therefore, YTM would not ne earned. YTC is

computed with the following formula:

Where, CP = Call price of bond, n*= Number of years until the assumed call date

For instance: ABC company issues 10 % callable bonds with a face value of Rs. 1000. The bond is currently selling

of Rs. 1,100. Maturity period is 10 years. Determine YTC assuming company calls bonds after 5 years because

interest rate has fallen by 2% at Rs. 1000.

Solution:

Years

CIFs (Rs.)

DF

PV (Rs.)

10%

5%

1 to 5

100

100

3.791

1000

1000

0.621

10%

5%

379.1

621.0

1000.1

1100

432.9

784

1216.9

1100.00

(-)99.55

116.9

Yield to Call =

= 5% +

= 5% + 2.69

= 7.69 %

Current yield

It is the yield that relates to the annual interest to the annual interest to the current market price.

Current Yield = I CMP

Where: I = Annual Interest (Rs.)

CMP = Current market price

For instance: From the following determine current yield on a bond

Face value of bond Rs.1200

Interest Rate 13 %

Maturity 10Years

Current market price Rs. 1000

Solution:

28/uts

From the above calculation we can see that yield represents analyse interest rate, it excludes capital gain or loss. It

ignores time value of money. Therefore, it is not a accurate measure of the bonds expected return.

Following are the bond values discussed below.

3.5.1 Required Rate of Return and Bond Values

Whenever there is change in the required rate of return, bond value shows fluctuations from its par value. Required

rate of return may change, due to shift in the basic cost of long-term sources of finance, and the change in the firm's

risk level.

Let us determine value of bond considering the following three cases.

Value of bond when interest-rate equals to required rate of return in this case value of bond is equals to par

value.

For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors

required rate of return is 12%. Determine value of bond.

Solution:

B = (Rs.120 X4.111) + (Rs. 1,000 X 0.507)

= Rs. 493.32 + 507

= Rs. 1,000

Value of bond when required rate of return is higher than the interest- rate in this case value of bond would

be less than par value

For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors

required rate of return is 15%. Determine value of bond

Solution:

B = (Rs.120 X3.784) + (Rs. 1,000 X 0.432)

= Rs. 454.08 + 432

= Rs. 886.08

Value of bond when required rate of return is less than interest rate In this case, value of bond would be above

par value.

For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors

required rate of return is 10%. Determine value of bond

Solution:

B = (Rs.120 X4.355) + (Rs. 1,000 X 0.564)

= Rs. 522.60 + 564

= Rs. 1086.6

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Financial Management

In nutshell the relationship between bond values and required rate of return is given below:

Interest Rate > Required Rate: Bond Value > Par Value

Interest Rate < Required Rate: Bond Value < Par Value

Value of Bond: When I (%) = Kd (%) and change in the time period- In this case value of bond is equals to par

value, whatever may be the maturity period.

For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period

is 10 year. Required rate of return is 10%. Determine value of bond when time period is (i) 5 years, and (ii) 15

years.

Maturity Period

(i) 5 years

10 years

(ii) 15 years

Equation

(100 X3.79)+(1000X0.621)

(100 X6.145)+(1000X0.386)

(100 X7.606)+(1000X0.239)

379 + 621= 1,000

614 + 386 = 1,000

761 + 239 = 1,000

Value of bond remains same (at par value) when interest rate equals to required rate of return, with the change

in time period to maturity.

Value of Bond: When I (%) < Kd (%) and change in the time period - In this case, value of bond decreases

when the time period to maturity increases and vice versa.

For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period

is 10 year. Required rate of return is 12%. Determine value of bond when time period is (i) 5 years, and (ii) 15

years.

Maturity Period

(i) 5 years

10 years

(ii) 15 years

Equation

((100 X3.605)+(1000X0.567)

(100 X5.650)+(1000X0.322)

(100 X6.811)+(1000X0.183)

360.5 +567 = 927.5

565 + 322 = 887

681.1 + 183 = 864.1

Value of Bond: When I (%) > Kd (%) and change in the time period to maturity In this case value of bond

increases when time period to maturity increases.

