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Module 1

Topic: Future Value and Compounding (Time value of money)

Source: Fundamental of Corporate Finance by Parrino, Bates, Gillan, Kidwell and Pooja

Q1. You have an opportunity to make a $5,000 investment that pays 15 percent per year. How
much money will you have at the end of 10 years. (Ans. $20227.79), (Chpt. 5, P. No. 5.9)

Q.2. Situation 1: your grandmother has $10,000. She wants to put into a bank saving account for
five years. The bank, Bank A, she is considering is within walking distance pays 5 percent
annual interest compounded quarterly. Another bank, Bank B, in town pays 5 percent interest
compounded daily. Which bank should your grandmother select? (Ans. Bank A: $12,820.37,
Bank B: $12840.03) (Chpt. 5, P. No. 5.11)

Situation 2: Bank A provides a free coffee bar and doughnuts’ in the morning to your
grandmother but for Bank B, your grandmother can ride free as a senior citizen. Now which bank
should your grandmother select? (Ans: She should enjoy free coffee and doughnuts).

Q. 3. Suppose you leave your $100 invested in the bank saving account at 10 percent interest for
five years. How much would you have in the bank at the end of 5 years? (Ans. $161.05) (Chpt. 5,
P. No. 5.7)

Q.4 (on Future value) Suppose you need $161.05 after 5 years. How much should you invested
in the bank saving account if the interest rate is 10 percent per annum? (Ans. $100)

Q.5 (on Future value) Suppose you are interested in buying a car after two years. You estimate
that the car will cost $40,000. If your local bank pays 5 percent interest on saving deposits, how
much money will you need to save in order to buy the car as planned? (Ans. $36,281.18, Chpt. 5,
p. no. 2.19)

Q.6 Suppose you plan to take a vacation to Europe when graduate from college in two years. If
your savings account at the bank pays 6 percent, how much money do you need to set aside
today to have $8,000 when you leave for Europe? (Ans. $7,119.97, Chpt. 5, p. no. 5.20 )

Q. 7. Congratulation! You have won the $1 Million lottery grand prize. You have been presented
with several payout alternatives and you have to decide which one to accept. The alternatives are
as follows:

 $1 Million today.
 $1.2 Million lump sum in two years
 $1.5 Million lump sum in five years
 $2 Million lump sum in eight years
Your cousin, a financial advisor, advises you that over the long term you should be able to earn
10 per cent on an investment. You are intrigued by the choice of collecting the prize money
today or receiving double the amount of money in the future. Which payout option should you
choose?

(Ans. alternative first; $1 Million should be accepted, Chpt. 5, P. No. 5.23)

Q.8 Suppose a firm is planning to issue $10 Million worth of zero coupon bonds with 20 years to
maturity. The bonds are issued in denomination of $1000 and are sold for $90 each. In other
words, the investor buys a bond for $90 and 20 years from now the firm pays the investor $1000.
If you bought one of these bonds, what would be your return on investment? (Ans. 12.79%, chpt.
5, p. no. 5.23)

Q. 9 (CAGR) Suppose that because of an advertisement campaign, a firm sales increased from
20 Million units in 2017 to more than 35 Million in 2020. What has been the average annual
growth rate (or compound annual growth rate, CAGR) in unit sales? (Ans. 20.51%, Chpt. 5, P.
no. 5.26)

Q. 10 Hannah, an industrial relation major, is writing a term paper and needs an estimate of how
fast the world population is growing. In her almanac, she finds that the world’s population was
an estimated 7.4 Billion people as of August 2016. The United Nations estimates that the
population will reach 11.2 billion people in 2100. Calculate the annual population growth rate (or
CAGR) implied by these numbers. At that growth rate, what will be the World’s population in
August 2030. (Ans. 0.5%, 7.94 billion pople, Chpt. 5, P No. 5.27).

