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Financial Management, 2e

FINANCIAL MANAGEMENT 2e

Rajiv Srivastava - Dr. Anil Misra

4-1: Relationship between Effective and Nominal Rates of Interest Financier Ltd(an NBFC) is offering personal loan within 24 hours of application, without any documentation. The interest rate charged by the Financier Ltd is 25% with monthly compounding. The borrower, Anand has another option, to borrow the required money from Banko (a national bank) at 27% p.a with annual compounding. The borrower feels that the option of borowing from NBFC is not only convenient but is also cheaper. Is the first option actually cheaper? Solution: The interest rate given in the first option is the nominal rate while in the second option since it is a case of annual compounding the interest offered rate is the effective rate. To compare the two options the effective interest rate for the first option needs to be computed. For the first option: Nominal interest rate (i) = 0.25 or 25% Number of compounding periods per year (n) = 12 n i Effective interest rate (r) = 1 1 +

n

r=

1 +

. 25 12

12

r= or

0.2807 28.07%

No, the borrower is not correct as the effective rate of interest for the first option is more than that for the second option. Hence borrowing from Banko @ 27% p.a is a cheaper option than borrowing from Financier Ltd (in which effective rate is 28.07%).

4-2: Future Value of a Single Sum Alpha Ltd has a surplus of Rs. 20 lacks available for the next 5 years. At the end of the period the firm will be needing the amount for investing in its business expansion. If the firm decided to invest the surplus in a scheme that offers a 13% per annum, how much would the amount grow to at the end of 5 years? Solution: Future Value (FV) = Present Value (PV) x Future Value Interest Factor (FVIF n FV = (1+r) Where; r = rate or return 13% n = time period of investment (years) 5 Rs 20.00 lakhs Present Value (PV)= Future Value (FV) = Rs 36.85 lakhs

Financial Management, 2e

FINANCIAL MANAGEMENT 2e

Rajiv Srivastava - Dr. Anil Misra

4-3: Future Value of Annuity An investor is thinking of investing in a recurring deposit scheme that offers an interest rate of 12% per annum. The investment that he is planning is for the higher education of his son who is just two years now. In case the investor decides to invest Rs. 20,000 every year, what will be the total money available to him when his son reaches the age of 20 years?

Solution:

Fut ure V alue Annuit y Fact or FV A(r,n) =

n (1 + r) 1 r

12% 18 Rs 20,000

So future value of annuity at the end of 18 years @ 12% p.a will be Future value Annuity Factor = 55.7497 Future Value = Amount of annuity x FVA Future Value = 20000 x 55.7497 = Rs 11,14,994

4-4: Determining the Implied Rate of Interest Two investment options are available to Prateek. The first option promises to pay Rs. 75,000 at the end of 8 years if the an investor deposits Rs. 7,000 annually for 8 years. The second scheme promises a lumpsum of Rs. 50,000 at the end of five years on an annual deposit of Rs. 7,000 for 5 years. Prateek is confounded as to which of the two schemes give him better returns? Please suggest. Solution: Amount to be invested annually Time period (years) Lumpsum received at the end Scheme A Rs 7,000 8 Rs 75,000 Scheme B Rs 7,000 5 Rs 50,000

Decision can be taken based on the interest rates implied in the offer. The implied interest rates for the two schemes can be computed as follows: Scheme A Scheme B Future Value Interest Factor for Annuity (FVIFA) 75000/7000 50000/7000 = 10.71 7.14 Now looking at the FVIFA table to locate the FVIFA of 10.71 against 8 years we can find out the rate of return. Return for option A lies between 8 and 9%. Now looking at the FVIFA table to locate the FVIFA of 7.14 against 5 years we can find out the rate of return. Return for option B is around 18%. Hence option B is better than option A.

Financial Management, 2e

FINANCIAL MANAGEMENT

Rajiv Srivastava - Dr. Anil Misra

4-5: Present Value of a Single Sum Assuming a discount rate of 12% find out which one of the following gives the highest returns: a. Rs 1,60,000 available today b. Rs 1,75,000 to be received after 8 years c. Rs 25,000 p.a. in perpetuity d. Rs 10,000 per month for a year and Rs 1,00,000 at the end of the year e. Rs 25,000 per year for the next 10 years. Solution: Since the the options have varied maturity they are incomparable. To make them comparable we need to find out the present value of all the above options. a) Since it is available today, this is the present value only i.e. Rs 1,60,000 is the present value. b) PVIF =