For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period

is 10 year. Required rate of return is 6%. Determine value of bond when time period is (i) 5 years, and (ii) 15

years.

Maturity Period

(i) 5 years

10 years

(ii) 15 years

30/uts

Equation

(100 X4.212)+(1000X0.747)

(100 X7.360)+(1000X0.558)

(100 X9.712)+(1000X0.417)

421.2 + 747 = 1,168.20

736 + 558 = 1,294

971.2 + 417 = 1,388.2

3.5.3 Relationship between Bond Value and Time to Maturity Period

Figure below shows the relationship between time to maturity period; required return and bond value.

1,600

1,400

Premium Bond

Required Rate 6%

1297

1,200

1000

1168

800

887

Discount Bond

Required Rate 12%

600

400

200

10 9

4 3

2 1 0

Following points can be extracted from the figure above:

When required rate of return equals to coupon rate, a bond will sell at face value. At the time of issue of bond

interest rate is set at par with required rate of return, to sell bond of par initially.

When required rate of return increases above coupon rate then, the bond value falls below par value. Such bond

is known as 'discount bond'.

When required rate of return falls below the interest rate, then the band values goes above par value. This bond

is called as 'premium bond'

Increase in required rate of return affects bond values (go up or fall below par value).

Market value of bond will always reach its face value by the end of its maturity period, provided the firm does

not go bankrupt.

A company's shares may be categorised as

Preference shares

The returns these shareholders receive are called dividends. Preference shareholders get a preferential treatment

as to the payment of dividend and repayment of capital in the event of winding up. Such holders are eligible for a

fixed rate of dividends. Some important features of preference and equity shares are.

Dividends

Rate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be paid off

after accumulation. The dividend rate is not fixed for equity shareholders. The dividend rate is not fixed for equity

shareholders.

31/uts

Financial Management

Claims

In the event of the business closing down, the preference shareholders have a prior claim on the assets of the company.

Their claims shall be settled first and the balance if any will be paid off to equity shareholders.

Redemption

Preference shares have a maturity date on which day the company pays off the face value of the share to the holders.

Preference shares are of two types redeemable and irredeemable.

Conversion

A company can issue convertible preference shares. After a particular period as mentioned in the share certificate,

the preference shares can be converted into ordinary shares.

3.6.1 Valuation of Preference Shares

Preference share gives some preferential rights to preference stockholders. The preferential rights are payment of fixed

rate of dividend and payment of principal amount at the time of liquidation, before paying to equity stockholders.

Value of preference stock is the present value of fixed annual dividends expected and he principal amount.

OR

Where,

PVIFA = Present value interest factor annuity

PVIF = Present value interest factor

For instance

ABC company issued 12% perpetual preference stock with a face value of Rs. 100. Compute value of preference

stock assuring 14% require rate of return.

Solution:

= Rs. 85.71

For instance

A company issued 12% preference stock with a face value of Rs. 100, redeemable after 5 years. Required rate of

return is 10%. Determine value of preferred stock.

Solution:

= (Rs.12 X 3.791) + (100x 0.621)

= Rs. 45.492 + 62.1

= Rs. 107.592

3.6.2 Valuation of Equity/Ordinary Shares

People hold common stocks for two reasons:

32/uts

The value of a share which an investor is willing to pay is linked with the cash inflows expected and risks associated

with these inflows. Intrinsic value of a share is associated with the earnings (past) and profitability (future) of the

company, dividends paid and expected and future definite prospects of the company.

Basic share valuation model

Stock value is present value of future cash inflows (dividends) that it is expected to provide over an infinite time

horizon. An investor who buys a stock with the intention of holding in forever, on this case the value of equity stock

is the present value of a stream of dividends expected over an infinite period.

Dt = Expected dividend per share at the end of year 't'

Ke = Required return on equity (cash of equity)

Under this we learn valuation of equity share using three models:

Zero growth

Constant growth

Variable growth

Here the value of the equity share is determined assuming an investors holds stock for one year period.

Where,

= Value of stock

= Price of the share at the end of one year

= Required rate of return

For instance

Mr. A purchased an equity stock of Gokul Company at Rs. 100 per share, it is expected to provide a dividend of Rs.