Q. 11 (Advanced) You have $12,000 in cash. You can deposit it today in a mutual fund earning
8.2 percent compounded semiannually, or you can wait, enjoy some of it, and invest $11,000 in
your brother's business two years from today. Your brother is promising you an annual return of
10 percent on your investment, but you will receive zero return for the two years that you are
waiting to invest with him. Assume that both investments have the same risk. Which investment
will give you the largest amount 10 years from today? ((Q. 5.33, Chpt. 5, P. No. 5.32)

Q.12 (Present value) Suppose you have the opportunity to buy a small business while you are in
a school. The business involves selling sandwiches, drinks and snack foods from a food truck
that you park around campus. The annual cash flows from the busi- ness have been predictable.
You believe you can expand the business, and you estimate that cash flows will be as follows:
$2,000 in the first year, $3,000 in the second and third years, and $4,000 in the fourth year. At
the end of the fourth year, the business will be closed down because the truck and other
equipment will need to be replaced. You did some research and found that a 10 percent discount
rate would be appropriate. How much should you pay for the business? (Ans. $9,283.51, Chpt. 6,
P. No. 6.7)
Q.13 (Present value) Suppose that your best friend needs cash and offers to pay you $1.000 at
the end of each of the next three years if you will give him $3,000 cash today. You realize that
because of the time value of money, the cash flows he has promised to pay are worth less than
$3,000. If the interest rate on similar loans is 7 percent, how much should you pay for the cash
flows your friend is offering? (Ans. $2624.32, he should not pay $3000,) (Any other method to
solve this question?, Chpt 6, P. No. 6.5)

Q.14 {Present value Annuity or ordinary annuity (when equal cash payment is received at the
end of each period is called annuity or ordinary annuity)}

Q Suppose that a financial contract pays $2,000 at the end of each year for three years and the
appropriate discounting rate is 8%. What is the most we should for this contract (annuity)?
($5154.19, Chpt 6, P. No. 6.9)

Q. 15 A loan of ₹10,00,000 has been given at an annual interest rate of 7.2% for 10 years by a
bank. Calculate monthly payment.

Step 1: calculate monthly interest rate: 7.2/12 = 0.5916% monthly

Step 2: calculate Present value factor for 120 months: 1/(1.005916)^120 = 0.4927

Step 3: Calculate Present value factor annuity: (1-PVF)/i = (1-0.4927)/0.005916 = 85.75

Step 4: Calculate monthly payment: 1000000/85.75 = Rs. 11,662 (App.) Ans.

Q.16 (Monthly or yearly payment or installments) suppose you have just purchase a $ 450,000
flat in Miami’s south beach district. You were able to put $50,000 down and obtain a 30-year,
fixed rate mortgage at 6.125% percent for the balance. What are your monthly payments? (Ans.
$2430.45, Chpt 6, P. No. 6.11)

Q.17 Developing Amortization schedule (table)

You have taken $10,000 loan with an interest rate of 5% for 5 years. Prepare an amortization
table (or schedule) for a five-year loan amount. (Annual payment: $2309.75 Or $2,310, prepare
table from your side) (Chpt. 6, P. No. 6.13)

Q.18 Topic: Perpetuity (A perpetuity is a series of equally spaced and level cash flows that goes
on forever. The most important perpetuities in the securities markets today are preferred stock
issues (preference share). The issuer of preferred stock promises to pay investors a fixed
dividend forever unless a retirement date for the preferred stock has been set. When these
expected cash flows are constant, they can be viewed as a perpetuity. PVP = CF/i)

Q. Suppose you had a great experience during your studies at the school of business and decided
to endow a scholarship fund for finance students. The goal of the fund is to provide the
university with $100,000 of financial supper each year forever. If the rate of interest is 8 percent,
how much money will you have to give the university to provide the desired level of support?
(Chpt. 6, P. No. 6.22)

Q. Preferred stock Dividend

Q.19. Suppose that you are the CEO of a public company and your investment banker
recommends that you issues preferred stock at $50 per share. Similar preferred stock issues are
yielding 6 percent. What annual cash dividend does the fin need to offer to be competitive in the
marketplace? In other words, what cash dividend paid annually forever would be worth with a 6
percent discount rate? Ans. $3, Chpt. 6, P. No. 6.21

