CAP II Financial Management

2. Time Value of Money

The relationship that exists between the value of money receivable at present and the value
of money receivable in the future is referred to as the time value of money.

As per the time value concept, one rupee today is worth more than one rupee in the future.
It is because we can invest the amount today in order to earn interest.

i) If you are offered Rs. 1000 today or Rs. 1000 after one year, you would accept Rs.
1000 today because you can earn interest of Rs. 100 (if the interest rate is 10%)
by investing Rs. 1000 today.
ii) Likewise, if you are requested to pay Rs. 1000 today or Rs. 1000 after one year,
you would pay after one year because you can invest the amount today to earn
interest income.

Simple Interest:

Simple Interest accrues interest only on the amount originally borrowed. So, the interest is
the same for every period.

Formula:

1. Simple Interest = Present Value * No. of Period * Interest Rate

2. Future Value = Present Value + Total amount of Interest

or, Future Value = Present Value + (Periodical Interest * No. of Period)
or, Future Value = Present Value + (Present Value * Interest Rate * No. of Period)
∴ Future Value = Present Value * [ 1 + (Interest Rate * No. of Period) ]
∴ FV = PV * (1 + i * n)

Q1. Calculate the amount of Simple Interest and FV of an amount of Rs. 10000 borrowed at
a Simple Interest Rate of 12% p.a. for:

a. 90 Days b. 1095 Days c. 6 Months d. 1 Year e. 2 Years

[Ans: SI: a) Rs. 295.89 b) Rs. 3600 c) Rs. 600 d) Rs. 1200 e) Rs. 2400 ]
[Ans: FV: a) Rs. 10295.89 b) Rs. 13600 c) Rs. 10600 d) Rs. 11200 e) Rs. 12400 ]

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Q2. Calculate the Present Value if:

FV = Rs. 26000
n = 3 Years
i = 10% S.I.
[ Ans: Rs. 20000 ]

Q3. Calculate SI Rate if:

FV = Rs. 39000
PV = Rs. 30000
N = 3 Years
[ Ans: 10% p.a. ]

Compound Interest:

Compound Interest is the interest which accrues not only on the amount originally borrowed,
but also on the interest accrued previously. So, the interest is different for different periods
of time.

Formula:

Future Value = Present Value * ( 1 + Interest Rate)No. of Period

∴ FV = PV * ( 1 + i )n

Using Financial Table:

FV = PV * FVIF ( i, n )

Note: Future value is always greater than present value.

If interest rate is continuously compounded:

FV = PV * ert

Where, e = exponential value = 2.71828

r = annual interest rate
t = no. of period

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No. of Periods and Periodic Interest Rate:

No. of Period in a Periodic Interest
Particulars Time
year Rate
Annual Interest
Compounded Annually Every Year 1
Rate/1
Compounded Semi- Every 6 Annual Interest Rate
2
annually Months /2
Every 3 Annual Interest
Compounded Quarterly 4
Months Rate/4
Annual Interest
Compounded Monthly Every Month 12
Rate/12
Annual Interest
Compounded Daily Every Day 365
Rate/365
Compounded
Infinite Infinite N.A
Continuously

Q4. Find the amount to which Rs. 500 shall grow under each of the following conditions:
a. 12% compounded annually for 5 Years
b. 12% compounded semi-annually for 5 Years
c. 12% compounded quarterly for 5 Years
d. 12% compounded monthly for 5 Years
[ Ans: a) Rs. 881.17 b) Rs. 895.42 c) Rs. 903.06 d) Rs. 917.43 ]

Q5. Find out the compound interest on Rs. 2000 after 2 years if the compounding is done:
a. Annually
b. Semi-annually
c. Monthly
[ Ans: a) Rs. 420 b) Rs. 431 c) Rs. 440.58 ]

Q6. If Rs. 2000 is invested at an annual rate of 9% p.a. compounded continuously, find the
amount at the end of 6 Years. [ e0.54 = 1.71601 ]
[ Ans: Rs. 3432.02 ]

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Effective Interest Rate:

It is a rate at which money held at present actually increases in a year. It may happen that
interest is compounded more than once in a year. In such circumstances, the effective rate
of interest is different from given rate of interest (or, nominal interest rate or quoted interest
rate).