1 1 + r

n

or PVIF at 12%=

0.4039 Rs 70,680

1 r

Present Value = Future Value *(PVIF) = c) As it is known, Present Value of a Perpetuity = Present Value Factor for Perpetuity at 12%= Present value of Rs 25,000 in perpetuity =

8.3333 Rs 2,08,333

d) Present Value = 10000 x(PVIFA 12%/12,12) + 100000 x (PVIF12%,1year) Present Value Interest Factor for Annuity (PVIFA) PVIFA 12%/12, 12 months = 11.2551 0.8929 Present Value Interest Factor (PVIF) = Present Value = 30000 x(PVIFA .12/12,12 months) + 500000 x (PVIF.12,1year = (10000 x 11.25508) + (100000 x 0.8929) = Rs 2,01,840.80 e) Present Value = 25000 x (PVIFA.12,10) PVIFA =

1 1 (1 + i i)

n

1 1 (1 + . 12 ) 1 0 . 12

Financial Management, 2e

FINANCIAL MANAGEMENT 2e

Rajiv Srivastava - Dr. Anil Misra

4-6: Present Value of a Cash Stream with Varying Sums Shruti Enterprises is considering making investment for expanding its operations to the north zone of the country. Such an expansion is likely to entail a capital expenditure of 120 lacks. The incremental inflows from such an investment are likely to be available for the next 10 years. The cash flows on account of such an expansion plan are as follows: Years Cash Flows -12,00,000 0 1 2,10,000 2 3,05,085 4,25,060 3 4 4,05,002 5 3,24,545 6 3,05,689 7 2,45,065 1,55,400 8 9 1,35,600 10 1,25,000 Assuming the discount rate to be 14% find out the present value of the cash outflows. Should Shruti Ltd go ahead with the expansion plans? Solution: The problem can be solved in three steps as follows: Step 1 : Finding the PV factor. As it is known that PVIF=

1 1 + r

Year wise PV factors are given below in Col 3. They have been computed using the above model. Step 2: Finding out the Present value. Present Value = Cash flows x PV Factor Step 3: Finding the Net Present Value (NPV). NPV = PV of Cash Inflows - PV of Cash outflows. NPV is shown in the last cell of the Table below: PV Cash Flows PV Factor PV (Rs) Col.1 Col.2 Col.3 Col. 4 1 -120,00,000 -120,00,000 0 1 18,00,000 0.8772 15,78,947 2 30,50,850 0.7695 23,47,530 3 42,50,600 0.6750 28,69,034 4 40,50,020 0.5921 23,97,937 5 32,45,450 0.5194 16,85,585 0.4556 13,92,678 30,56,890 6 7 2,45,065 0.3996 97,937 0.3506 54,477 1,55,400 8 0.3075 41,698 1,35,600 9 0.2697 33,718 1,25,000 10 4,99,541 Acceptance of the Project is likely to create value for the business to the tune of 4.99 lakhs approx. hence Shruti Ltd is advised to go ahead with the expansion plans.

Financial Management, 2e

FINANCIAL MANAGEMENT 2e

Rajiv Srivastava - Dr. Anil Misra

4-7: Comparing the Yield Rahul Sharma is to retire in 15 years time. He is considering two schemes available for investment.The first scheme pays him an interest rate of 8% per annum while the second scheme will pay him Rs.2000 per annum perpetually beginning from the end of 16 years, if he deposits at the end of every year Rs. 2500 till he retires. Which scheme should Mr. Sharma opt for? Solution: Interest rate (per annum) Time period (years) Scheme I 8.00% 11 Scheme II ? 11

Assuming that the interest rate inherent in the second scheme is 'r'

Future Value Annuity Factor FVA(r, n) = = (1+ r)n 1 r

1.0815 1 0.08

27.1521

The value of Rs 2,000 contributed for 15 years with an interest rate of 8% = Rs 2,500 x 27.1521 = Rs 67880.25 The present value of an annuity = 1/r The value of Rs 2,000 to be received in perpetuity at the start of Year 16 = Rs 2,000/r If this is equated to Scheme I then the implied rate in Scheme II is given by:

gives r = 2.95%

4-8: Calculating the Growth Rate An investor bought a share of a Blue Chip 20 years back at a price of Rs 50. If the price of the share has gone up to Rs 350, what is the compound rate of growth in the price of shares of the firm? Solution: CAGR =

EndingV alue n Beginning 1 V alue

1

CAGR =

10.22%

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