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Annuity = 100
4. Sinking Fund:
If A plans to invest Rs 10,000 today for a period of 4 years, and the interest rate
is 10%, how much income per year should he receive to recover the investment?
In this question, in order to use the formula of Sinking Fund, we need to find the
Future value of investment.
FV = 10000 ( 1 + 0.10) 4 = 14641
Now, Sinking Fund / Annuity = Future Value * 1
( (1 + i)n -1 / interest )
Sinking Fund = 10,000 * 1 / (1.10)4 -1/ 010 = 3155
5. Present Value of Annuity Factor (PVAF):
An investor will receive Rs 1000, 1500, 800, 1100 and 400 respectively each year
for the next 5 years.
Find out the present value of this stream of uneven cash flows, if the interest rate
is 8%.
Present Value = 1000 / (1.08) + 1500/ (1.08)2 + 800/ (1.08)3 + 1100/ (1.08)4 +
400/ (1.08)5
This can be calculated manually using a normal calculator.
PV = 1000 * 0.926 + 1500 * 0.857 + 800 * 0.794 + 1100 * 0.735 + 400 * 0.681 =
3927.60
6. Present Value Factor:
Calculate the Present Value of Rs 1000 received 5 years from now, assuming an
interest rate of 8%
Solution:
Formula of PVF = FV * (1/ (1 + i)n )
PVF = 1000 * 1/ (1.08)5 = 680
In hit and trial, sometimes you might arrive at the exact answer in one go
as well. A small difference of Rs 50 can be ignored here unless the answer
choices do not contain values near 10% like 10.06% or 10.13% et cetera)
9. Annuity- Time Value of Money:
A company wants to buy a machinery costing Rs 20,00,000. The company makes
15% down payment and borrows the remaining at 9% interest rate. The loan is
to be repaid in 8 equal annual installments beginning 4 years from now. What is
the size of the required annual loan repayments?
Solution:
The firm pays Rs 300,000 and borrows Rs 1700,000. Compound Interest occurs
over the entire 11 years of life of the loan.
Method to calculate time period- since first installment starts at the end of 4th
year and there are 8 installments, the time period comes out to be 11 years.
We have to find out annuity payments from 4th year onwards. To do that, first
calculate the value of 1700,000 at the end of 3 years. It will be the PV of annuity
starting from 4th year onwards.
FV = PV (1 + r) n
FV = 1700,000 (1.09)3 = 2201550
Now, applying the following formula of annuity, we can calculate the yearly
installment:
PV = Annuity * (1 – 1/(1 + i)n) / i
Annuity = 2201500/ 5.535 = 397750
12. Capital Budgeting decision:
ABC is trying to decide whether it should replace a manually operated machine
with a fully automatic version of the same machine. The existing machine,
purchased 10 years ago, has a book value of Rs 140,000 and remaining life 10
years. Salvage value is Rs 40,000. Maintenance expenses on the present machine-
Rs 20,000 per year. The company has been offered Rs 100,000 for the old
machine with trade for the new machine which costs rs 220,000 before exchange
price. Its life is 10 years and salvage value is 20,000. Installation expense- Rs
40,000. Annual savings on the new machine is Rs 80,000. No annual maintenance
charges. The tax rate is 40% depreciation is straight line. Should the investor buy
the new machine?
The required rate of return is 10%
Solution:
Answers of this type need to be divided into initial cash outflow (assuming that
new machine is purchased); regular incremental cash outflows or inflows and
terminal cash outflow or inflow.
Initial cash outflow-
Cost of the new machine 220,000
+ installation expense 40,000
- trade in for old machine 100,000
tax saving (capital gain tax) 16000
144000 (outflow)
(The old machine has a book value of 140,000 but is sold away for Rs
100,000. Thus, there is a capital loss of Rs 40,000. This capital loss will save
tax to the extent of 40% i.e. 16000)
Subsequent cash flows (incremental):
IRR = L + A *(H-L)/(A-B)
IRR = 10% + 67 *1/ 67 – (-235) = 10.22%
If the opportunity cost is more than IRR, the project is to be rejected.
