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Time Value of Money Class Problems

1. Suppose you make an investment of Rs10,000. This first year the investment returns
15%, the second year it returns 2%, and the third year in returns 10%. How much would
this investment be worth at the end of three years, assuming no withdrawals are made?
(12903)

2. You discover that you are lucky winner of Rs 30 million. The prize money will be paid
in 30 payments of Rs 1 million per year. At a rate of 8%, what is the present value of the
prize money? ( Rs 11.26 million)

3. Amit just turned 35 years old and he decides it is time to plan seriously for his
retirement. On each birthday, beginning in one year and ending when he turns 65, he will
deposit Rs 10,000 in a savings account. If the savings earn 10%, how much would have
Amit saved at the age of 65 years? (Rs 16,44,940.23)

4. What is the present value of a stream of Rs 2,500 semiannual payments received at (i) the
end of each period (ii) the start of the period for the next 10 years? The annual rate is
6%. (i) Rs 37193.69 (ii) Rs 38309.50

5. You borrow Rs 80,000 to be repaid in equal monthly installments for 30 years. The
annual nominal rate is 9%. What is the monthly payment? (Rs 643.70)

6. You borrow Rs 5,000 and repay the loan with 12 equal monthly payments of Rs 500?
Calculate the interest rate per month and the yearly nominal rate. (2.92%, 35.07%)

7. A pipeline would generate Rs 2 million cash return over the coming year. The operating
cost is negligible and the volume would decline at a rate of 4%. The discount rate is 10%.
What is the present value of the cash flows? (Rs 14.28 million)
8. How much would must you deposit monthly in an account paying 6% a year,
compounded monthly, to accumulate Rs. 1,000,000 by age 65 beginning at age 30? (Rs
701.90)

9. An NGO has received a credit of Rs 10 million from a National Development Finance Body. The
funds are to be used for financing to needy, deserving people to enable them to engage in some
self-sustaining ventures. The credit carries a nominal annual interest rate of 10% and has to be
repaid by the NGO in 5 half yearly installments. The NGO in turn, would finance Rs 20,000/- to
each of 500 beneficiaries who have already been identified. The beneficiaries would also have to
repay the amount to the NGO in 5 equal half yearly installments but they would be charged a
nominal annual interest rate of 12% per annum.

Discussion points:

1. What would be the half yearly installment that the NGO has to pay to the National
Development Finance Body. ( Rs 2.31 million)
2. What would be the half yearly installment that each beneficiary has to pay to the
NGO (Rs 4747.93)
3. Prepare the Loan Amortization schedule for the loan taken and repaid by the NGO

10. You plan to retire in twenty years. If the annual (year-end) amount you save each year increases
annually at a 6 percent rate (the growth rate of your income) and will be Rs. 10,000 initially at
year end, and if you can earn 8 percent on your savings, how much will your retirement fund be
worth in 20 years? (Rs 7,26,910)

11. Your Uncle expects to live another 10 years. He currently has Rs 5,00,000 in savings which he
wishes to spread evenly in terms of purchasing power over the remainder of his life. Since he
feels inflation will average 6 percent annually, his annual beginning-of-year withdrawals should
increase at a 6% growth rate. If he earns 8 percent on his savings not withdrawn, how much
should his first withdrawal be? ( Rs 58685.44)
Capital Budgeting Class Problems

1. BlackInSoon, Inc., has estimated that a proposed project’s 10-year annual net cash benefit, received
each year end, will be Rs. 2,500 with an additional terminal benefit of Rs. 5,000 at the end of the
tenth year. Assuming that these cash inflows satisfy exactly BlackInSoon’s required rate of return of
8%, calculate the initial cash outlay. (Rs 19,091)

2. A project has the following expected cash flows: CF0 = (Rs. 500), CF1 = Rs. 200, CF2 = Rs. 200, CF3 = Rs.
400. Using a 10% discount rate and reinvestment rate, what is the MIRR and the profitability index?
(MIRR=25.75% , PI= 1.29)

3. You have the opportunity to invest in a project which pays Rs. 1,000 annually. Your required rate of
return on this investment is 15%. What should be the initial investment for which you would be
essentially indifferent to investing or not investing in the project? (Rs 6,666 assuming perpetual
returns)

