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Q1.

What is meant by the phrase present value of a future


amount? How are the present values and future values
calculated?
Answer:- Present value, also known as present discounted value,
is a future amount of money that has been discounted to reflect its
current value, as if it existed today. The present value is always
less than or equal to the future value because money has interestearning potential, a characteristic referred to as the time value of
money. Time value can be described with the simplified phrase, A
dollar today is worth more than a dollar tomorrow. Here, 'worth
more' means that its value is greater. A dollar today is worth more
than a dollar tomorrow because the dollar can be invested and earn
a day's worth of interest, making the total accumulate to a value
more than a dollar by tomorrow. Interest can be compared to rent.
[2]
Just as rent is paid to a landlord by a tenant, without the
ownership of the asset being transferred, interest is paid to a
lender by a borrower who gains access to the money for a time
before paying it back. By letting the borrower have access to the
money, the lender has sacrificed their authority over the money,
and is compensated for it in the form of interest. The initial amount
of the borrowed funds (the present value) is less than the total
amount of money paid to the lender.

Q2. What do you mean by leverage? Why is increasing


leverage indicative of increasing risk?
Answer:- Leverage, as a business term, refers to debt or to the
borrowing of funds to finance the purchase of a company's assets.
Business owners can use either debt or equity to finance or buy
the company's assets. Using debt, or leverage, increases the
company's risk of bankruptcy. It also increases the company's
returns; specifically its return on equity. This is true because, if

debt financing is used rather than equity financing, then the


owner's equity is not diluted by issuing more shares of stock.
Investors in a business like for the business to use debt financing
but only up to a point. Beyond a certain point, investors get
nervous about too much debt financing as it drives up the
company's default risk.

There are three types of leverage:


Operating Leverage:Breakeven analysis shows us that there are essentially two types
of costs in a company's cost structure -- fixed costs and variable
costs. Operating leverage refers to the percentage of fixed costs
that a company has. Stated another way, operating leverage is the
ratio of fixed costs to variable costs. If a business firm has a lot of
fixed costs as compared to variable costs, then the firm is said to
have high operating leverage. These firms use a lot of fixed costs
in their business and are capital intensive firms.
A good example of capital intensive business firm are the
automobile manufacturing companies. They have a huge amount of
equipment that is required to manufacture their product automobiles. When the economy slows down and fewer people are
buying new cars, the auto companies still have to pay their fixed
costs such as overhead on the plants that house the equipment,
depreciation on the equipment, and other fixed costs associated
with a capital intensive firm. An economic slowdown will hurt a
capital intensive firm much more than a company not quite so
capital intensive.
You can compare the operating leverage for a capital intensive
firm, which would be high, to the operating leverage for a labour
intensive firm, which would be lower. A labour intensive firm is one
in which more human capital is required in the production
process. Mining is considered labour intensive because much of
the money involved in mining goes to paying the workers. Service
companies that make up much of our economy, such
as restaurants or hotels, are labour intensive as well. They all
require more labour in the production process than capital costs.

In difficult economic times, firms that are labour intensive typically


have an easier time surviving than capital intensive firms.
What does operating leverage really mean? It means that if a firm
has high operating leverage, a small change in sales volume
results in a large change in EBIT and ROIC, return on invested
capital. In other words, firms with high operating leverage are very
sensitive to changes in sales and it affects their bottom line
quickly.

Financial Leverage:Financial leverage refers to the amount of debt in the capital


structure of the business firm. If you can envision a balance sheet,
financial leverage refers to the right-hand side of the balance sheet.
Operating leverage refers to the left-hand side of the balance sheet
- the plant and equipment side. Operating leverage determines the
mix of fixed assets or plant and equipment used by the business
firm. Financial leverage refers to how the firm will pay for it or how
the operation will be financed.
As discussed earlier in this article, the use of financial leverage, or
debt, in financing a firm's operations, can really improve the firm's
return on equity and earnings per share. This is because the firm is
not diluting the owner's earnings by using equity financing. Too
much financial leverage, however, can lead to the risk of default
and bankruptcy.
One of the financial ratios we use in determining the amount of
financial leverage we have in a business firm is the debt/equity
ratio. The debt/equity ratio shows the proportion of debt in a
business firm to equity.