Formula:
ER = (1+i)n – 1
Where, ER = Effective Interest Rate
i = nominal interest rate
n = no. of period

Q7. Calculate the effective rate of interest under each of the following cases:
a. Nominal interest rate = 12% ( Compounds Annually)
b. Nominal interest rate = 12% ( Compounds Semi-annually)
c. Nominal interest rate = 12% ( Compounds Quarterly)
d. Nominal interest rate = 12% ( Compounds Monthly)
[ Ans: a. 12% b. 12.36% c. 12.55% d. 12.68% ]

Q8. Everest Bank provides 10% Interest and compounds quarterly but Global IME bank provides
9% interest compounding monthly.
a) Which bank will you select to deposit the funds?
b) If you were going to withdraw the funds before 3 months, which bank will you prefer and
why?
[ Ans: EB = 10.38% and GBIME = 9.38% ]

Q9. Bank of Maharashtra pays 8% interest, compounded quarterly, on its money market account.
The manager of Bank of Punjab wants its money market account to equal Bank of Maharashtra’s
effective annual rate, but interest is to be compounded on monthly basis. What nominal, or
quoted, or annual percentage Rate must Bank of Punjab set?

[ Ans: 7.94% ]

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Calculation of Present Value:

Formula:
FV
1. PV =
( 1+𝑖 )𝑛

2. PV = FV * PVIF( i, n)
Where, PV = Present Value
FV = Future Value
i = Interest Rate
n = No. of periods

Q8. Calculate the present value if:

a. FV = Rs. 10000, n = 5 Years and i = 12% p.a. annually
b. FV = Rs. 10000, n = 5 Years and i = 12% p.a. semi-annually
[ Ans: a) Rs. 5674 b) Rs. 5584 ]

Compounding/Discounting of Multiple Cash Flows:

Irregular Cash Flows:

Q9.
Rs. 0 Rs. 450 Rs. 250 Rs. 650 Rs. 750

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4
Calculate Present Value if Interest Rate is 12%.
[ Ans : Rs. 1540.39 ]

Annuity:
A series of equal amounts of cash flows over a certain period is called an annuity. There are two
types of annuity. They are:
i) Ordinary annuity: A series of equal payments at the end of each period.
ii) Annuity due: A series of equal payments at the beginning of each period.

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Q10.
Rs. 0 Rs. 850 Rs. 850 Rs. 850 Rs. 850

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4
Calculate Present Value if Interest Rate is 12%.
[ Ans : Rs. 3064.05 ]

Perpetuity:
Perpetuity means equal amount indefinitely.

Perpetuity
PV of Perpetuity = (If there is no growth)
Interest Rate
Perpetuity
PV of Perpetuity = (If there is growth)
Interest Rate−Growth

Q11. Investor expects a perpetual sum of Rs. 500 annually from his investment. What is the
present value of this perpetuity if his interest rate is 10%?
[ Ans: Rs. 5000 ]

Q12. Investor expects a perpetual sum of Rs. 500 annually from his investment from today. What
is the present value of this perpetuity if his interest rate is 10%?
[ Ans: Rs. 5500 ]

Q13.

Rs. 100 Rs. 150 Rs. 90 Rs. 200 Rs. 100 Rs. 100 Rs. 100 ………………. ∞

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7
Calculate PV if interest rate = 10%
[ Ans: Rs. 1102.09 ]

Q14. A person is required to pay four equal annual payments of Rs. 4,000 each in his Deposit
account that pays 10 percent interest per year. Find out the Present value and future value of
annuity at the end of 4 years.
[ Ans: Rs. 12,676 & Rs. 18,564 ]

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Loan and Amortization Table:

Loan amortization is the determination of equal annual loan payments necessary to provide the
lender with a specified interest return and repay loan principle over a specified period. This process
involves finding the future payments while PV at loan interest rate equals the amount of initial
principal borrowed.

Formula:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡
Equal periodic installment = 𝐶𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑔𝑖𝑣𝑒𝑛
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 [𝑃𝑉𝐼𝐹𝐴 (𝑖,𝑛)]

Amortization table:

Period Opening Loan Interest on Installment Principal Closing Loan

Amount Opening Loan (Calculated (Installment – Amount
(a) Amount from above) Interest) (e = a – d )
(b = a * (c) (d = c – b)
Interest Rate)
1
2

Q19. Assume that you have borrowed a 3-Yr loan of Rs. 10000 at 9% from your employer. If your
employer requires three equal end-of-year repayments, calculate the annual installment. Show
segregation of principal and interest amounts.
[ Ans: Rs. 3951 & Rs. 3624.5 ]

Concept of Interpolation:
Interpolation concept is used when we have present value and future value given in the question
alongside the time period and we need to calculate the interest rate.

Steps to calculate Interest Rate:

Using FVIF table:
1. Calculate the value of ( 1 + i )n using the formula FV = PV (1 + i )n .
2. Locate the above calculated value in FVIF table, you might get the exact value, or the value
might be located somewhere between a higher and lower interest rate.
3. If we find the exact value, the corresponding interest rate is the required rate. If the value
lies between two rates, calculate the interest rate using the interpolation technique.