4. You are planning to buy a few cars for your rental car company. These cars will cost you Rs. 300,000.
From these cars you expect to make Rs. 120,000 in the first year. Over the next four years, your
payouts from the cars are expected to DECLINE by 20% per year relative to the previous year. Then
in the next year, the payout is expected to be Rs. 35,000, including any proceeds from the sale of the
cars. The discount rate for this investment is 14%. Assume all future cash flows occur at the end of
the year.
(a) Compute the investment’s NPV. ( -Rs 14,474)
(b) Compute the IRR of the investment. (11.55%)
(c) Would you invest in the project based on its NPV? Would you invest in the project based on its
IRR? (No)

5. You are offered an investment with the following conditions:


- The cost of the investment is Rs. 1,000.
- The investment pays out a sum X at the end of the first year; this payout grows at the rate of 10
percent per year for 11 years.

If your discount rate is 15 percent, calculate the smallest X that would entice you to purchase the
asset. For example, as you can see in the following display, X = Rs. 100 is too small - the NPV is
negative. (x = Rs 130)

6. A cosmetic company is considering introducing a new lotion. The manufacturing equipment will cost
Rs. 5,60,000. The expected life of the equipment is 8 years. The company is thinking of selling the
lotion in single standard pack of 50 grams at Rs. 12 each pack. It is estimated that variable cost per
pack would be Rs. 6 and annual fixed cost of Rs. 4,50,000. Fixed cost includes (straight line)
depreciation of Rs. 70,000 and allocated overheads of Rs. 30,000. The company expects to sell
1,00,000 packs of the lotion each year. Assume that tax is 45% and straight line depreciation is
allowed for tax purpose. Calculate the cash flows.

7. Gagan, an NGO, plans to start a project whereby they will supply fertilizers to small farmers for free
under the “Kisan Vikas Yojna”. Gagan needs to invest in a mini-truck to supply the farmers. They
have two options: Truck X and Truck Y. Details are given below:
X Y
Initial Cost Rs 7,20,000 Rs 4,50,000
Salvage Value 0 0
Life of the Vehicle 5 years 4 Years
Operating Cost Rs 18000 per year Rs 24000 per year

Discount rate is 8%. Which alternative will Gagan choose?

9. XYZ is introducing a new plant. The cost is estimated at Rs 250 Lakh. The annual capacity of the plant
is to manufacture 5,00,000 packets. The price per packet would be Rs 140 and variable cost per packet
would be Rs 85. The initial fixed cost would be Rs 150 Lakhs which includes onetime promotion
expenditure of Rs 75 lakhs. WDV depreciation rate is 25%. Working capital requirement is 15% of sales.
Inflation is expected to be 4.6% p.a. Life of plant 7 years. The salvage value of plant is Rs 25 Lakhs, tax:
35% and required rate of return is 9%.

Utilization:

Year 1 2 3 4 5 6 7

Utilization (%) 25 35 50 75 90 100 100


Valuation of Bonds – Class problems

1. You have bought a 7%, Rs 1000 bond maturing in 8 years for Rs 850. What is the return you
would receive if you hold the bond till maturity? You wish to sell this bond after one year and
the price you would receive is Rs 863.22. What is the current yield and capital gains yield on this
bond. Have you made a loss or a gain compared to the original expected return? Explain.

2. A firm has two bond issues outstanding (bond X and bond Y). Both bonds pay Rs 100 annual
coupons and have face value of Rs 1000. Bond X has a maturity of 2 years and bond Y has
maturity of 15 years.
a. What will be the value of each bond if discount rate is (i) 5% (ii) 10%
b. Explain the reason for fluctuations.

3. XYZ firm’s bonds will mature in 10 years. The bonds have a face value of Rs 1000 and an 8%
coupon rate paid semi annually. The discount rate for the bond is 6.62%. What is the value of
the bond?
If the bonds are callable in 5 years at a call price of Rs 1050, what is the yield to call for this
bond?

4. The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during
the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year
Treasury securities? What is the yield on 3-year Treasury securities?