Q.20. Topic: Growing Annuity: (Financial managers often need to compute the value of
multiyear product or service contract with cash flows that increase each year at a constant rate.
These are called growing Annuities. PVAn = CF1/(i-g) X [1-{(1+g)/(1+i)}n]

Q. Suppose you work for a company that owns amber of coffee shops in the New York City area.
One coffee shop is located in the Empire Building, and your boss wants to know how much it is
worth. The coffee shop has a lease, so we will assume that it will be in business for 50 years. It
produced cash flows $3000,000 after all expenses this year, and the discount rate used by similar
businesses is 15 percent. You estimate that, over the long term, cash flows will grow at 2.5
percent per year because of inflation. Calculate the value of coffee shop. (Ans. $2,452,128 Chpt.
6, P. No. 6.23).

Q.21 (Advance)

Gary Kornig is 30 years old and wants to retire when he is 65. So far, he has saved (1) $6,950 in
an IRA account in which his money is earning 8.3 percent annually and (2) $5,000 in a money
market account in which he is earning 5.25 percent annually. Gary wants to have $1 million
when he retires. Starting next year, he plans to invest the same amount of money every year until
he retires in a mutual fund in which he expects to earn 9 percent annually. How much will Gary
have to invest every year to achieve his savings goal?

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Topic: Risk and return

Q.22. One year ago today, you purchased a share of Twitter, Inc, stock for $32.05. today it is
worth $44.00. what total return (holding period return) did you earn on this stock over the past
year if Twitter paid $ 1 as the dividend. (Chpt. 7, p. no. 7.3, a mixed Question taken)

Q.23b. Jennifer has invested $5,000 into a money market that earns 10% in year one, 6% in year
two, and 2% in year three. Calculate Jennifer’s return using Arithmetic average return and
Geometric (compounded) average return. Which return is profitable for her? (Ans. Under
Arithmetic Average return: $5,955.08, Geometric average return: $5,946.66)
(Note: Geometric average return = [(1+R1) x (1+R2) x (1+R3) x………..(1+Rn)^1/n – 1]

Q.23a. (Expected return with probability)

Suppose you are considering to purchase Twitter, Inc. stock for $44.00. you plan to sell stock in
one year. You estimate the following:

Probability (%) Price($)

30 41.50
30 47.00
30 48.25
10 50
What is the return (expected return) that you expect from this stock in the next year? (Ans.
4.60%, chpt. 7, p.no. 7.6)

Q.24 Assume that you are considering investing in one of two stocks for next year: Advance
Micro Device (AMD) or Intel. Also, to keep things simple, assume that there are only three
possible economic conditions (outcomes) a year from now and the returns on AMD and Intel
under each of these outcomes are as follow:

Eco. outcome Probability AMD Return Intel Return

Poor O.2 -0.13 -0.10
Neutral 0.5 0.10 0.07
Good 0.3 0.25 0.22
Calculate each stock expected rate of return, Variance and Standard Deviation. (Ans. E(r AMD)
= 9.9%, E(r Intel) = 8.1%, SD = 13.164% and 11.140%, Chpt. 7, P. No. 7.18)

Q. 25 (Home work) For each year from 2015 through 2019, the annual returns on small U.S. stocks were
-3.60 percent, 25.65 percent, 11.19 percent, -11.60 percent, and 20.63 percent, respectively. What
would a $1 investment, made at the beginning of 2015, have been worth at the end of 2019 (Geometric
avg. return in $)? What average annual return would have been earned on this investment?

(Geometric average Return = $1.436, Geometric average return (yield) = 7.51 percent per year. Chpt. 7,
P. No. 7.37)

Q. 26 (Intermediate) (home work)

Calculating the variance and standard deviation:

Barbara is considering investing in a company's stock and is aware that the return on that investment is
particularly sensitive to how the economy is performing. Her analysis suggests that four states of the
economy can affect the return on the investment. Using the table of returns and probabilities that
follows, find the expected return and the standard deviation of the return on Barbara's investment.