Using Interpolation:
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐹𝑎𝑐𝑡𝑜𝑟−𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒 + ∗ (𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒 − 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒)
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒−𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒

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Using PVIF table:

1 FV
1. Calculate the value of using the formula PV = .
( 1+𝑖 )𝑛 ( 1+𝑖 )𝑛
2. Locate the above calculated value in PVIF table, you might get the exact value, or the value
might be located somewhere between a higher and lower interest rate.
3. If we find the exact value, the corresponding interest rate is the required rate. If the value
lies between two rates, calculate the interest rate using the interpolation technique.

Using Interpolation:
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒−𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐹𝑎𝑐𝑡𝑜𝑟
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒 + ∗ (𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒 − 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒)
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒−𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒

Q20. Calculate the interest rate in the following condition using both FVIF and PVIF table:
PV : Rs. 150 FV : Rs. 200 n : 5 yrs
[ Ans: 14.87% ]

Q21. Calculate the interest rate in the following condition:

a) PV = Rs. 50,000

Rs. 15k Rs. 15k Rs. 15k Rs. 15k Rs. 15k

Yr. 0 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

[ Ans: 15.24% ]

b) FV = Rs. 90, 000

Rs. 15k Rs. 15k Rs. 15k Rs. 15k Rs. 15k

Yr. 0 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

[ Ans: 15.13% ]

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Sinking Fund:
It is a kind of reserve by which a provision is made to reduce a liability, e.g. redemption of
debentures or repayment of loan. The main purpose of creating a sinking fund is to have a certain
sum of money accumulated for a future date by setting aside a certain sum of money every year.

Q22. ABC Co is creating a sinking fund to redeem its preference share capital of Rs. 10 Lakhs
issued on April 6, 2010 and maturing on April 5, 2022. The first annual payment will be made on
April 6, 2010. The company will make annual payments & expects the fund will earn 12% p.a. How
much will be the amount of sinking fund payment?
[ Ans: Rs. 36,997.35 ]

Q23. A machine costs Rs. 300,000 and its effective life is estimated to be 6 years. A sinking fund is
created for replacing the machine at the end of its effective life when its scrap realizes a sum of Rs.
20,000 only. Calculate to the nearest hundreds of rupees, the amount which should be provided,
every year, for the sinking fund if it accumulates at 8% p.a. compounded annually.
[ Ans : Rs. 38,200 ]

Other Practice Questions:

Q1. The table below provides a cash flow stream of Bank A and B for different years.
Year Bank A Bank B
1 Rs. 100 Rs. 300
2 Rs. 400 Rs. 400
3 Rs. 400 Rs. 400
4 Rs. 400 Rs. 400
5 Rs. 300 Rs. 100
a) What is the value of each cash flow stream at 0% Interest Rate?
b) What is the present value of the cash flow stream at 8% Interest Rate?
[Ans : a) A: Rs. 1600 B: Rs. 1600
b) A: Rs. 1251.18 B: Rs. 1300.26 ]

Q2. Determine the present value of the cash inflows of Rs. 3000 at the end of each year for the next
four years and Rs. 7000 and Rs. 1000 respectively at the end of years 5 and 6. The appropriate
discount rate is 14%.
[ Ans: Rs. 12809.2 ]

Q3. Suppose I want to be able to withdraw Rs. 5,000 at the end of 5 years and withdraw Rs. 6,000
at the end of 6 years, leaving a zero balance in the account after the last withdrawal. If I can earn
5% on my balance, how much I deposit today to satisfy my withdrawals needs?
[ Ans: Rs. 8396.1 ]

Q4. Mr. X plans to receive an annuity of Rs. 5,000 semi-annually for 10 years after he retires in 18
years. Money is worth 9% compounded semi-annually.
a) How much amount is required to finance the equity?

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b) What amount of single deposit made now would provide the fund for the annuity?
c) How much will Mr. X receive from the annuity?
[ Ans: a) Rs. 65,039.5 b) Rs. 13,335.96 c) Rs. 100,000 ]

Past Exam Questions:

Q1. Mohan has just won a lottery and has three award options to choose from:
a. To receive a lump sum payment today of Rs. 61 million, or,
b. To receive 10 annual end of year payment of Rs. 9.5 million, or,
c. To receive 30 annual end of year payment of Rs. 5.5 million.
He expects to earn 8% annual return on his investment.
Required: Recommend the best option for him. [ 5 Marks ]
[Ans: PV of award options: a) Rs. 61 million b) Rs. 63.75 million c) Rs. 61.92 million ]

Q2. A 12-payment annuity of Rs. 10,000 will begin 8 years hence, i.e, the first payment occurs at
the end of 8 years. What is the present value of this annuity, if the discount rate if 14%? [ 3 Marks ]
[Ans: Rs. 22,619 ]