5. A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield
of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default
risk premium on the corporate bond?
Problems Valuation of Shares

1. Consider the stock of Davidson Company that will pay an annual dividend of $2 in the
coming year. The dividend is expected to grow at a constant rate of 5 percent
permanently.
The market requires a 12-percent return on the company.
a. What is the current price of a share of the stock? Ans: $28.57
b. What will the stock price be 10 years from today? Ans: $346.5

2. Allen, Inc., is expected to pay an equal amount of dividends at the end of the first two
years. Thereafter, the dividend will grow at a constant rate of 4 percent indefinitely. The
stock is currently traded at $30. What is the expected dividend per share for the next year
if the required rate of return is 12 percent? Ans: $2.04

3. You own $100,000 worth of Smart Money stock. At the end of the first year you receive
a dividend of $2 per share; at the end of year 2 you receive a $4 dividend. At the end of
year 3 you sell the stock for $50 per share. Only ordinary (dividend) income is taxed at
the rate of 28 percent. Taxes are paid at the time dividends are received. The required rate
of return is 15 percent. How many shares of stock do you own? Ans: Value of Share:
36.3, No of shares: 2754

4. Whizzkids, Inc., is experiencing a period of rapid growth. Earnings and dividends per
share are expected to grow at a rate of 18 percent during the next two years, 15 percent in
the third year, and at a constant rate of 6 percent thereafter. Whizzkids’ last dividend,
which has just been paid, was 1.15. If the required rate of return on the stock is 12
percent, what is the price of a share of the stock today? Ans: 30.93

5. A company retains 70% of its earnings, which are currently Rs1 5 per share. Its
investment opportunities promise a return of 15%. What price should be paid for the
share if the required rate of return is 13%? What is the value of growth opportunities?
Ans: Price of Share: Rs 154.7. Value of Growth opportunities: 154.7-115.3= Rs 39.31

6. A company has earnings of Rs 25 million. Its paid up share capital is Rs 200 million with
a face value of Rs 10. If the company makes no new investments, its earnings are
expected to grow at a rate of 2% indefinitely. It has an opportunity of investing Rs 10
million which will generate net earnings of Rs 2 million for next 15 years. The
company’s opportunity cost of capital is 10%. Find the share value if the company does
not make the investment. Find NPV of this investment opportunity. Find share value if
this investment is undertaken.
Ans: Value of share (No investment): Rs 15.93, Value of share (with inv): 15.93+0.11=
Rs 16.05.
Class Problems: Risk and Return

1. A stock has had returns of 29%, 14%, 23%, -8%, 9% and 14% over the last 6 years. What
is the arithmetic and geometric return for the stock? (14%, 12.87%)

2. Mr. Henry can invest in Highbull stock or Slowbear stock. His projection of the returns
on these two stocks is as follows:
State of Probability of Return on Return on
Economy State Occurring Highbull Stock (%) Slowbear
Recession 0.25 -2.0% 5.0%
Normal 0.60 9.2 6.2
Boom 0.15 15.4 7.4
Calculate the expected return and std dev. of each stock. Calculate the covariance and
correlation between the two stocks. (Exp ret: 0.0733, 0.0608 STDEV: 0.0579, 0.0074
Covariance: 0.000425, Correl: 0.97)

3. You own a portfolio that has Rs 1200 invested in stock A and Rs 1900 invested in stock
B. If the expected returns on the stock are 11% and 6% and the standard deviations of the
stock are 25 and 4% respectively. What is the expected return and standard deviation of
the portfolio assuming perfect positive correlation? (7.93%%, 12.12%)

4. The Alpha firm makes pneumatic equipment. Its beta is 1.2. The market risk premium is
8.5 percent, and the current risk-free rate is 6 percent. What is the expected return for the
Alpha firm? ( 16.2%)

5. Suppose the beta for the Ross Corporation is 0.80. The risk-free rate is 6 percent, and the
market risk premium is 8.5 percent. What is the expected return for the Ross
Corporation? (8%)