10 per share, and fetch a price of Rs. 110 after one year. Compute stock value assuming required date of return.

Solution:

= (Rs. 10x0.877) + (Rs. 110 X 0.877)

= Rs.8.77 + Rs. 96.47

= Rs. 105.24

Zero Growth Model: It is the model under which value of stock is determined assuming dividends are not

expected to grow, (non-growing). Here value of equity stock is the present value of perpetuity of dividends:

Constant Growth (Gorden) Model: In this model value of equity stock is valued assuming that dividends would

growth at a constant rate.

33/uts

Financial Management

Variable Growth Model: Growth of the firm should be different life cycle. That is in the early stages growth's much

be faster than that of economy as a whole. Economic growth in the later stages the growth comes down.

Compute the value of the dividends at the end of each year during the super normal growth period.

Compute the present value of the dividends expected during the initial growth period

PV of stock is

Add the PV found in step 2 and step 3 to get intrinsic value of stock. (ESo)

34/uts

Summary

Valuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset

depends on the cash flow it is expected to provide over the holding period.

Book value is an accounting concept. Assets are recorded in balance sheet at their book values. Book value of

an asset is cost of acquisition less accumulated depreciation.

Market value of an asset is the price at which the asset is bought or sold in the market. Market value per share

is generally higher than the book value per share for profitable and growing firms.

Liquidation value of a equity stock is the actual amount that would be received if all of the firm's assets were

sold at their market value, liabilities were paid, and the remaining proceeds were by number of equity shares

outstanding.

A bond is a legal document issued by the issuing company under is common seal acknowledging a debt and

setting forth the terms under which they are issued and are to be paid.

Irredeemable bond is the bond which is not repaid till closing of the firm. It is the bond without maturity

period.

References

pdf> [Accessed 28 May 2013].

[Accessed 28 May 2013].

Shim, J. K. & Siege, J. G., 2008. Financial Management, 3rd ed., Barron's Educational Series.

Prof. Ahmed, M., 2012. Bond Valuation, [Video online] Available at: <http://www.youtube.com/

watch?v=tid0RVUmY3M>[Accessed 28 May 2013].

2012. Value a Bond and Calculate Yield to Maturity (YTM), [Video online] Available at: <http://www.youtube.

com/watch?v=pfhjJ00IuW4>[Accessed 28 May 2013].

Recommended Reading

Staff, I., 2005. Stocks, Bonds, Bills, and Inflation 2005 Yearbook. Ibbotson Associates

Satyaprasad, B.G. & Raghu, G.A. 2010. Advanced Financial Management.Global Media.

35/uts

Financial Management

Self Assessment

1. _________ is divided by the number of equity shows outstanding to get book value per share.

a. Net worth

b. Yield

c. Equity stock

d. Premium bond

2. Value of bond equals to __________ value when required rate equals to interest rate.

a. present

b. current

c. par

d. net

3. Which of the following statements is false?

a. Preference stock is also known as hybrid security.

b. Liquidation value equals to value of assets minus value of liabilities

c. Value of bond is less than par value when required rate of return than interest rate.

d. Cash inflows, timing and required return are the three inputs required to value any asset.

4. Bond value equals to par value when it reaches to __________ period.

a. maturity

b. premium

c. value

d. completion

5. Current yield relates to the annual interest to the current________.

a. cost price

b. asset price

c. market price

d. specific price

6. A bond is said to be premium bond when its value is:

a. Higher than the par value

b. Less than the par value

c. Equal to than the par value

d. Higher than the present value

7. Intrinsic value is the __________ value of cash flows expected over a series years of holding an asset.

a. coming

b. going

c. present

d. net

36/uts

a. Equity stock

b. Ordinary stock

c. Hybrid security

d. Security stock

9. When required rate of return is different from the interest rate the length of time to maturity effects _______

values.

a. bond

b. equity

c. share

d. net

10. Value of bond is less than par value when required rate of return higher than ________ rate.

a. interest

b. return

c. required

d. present

37/uts

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