Economic outcome Probability Return

Boom 0.1 25%
Good 0.4 15%
Level 0.3 10%
Slump 0.2 -5%
(Chpt. 7, p.no. 7.4)

Q. 27 (Capital Asset Pricing Model-CAPM)

ABX, Inc., stock has Beta of 2.57. If the expected market return is 11.5 percent and the risk-free rate is
8.5 percent, what is the appropriate required return of ABX under the CAPM? Also calculate risk
premium. (Ans. 16.21%, 3%, Chpt. 7, P. No. 7.38)

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Topic: Capital Budgeting

Home work: Back ground (Basic)

What is capital budgeting?

Types of projects?

Cost of capital? (Discounting rate, WACC, Minimum rate of return, opportunity cost, hurdle
rate, cut off rate,)

Conventional cash flows?

Unconventional cash flows?

Incremental cash flows?

Nominal cash flows?

Real cash flows?

Very important Free cash Flows (FCF and its format)

NPV IRR, Discounted pay back method, PI method of capital budgeting

Accounting rate , pay back method of capital budgeting

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Q. 29 (NPV)

A Company considers to invest in project A or Project B (Mutually exclusive project?). The cash
flows (FCF, Imp concept) for two projects, A and B, are as follows:

Year Project A Cash Flows ($) Project B Cash flows ($)

0 -100 -100
1 50 20
2 40 30
3 30 50
4 30 65
Which project should be opted on the basis of NPV method? (Chpt. 10, p. no. 10.24)

Q.30 (FCF Calculation)

Suppose you are considering purchasing a new truck for your plumbing business. This truck will
increase revenues $50,000 and operating expenses $30,000 in the next year. Depreciation and
amortizations for the truck will equal $10,000 next year and your firm marginal tax rate will be
25 percent. Capital expenditure of $3000 will be required to offset wear and tear on the truck,
but no addition to working capital will be required. Calculate the FCF (Free cash Flows) for the
project in the next year. (Ans. $14,500, Chpt. 11. P. no. 11.5)

Q. 31 (FCF Calculation)

(How FCF is calculated in practice). Suppose that you work at an outdoor performing arts center
and are evaluating a project to increase the number of seats by building four new box seating
areas and adding 5000 seats for general public. Each box seating areas is expected to generate
$400, 000 incremental annual revenue (incremental cash flows?), while each of new seats for the
general public will generate $2,500 in incremental annual. The incremental expenses associated
with the new boxes and seating will amount to 60 percent of the revenues. These expenses
include hiring additional personnel to handle concessions, ushering, and security. The new
construction will cost $10 million and will be fully depreciated (to a value of zero dollars) on a
straight-line bass over the 10-year life of the project. The arts center will have to invest $1
million in additional working capital immediately, but the project will not require any other
working capital Investments during its life. This working capital will be recovered in the last
year of the project. The center's marginal tax rate is 30 percent. What are the incremental cash
flows from this project? Calculate the NPV of the project if the cost of capital is 10%.
Q.32(NPV)

Techtronics Ltd. is considering a new project for manufacture a pocket video game involving a
capital expenditure of Rs. 600 lakh and working capital of Rs. 150 lakh. The project economic
life is for 6 years. The project will generate the following CFAT:

Year CFAT (in Rs. Lakh)

1 122
2 229
3 281
4 333
5 326
6 321
At the end of the 3rd year, an additional investment of Rs. 100 lakh would be required for the
working capital. The terminal value for the fixed assets would be Rs. 58 lakh. The cost of capital
is 15%.

(it might be also called salvage value). The cost of capital (Discounting rate) is 15%. (Ans. NPV
= Rs. 273 lakh app, But with excel ans. is Rs. 295.173 lakh, I think if you solve manually ans
will be near to 273 Lakh, try pls- Rajesh Kr.)

(Note: Leaning out comes of this question: to know about the calculation of pv of
initial investment (out flows, or also called outlays) which are capital investment,
working capital investment, and additional working capital investment, to know
about the calculation pv of cash inflows, to know about the PV of salvage
value/terminal value of the project, this terminal value/sa;vage is also known as the
sale proceeds of fixed assets)
Q.33 (NPV, PI, Discounted pay-back period)
A company is considering an investment proposal to install new milling controls at
a cost of Rs. 50,000. The facility has a life expectancy of 5 years and no salvage
value. The tax cate is 35 per cent. Assume the firm uses straight line depreciation
and the same is allowed for tax purposes The estimated cash flows before
depreciation and tax (CFBT) from the investment proposal are as follows:
Year CFBT (Rs.)
1 10,000
2 10692
3 12769
4 13462
5 20385
The discounting rate (for NPV and PI) is 10%.