6. A portfolio has 40% invested in Asset 1 and 60% invested in Asset 2. If Asset 1 has a
beta of 1.2 and Asset 2 has a beta of 1.8, what’s the beta of the portfolio? (1.56)

7. A stock X has a beta of 1.2 and an expected return of 16%. A risk free asset currently
earns 5%.
a. What is the expected return and beta on a portfolio that is equally invested in the
two assets? (10.5% and 0.6)
b. If a portfolio of the two assets has a beta of 0.75, what are the portfolio weights?
(62.5%. 37.5%)
c. If a portfolio of two assets has an expected return of 8%, what is beta of X?
(27.27%, 0.324)

8. The risk-free rate is 8 percent. The beta for the Jordan Company is 1.5, and the expected
return of the market is 15 percent. What is the expected return for the Jordan Company?
Suppose the market risk premium is 7.5 percent and the risk-free rate is 3.7 percent. The
expected return of TriStar Textiles is 14.2 percent. What is the beta for TriStar Textiles? (
18.5%, 1.4)

9. Suppose the current risk-free rate is 7.6 percent. Potpourri Inc. stock has a beta of 1.7 and
an expected return of 16.7 percent. (Assume the CAPM is true.)
a. What is the risk premium on the market? (5.35%)
b. Magnolia Industries stock has a beta of 0.8. What is the expected return on the
Magnolia stock? (11.9%)
c. Suppose you have invested Rs10,000 in both Potpourri and Magnolia, and the beta of
the portfolio is 1.07. How much did you invest in each stock? What is the expected return
on the portfolio? (3000,7000) , (13.34)

10. Suppose you have invested Rs30,000 in the following four stocks.
Security Amount Invested Beta
Stock A Rs 5,000 0.75
Stock B Rs10,000 1.10
Stock C Rs8,000 1.36
Stock D Rs7,000 1.88
The risk-free rate is 4 percent and the expected return on the market portfolio is 15
percent.
Based on the CAPM, what is the expected return on the above portfolio? (18.23%)
Practice Problems: Capital Structure

1. Ansal, a well-known consumer good company, is evaluating whether or not to change its
all-equity capital structure to one that is 40 percent debt. Presently, there are 2,000 shares
outstanding and the price per share is Rs. 70. EBIT is expected to remain at Rs. 16,000
per year till perpetuity. The interest rate on new debt is 8 percent, and there are no taxes.
a. A shareholder of the firm owns 100 shares of stock. What is her cash flow under
the current capital structure, assuming the firm has a dividend payout rate of 100
percent?
b. What will the shareholders’ cash flow be under the proposed capital structure of
the firm? Assume that she keeps all 100 of her shares.
c. Suppose Ansal does not convert, but the shareholder prefers the new capital
structure. Show how she could recreate the new capital structure.
d. Suppose Ansal does convert, but the shareholder prefers the current all-equity
capital structure. Show how she could unlever her shares of stock to recreate the
original capital structure.
e. Using your answer to part (c), explain why Ansal's choice of capital structure is
irrelevant.

2. Bradget & Co. expects its EBIT to be Rs. 95,000 every year till perpetuity. The firm can
borrow at 11 percent. Bradget at present has no debt, and its cost of equity is 22 percent.
If the tax rate is 35 percent, what is the value of the firm? What will the value be if
Bradget borrows Rs. 60,000 and uses the proceeds to repurchase shares?

3. Tool Manufacturing has an expected EBIT of Rs. 35,000 in perpetuity and a tax rate of
35 percent. The firm has Rs. 70,000 in outstanding debt at an interest rate of 9 percent,
and its unlevered cost of capital is 14 percent. What is the value of the firm according to
M&M Proposition I with taxes? Should Tool change its debt-equity ratio if the goal is to
maximize the value of the firm? Explain.