Combined, or Total, Leverage:Combined, or total, leverage is the total amount of risk facing a
business firm. It can also be looked at in another way. It is the total
amount of leverage that we can use to magnify the returns from our
business. Operating leverage magnifies the returns from our plant
and equipment or fixed assets. Financial leverage magnifies the
returns from our debt financing Combined leverage is the total of

these two types of leverage or the total magnification of returns.


This is looking at leverage from a balance sheet perspective.
It is also helpful and important to look at leverage from an income
statement perspective. Operating leverage influences the top half
of the income statement and operating income, determining return
from operations. Financial leverage influences the bottom half of
the income statement and the earnings per share to the
stockholders..

Q3. Individuals do have a time preference for money. State


the reason for such preference.
Answer:- Inclination of a consumer
towards current consumption (expenditure) over future
consumption, or vice versa. What may induce a consumer
to delay consumption is called Rate of Time
Preference amount of money (expressed as a proportion of
the consumer's current income) that will compensate him or her for
forgoing current consumption. This rate corresponds with
the market interest rate and depends (among other factors) on the
consumer's expectations of the future income. If the future income
is expected to be higher than the consumer's current income, he or
she will have a high rate of time preference; thus, the interest
rate has to be high enough to induce savings instead of spending.
Similarly, if the future income is expected to be less than the
current income, a rational consumer will be inclined to save even if
theinterest rate is low. Also, the consumer's rate of time preference
(hence the interest rate demanded) is likely to rise as the amount of
his or her savings rises. Therefore, the consumer will limit his or
her savings to the amount at which the rate of time
preference equals the rate of interest. This concept forms the basis
of the theory of interest proposed by the Austrian economist Eugen
von Bohem-Bawerk (1851-1914).

reason for such preference:A finance manager is required to make decisions on


investment, financing and dividend in view of the
company's objectives. The decisions as purchase of
assets or procurement of funds i.e. the
investment/financing decisions affect the cash flow in
different time periods. Cash outflows would be at one
point of time and inflow at some other point of time,
hence, they are not comparable due to the change in rupee
value of money. They can be made comparable by
introducing the interest factor. In the theory of finance, the
interest factor is one of the crucial and exclusive concept,
known as the time value of money.
Time value of money means that worth of a rupee
received today is different from the same received in
future. The preference for money now as compared to
future is known as time preference of money. The concept
is applicable to both individuals and business houses.
Reasons of time preference of money :
1) Risk :
There is uncertainty about the receipt of money in future.
2) Preference for present consumption :
Most of the persons and companies have a preference for
present consumption may be due to urgency of need.
3) Investment opportunities :
Most of the persons and companies have preference for
present money because of availabilities of opportunities of
investment for earning additional cash flows

Q5. Write short notes on:


Answer:- Effective rate of interest:- The effective interest
rate is the true rate of interest earned. It could also be referred to
as the market interest rate, the yield to maturity, the discount

rate, the internal rate of return, the annual percentage rate


(APR), and the targeted or required interest rate.

Answer:- Present value of a growing annuity:Growing


annuities are payment plans in which the payouts increase by a
fixed percent each period. The present value of a growing annuity
(PVGA) is the current monetary value of the annuity. For instance,
suppose it is January 1, 1999 and you will receive a payment on
January 1 for the next five years. Each passing year the payments
increase
by
2%.
Your
payments
are
thus:
Jan
1,
Jan
1,
Jan
1,
Jan
1,
Jan 1, 2004: $1353.04

2000:
2001:
2002:
2003:

$1250
$1275
$1300.50
$1326.51