15. Internal Rate of Return:
Outflow of two projects is given as 100,000 each. Project A earns a cash inflow of
Rs 30,000 for 5 years and Project B earns a cash inflow of 40,000 for 5 years.
What is the IRR of both projects?
Solution:
Project A-
PV of Outflow= 100,000
PV of inflow = 30,000 * (1 – 1/(1 + i)n ) / I
For IRR, outflow is equal to inflows.
Using hit and trial method, at 15%, PV of Inflow = 30,000 * 3.352 = 100564
At 16%, PV of inflows = 30,000 * 3.274 = 98228
Interpolating between 15 and 16, IRR comes to be
IRR = L + A *(H-L)/(A-B)
15% + 564 *1/ 564 – (1772) = 15.24%
Similarly for Project B can also be calculated
16. Yield to maturity:
Consider a Rs 100 par value bond. The current market price is Rs 85. Maturity
period is 9 years and coupon rate is 8%. Find out the rate of return earned by the
investor on this bond
Solution:
To measure YTM-
PV of cash outflow (B0) = PV of inflows
85 = 8 * PVAF (9 years, @ ytm) + 100 * PVF (9 years, @ ytm)
Hit and Trial method can now be used to find out YTM (similar to IRR)
17. A Rs 5000 bond with a 10% coupon rate matures in 8 years and currently sells at
97%. Is this bond a desirable investment for an investor whose required rate of
return is 11%
Answer:
PV = Interest (1/ 1 + .11)1 +…(1/ 1 + .11)8 + (5000/ 1 +0.11)8 = 4743
Current price in the market = 5000 * 97% = 4850
Since the bond is available at a higher price than its present value, it is not
desirable
18. Mrs. Laxmi bought 10% p.a. Bonds of ABC Limited for Rs.105/- each, the face
value being Rs.100/- each, with maturity date being exactly 3 years after the date
of acquisition. Assuming market rate of return being 12% p.a., the per bond
present value of the inflow will be:
a. Rs. 130.00
b. Rs. 95.30
c. Rs. 102.70
d. Rs. 87.90
e. Rs. 114.40
Answer:
Now, we find out present values of the bond at 15% and 16%, assuming IRR as
given (hit and trial):
At 16%, it is 903.73
We need to get the %age IRR at 900, for that one % should be above 900 and
another below 900, as~~ 900 = 100/(1 + k)1 + 100/ (1 +k)2 + 1000/ (1 + k)2
So, we have 16% and 17%, 16% being above 900 and 17% being below 900:
IRR= lower % + (PV at lower %age – 900)/ (PV at lower % - PV at Higher %age)
* difference between %ages
IRR= 16.25%
Find out:
Answer:
21. ABC ltd issues 12.5% debentures of face value of Rs 100 each, redeemable at the
end of 7 years. The debentures are issued at a discount of 5% and floatation cost
is estimated to be 1%. Find out the cost of capital of debentures given that the
firm has 40% tax rate.
Answer:
PV/ B0 = 100 – 5% - 1% = 94
Applying formula 1, find the approx. value of IRR by using the formula~~
Now, we find out present values of the bond at 8% and 9%, assuming IRR as
given (hit and trial):
At Kd = 8%,
At Kd = 9%
Both the above figures lie on either side of 94, thus now we apply formula 2,
IRR = lower % + (PV at lower %age – 94)/ (PV at lower % - PV at Higher %age) *
difference between %ages
IRR = 8.68%
Answer:
Long term debt = total debt – current liabilities = 1,00,000 – 50,000 = 50,000
Reserves= 250,000
Answer:
24. Financial leverage:
The sales of A ltd are given as 500. Variable cost is 40% of sales. Fixed costs are
Rs 150. Interest expense is Rs 50
Find out Financial leverage of A ltd.
Solution:
FL = EBIT/ PBT = 150/ 100 = 1.5
25. Financial leverage:
The sales of P ltd are given as Rs 10,00,000. Variable cost is 60% and fixed
expenses are 200,000. Interest on loan is 10% on 10,00,000. Tax rate is given as
30%. Find out Financial leverage.
Solution:
FL = EBIT/ PBT = 200,000/ 100,000 = 2