Calculate: (a) NPV with your decision, (b) PI (profitability Index) with your
decision and (c1 Extra) Discounted Pay-back period (c2) Pay-back period (Ans. a.
NPV = (-) Rs. 4648, not accepted, (b) PI = 0.907, It is less than 1, so project should
not be selected. (c1 Extra) Discounted pay-back period = Rs. 50,000 is not being
covered before or during 5 years , so project should not be accepted , (c2) Pay-back
period = 4.328 years, ir is less than 5 years (the life of the project), so project
should be selected.

(note: learning outcomes of this question: to know CFAT calculation, to know

about the calculation of NPV, PI Discounted pay-back period with their decision)

(Hints: 1st calculate CFAT:

CFBT: -----

Less: Depreciation : -----

Called Profit before tax: -------

Less: tax: -------

Called Earning After Tax (EAT): -----

Add: Depreciation: ------

Called CFAT: --------

Q.34 (NPV)

A company wants to start a new project which cost Rs. 10,00,000. The capital will be collected
in the following ways:

Sources of capital Capital (Rs) Cost of capital

Equity share capital Rs. 5,00,000 20%
Preference share capital Rs. 2,00,000 25%
Debt Rs. 3,00,000 15%
The life of the project is for 4 years. The working capital of Rs. 1,00,000 is required at the
beginning of the year. At the end of 3 rd year, an additional working capital of Rs. 50,000 would
also be required. The project would generate the following CFAT:

Year CFAT (Rs)

1 2,00,000
2 3,00,000
3 5,00,000
4 6,00,000
The tax rate is 30%. The salvage value at the end of the 4 th year would be Rs. 30,000. Calculate
NPV and give your suggestion.

(Note: Learning out comes of this question: to calculate discounting rate (Cost of capital or
WACC)

Q. No. 35 (IRR)

A project cost Rs. 16,000 and is expected to generate cash inflows of Rs. 8,000, Rs. 7,000 and Rs. 6,000
at the end of each year for next 3 years. Calculate IRR.

Sol:

Calculation of IRR using the Trial and error method-

Assume IRR (Discounting Rate) is 20%

PV at 20% = 8000/(1.20)^1 + 7000/(1.20)^2 + 6000/(1.20)^3 = 6666.667 + 4861.111 + 3472.222

= 15000

NPV at 20% discounting Rate = 15000 – 16000 = Rs. – 1000 (-Ve)

{ Note: A negative NPV of Rs. 1000 at 20% indicates that the project’s true IRR is lower than 20%, let us
try at 16%, as a discount rate}

Now, Assume IRR (Discounting Rate) is 16%

PV at 16% = 8000/(1.16)^1 + 7000/(1.16)^2 + 6000/(1.16)^3 = 6896.552 + 5202.14 + 3843.946

= Rs. 15942.64

NPV at 16% discounting Rate = 15942.64 – 16000 = Rs. – 57.36 (- ve)

{Note: Since the project’s NPV is still negative at 16%, a rate lower than 16% should be tried, as a
discount rate, let us try at 15%}

Now, Assume IRR (Discounting Rate) is 15%

PV at 15% = 8000/(1.15)^1 + 7000/(1.15)^2 + 6000/(1.15)^3 = 6956.522 + 5293.006 + 3945.097

= Rs. 16194.62

NPV at 15% = 16194.62 – 16000 = Rs. 194.62 (+ve)

The true IRR should be between 15% and 16%. We find out a close approximation of the rate of return
by the method of Linear Interpolation as follows:

PV required 16000
PV at 15% 16194.62 194.62 (Difference)
PV at 16% 15942.64 251.98 (Difference)

Now,

IRR = 15% + (16%-15%)*194.62/251.98 = 15% + 0.77% = 15.77% Ans.