4. Old School Corporation expects an EBIT of Rs. 9,000 every year forever. Old School
currently has no debt, and its cost of equity is 17 percent. The firm can borrow at 10
percent. If the corporate tax rate is 35 percent, what is the value of the firm? What will
the value be if Old School converts to 50 percent debt? To 100 percent debt?
WCM PROBLEMS

1. Williams & Sons last year reported sales of Rs. 10 million and an inventory turnover ratio
of 2. The company is now adopting a new inventory system. If the new system is able to
reduce the firm’s inventory level and increase the firm’s inventory turnover ratio to 5
while maintaining the same level of sales, how much cash will be freed up? (3 million)

2. A large retailer obtains merchandise under the credit terms of 1/15, net 45, but routinely
takes 60 days to pay its bills. (Because the retailer is an important customer, suppliers
allow the firm to stretch its credit terms.) What is the retailer’s effective cost of trade
credit? (8.49%.)

3. The Zocco Corporation has an inventory conversion period of 60 days, an average


collection period of 38 days, and a payables deferral period of 30 days. Assume that cost
of goods sold is 75% of sales.

a. What is the length of the firm’s cash conversion cycle? (83 days)
b. If Zocco’s annual sales are Rs. 3,421,875 and all sales are on credit, what is the
firm’s investment in accounts receivable? (356,250)
c. How many times per year does Zocco turn over its inventory? (4.87)

4. Suppose a firm makes purchases of Rs. 3.65 million per year under terms of 2/10, net 30,
and takes discounts.
a. What is the average amount of accounts payable net of discounts? (Assume the
Rs. 3.65 million of purchases is net of discounts—that is, gross purchases are Rs.
3,724,489.80, discounts are Rs. 74,489.80, and net purchases are Rs. 3.65
million.) (100,000)
b. If the firm did not take discounts but did pay on the due date, what would be its
average payables and the cost of this nonfree trade credit? (300,000, 44.59%)
c. What would be the firm’s cost of not taking discounts if it could stretch its
payments to 40 days? ( 24.83%, 27.86%)
Time value of Money Formulas

1. Present Value

𝐶𝐶𝐶𝐶
𝑃𝑃𝑃𝑃 =
(1 + 𝑟𝑟)𝑛𝑛
where CFn is the single cash in the nth period. R is the discount rate

0 1 2…… n

| | | |

CF

2. Future Value

𝐹𝐹𝐹𝐹 = 𝐶𝐶𝐶𝐶 ∗ (1 + 𝑟𝑟)𝑛𝑛


0 1 2…… n

| | | |

CF

3. Present Value of an annuity ( a. ordinary annuity b. annuity due)

𝐶𝐶𝐶𝐶 1
a) 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = ∗ �1 − �
𝑟𝑟 (1+𝑟𝑟)𝑛𝑛

b) PV of annuity due = PV of normal annuity * (1+r)


0 1 2…… n

| | | |

CF CF CF
4. Future value of an annuity (a. ordinary annuity b. annuity due)

𝐶𝐶𝐶𝐶
a) 𝐹𝐹𝐹𝐹 𝑜𝑜𝑜𝑜 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = ((1 + 𝑟𝑟)𝑛𝑛 − 1)
𝑟𝑟

b) FV of annuity due = FV of normal annuity * (1+r)

0 1 2…… n

| | | |

CF CF CF

5. Present value of growing annuity

𝐶𝐶𝐶𝐶1 (1 + 𝑔𝑔)𝑛𝑛
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = �1 − �
(𝑟𝑟 − 𝑔𝑔) (1 + 𝑟𝑟)𝑛𝑛
0 1 2…… n

| | | |

CF1 CF2 CF3

CF0(1+g) CF0(1+g)^2 CF0(1+g)^n

6. Future value of growing annuity

𝐶𝐶𝐶𝐶1
𝐹𝐹𝐹𝐹 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = ((1 + 𝑟𝑟)𝑛𝑛 − (1 + 𝑔𝑔)𝑛𝑛 )
(𝑟𝑟 − 𝑔𝑔)
0 1 2…… n

| | | |

CF1 CF2 CF3

CF0(1+g) CF0(1+g)^2 CF0(1+g)^n

7. Perpetuity
𝐶𝐶𝐶𝐶
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =
𝑟𝑟

0 1 2…… ∞

| | | |

CF CF CF

𝐶𝐶𝐶𝐶1
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑎𝑎 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =
𝑟𝑟 − 𝑔𝑔
0 1 2…… ∞

| | | |

CF1 CF2 CF∞