Q3. Pradeep’s brother Sandeep has promised to give him Rs. 100,000 in cash on his 25th birthday.
Today is Pradeep’s 16th birthday.
Required: Help Sandeep with the following calculation:
a) If Sandeep wants to make annual payment into a fund after one year, how much will each
payment have to be if the fund pays 8% interest?
b) If Sandeep decides to invest a lump sum in the fund after one year and let it compound
annually, how much will the lump sum be?
c) If in “a” above, the payments are made in the beginning of the year, how much will be the
value of annuity? [ 1.5 + 1.5 + 2 = 5 Marks ]
[Ans: a) Rs. 8007.94 b) Rs. 54,027 c) Rs. 7414.76 ]

Q4. Mr. X wants to get his daughter admitted into a medical college after 15 years from now. He
will require a total of Rs. 25 Lakhs to get admission into the college. For this, he has identified a
fund which pays interest at 9% p.a.
Required: Determine the amount to be invested if Mr. X decides to:
a) Make annual payment into the fund at the end of each year.
b) Invest a lump sum in the fund at the end of the year.
c) Make annual payment into the fund at the beginning of each year. [ 5 Marks ]
[Ans: a) Rs. 85146.96 b) Rs. 748000 c) Rs. 78117.68 ]

Q5. A bank offers a fixed deposit scheme whereby Rs. 100,000 matures to Rs 126,250 after 2 years
on half yearly compounding basis. If the bank wishes to amend the scheme by compounding
interest every quarter, what will be the revised maturity value? [ 6 Marks ]
[ Ans: 12% p.a.]

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Q6. Madhu opened an account on Shrawan 1, 2069 with a deposit of Rs. 800. The account paid 6%
interest compounded quarterly. On Magh 1, 2069, she closed the account and added enough
additional money to invest in a 6-month time deposit for Rs. 1,000 earning 6% interest
compounded monthly.
Required:
a) How much additional amount did Madhu invest on Magh 1?
b) What was the maturity value of her time deposit on Shrawan 1, 2070?
c) How much total interest was earned during the period? [ 2 + 2 + 1 = 5 Marks ]
(Given: (1+i) : when i=1.5% and n=2 is 1.030225 and when i=0.5% and n=6 is 1.030775)
n

[Ans: a) Rs. 175.82 b) Rs. 1030.38 c) Rs. 54.56 ]

Q7. Assume the total cost of a college education will be Rs. 300,000 when your child enters college
in 18th year from now. You presently have Rs. 24,240 to invest. What annual rate of interest must
your earn on your investment to cover the cost of your child’s college education? [ 3 Marks]
[Ans: 15%]

Q8. A company has to make the payment of Rs. 2,000,000 on 5th of March 2015. It has some
surplus money today i.e. 4th December 2014 and it has decided to invest in a deposit of bank at
8% per annum to meet the amount for payment. What money is required to be invested now?
Take year as 365 days. [ 2 Marks ]
[Ans: Rs. 1,961,361 ]

Q9. Mr. Liberal, an established Development Planning Consultant, was approached by the officer
of N Investment Banking Ltd. for his wealth management. Mr. Liberal is currently aged exactly 57
years and is planning to retire from his profession after the age of 60. He is currently living with his
wife and a daughter, who is settled in US. He wants to set aside some funds and let the Investment
Bank manage his funds for guaranteed return from 61st year for at least 10 years for his and his
wife's living.
Mr. Liberal estimates the requirement of Rs. 120,000 per month to cover up his living from the 1st
year of retirement. The officer of the Investment Bank has offered 3 schemes of which he has
chosen fixed income scheme with 0% risk and yields 10% interest per annum compounded
annually during the entire scheme period from the beginning of 61st birthday till 70th birthday while
9.5% compounded quarterly from the beginning of deposit till the end of 60th birthday. The
proceeds by the Investment Bank are paid in lump-sums and at the beginning of every year. Ignore
management fees of Investment Bank and taxation.
Required: What is the amount Mr. Liberal needs to deposit at the Investment Bank as of today
under the scheme? Present your calculations on Rs. in thousands. [ 5 Marks ]
[ Ans: Rs. 7343.96 ]

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CAP II Financial Management

Other Notes:
i) We use FVIF table to calculate FV of a single cash flow.
ii) We use FVIFA table to calculate FV of annuity.
iii) We use PVIF table to calculate PV of a single cash flow.
iv) We use PVIFA table to calculate PV of annuity.
v) Conditions for FVIFA/PVIFA table:
a. Equal Installments
b. Due after ‘n’ period
c. Equal time gap
vi) To remember:
a. PVIF (0%, n) = 1
b. FVIF (0%, n) = 1
c. PVIF (i% , 0) = 1
d. FVIF (i% , 0) = 1

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