INTRODUCTION TO FINANCE & CORPORATE FINANCE

The world of finance can seem complex, but at its heart, it's about making informed decisions with
your money. This guide will unveil the core concepts and explore how they shape our financial
landscape.

The Power of Money Through Time

Imagine having the option of receiving $100 today or $100 a year from now. Most would choose the
money now. This simple scenario highlights the time value of money. Money has the potential to
grow over time through investments or interest. Financial decisions heavily rely on this principle,
considering the future value of money when making investment choices or evaluating loan options.

Balancing Risk and Reward

Finance is about navigating the delicate dance between risk and return. Generally, higher potential
returns come with increased risk. Investors seek to maximize their returns while minimizing risk.
Financial markets, through instruments like stocks and bonds, offer options to manage risk and
pursue investment goals.

Financial Marketplaces: Where Money Moves

Imagine a giant marketplace where individuals, businesses, and governments can buy and sell
financial assets. That's the essence of a financial market. Stocks, bonds, currencies, and
commodities are all traded in these markets. They play a critical role in efficiently allocating
resources and fueling economic activity.

The Financial Engine of Businesses

Corporate finance focuses specifically on the financial health and decision-making of corporations.
It delves into how companies raise capital, structure their finances, and invest for growth. The
ultimate goal? To maximize value for the company's owners, the shareholders.

Investing for the Future: Capital Budgeting

Companies, like individuals, need to plan for future growth. Capital budgeting involves
meticulously evaluating potential investments to identify those with the most promising returns.
Tools like net present value (NPV) and internal rate of return (IRR) help assess profitability and
make informed investment decisions.

Building a Strong Foundation: Capital Structure

A company's capital structure refers to the mix of debt and equity financing it uses to fund its
operations. Finding the right balance is crucial. Too much debt can be risky, but too little may limit
growth. The goal is to optimize the cost of capital while maintaining financial flexibility and
managing risk.

Keeping the Cash Flowing: Working Capital Management

A company's day-to-day operations rely on managing its short-term assets (like inventory) and
liabilities (like upcoming bills). Working capital management ensures a smooth flow of cash by
maintaining sufficient liquidity, optimizing cash flow, and minimizing borrowing costs.

The Impact of Corporate Finance

From startups to established giants, corporate finance plays a vital role in a company's success. It
empowers businesses to make strategic financial decisions, manage risks effectively, and allocate
resources efficiently. By fostering growth, profitability, and long-term shareholder value, corporate
finance helps companies navigate the dynamic world of business.

CORPORATE FINANCE & ITS SCOPE

Corporate finance is a specialized branch of finance focusing on the financial health and decision-
making of businesses. It encompasses a wide range of activities that steer a company's financial
course, from securing funding to strategically allocating resources. Ultimately, corporate finance
aims to maximize value for the company's owners, the shareholders.

Key Functions of Corporate Finance

Function Description
Evaluating and selecting investment projects that promise positive returns. This
Capital
involves careful analysis of potential investments, considering factors like risk,
Budgeting
expected cash flows, and the cost of capital.
Determining the optimal mix of debt and equity financing to fund a company's
Capital Structure operations and growth. Striking a balance between the cost of capital and financial
Management risk is essential. The capital structure should support the company's long-term
goals while maximizing shareholder returns.
Identifying, assessing, and managing various financial risks, such as market risk,
Financial Risk
credit risk, liquidity risk, and operational risk. Effective risk management
Management
safeguards a company's financial well-being and stability.
Making decisions regarding the distribution of profits to shareholders through
dividend payments. Companies must determine a dividend policy that balances
Dividend Policy
shareholder interests with the need to retain earnings for reinvestment in the
business.
Managing the company's short-term assets (like inventory) and liabilities (like
upcoming bills) to maintain liquidity and ensure smooth operations. Working
Working Capital
capital management involves optimizing inventory levels, managing accounts
Management
receivable and payable, and monitoring cash flow to meet short-term financial
obligations.
Establishing and maintaining sound corporate governance structures within an
Corporate organization. This includes defining the roles and responsibilities of corporate
Governance officers and board members, implementing internal controls and accountability
mechanisms, and ensuring compliance with regulatory requirements.
Evaluating potential M&A opportunities, conducting due diligence, structuring
Mergers and
transactions, and negotiating deals to maximize shareholder value. Mergers,
Acquisitions
acquisitions, and divestitures are significant corporate finance activities that
(M&A)
involve buying, selling, or combining businesses.
Analyzing financial statements and performance metrics to assess the company's
Financial
financial health and performance. This includes evaluating profitability, liquidity,
Reporting and
solvency, and efficiency ratios to gain insights into the company's financial
Analysis
condition and performance drivers.
By effectively managing these core functions, corporate finance empowers businesses to make
sound financial decisions, navigate financial risks, and achieve long-term financial objectives. This
ultimately translates to creating value for shareholders and ensuring the sustainable growth of the
company.

CORPORATE GOVERNANCE AND AGENCY PROBLEM

Every company operates within a framework of rules and practices known as corporate governance.
This system dictates how the company is directed and controlled, fostering accountability,
transparency, and fairness in decision-making. It's a balancing act involving various players:

 Management: Responsible for the day-to-day operations of the company.

 Board of Directors: Oversees management and sets strategic direction.
 Shareholders: The owners of the company, with a vested interest in its success.
 Stakeholders: Other parties affected by the company's actions, such as employees,
customers, and the community.

The Agency Problem:

A potential challenge arises when the goals of management (the agents) and those of the
shareholders (the principals) don't perfectly align. This is known as the agency problem. Separation
of ownership and control in publicly traded companies is a key factor. Shareholders delegate
decision-making to managers, who might prioritize personal gain over shareholder interests.

Common Issues
 Principal-Agent Misalignment: Shareholders and management may have differing
priorities, leading to potential conflicts.
 Managerial Opportunism: Managers might pursue ventures that benefit them personally
but harm shareholders, such as excessive compensation or unethical practices.
 Risky Business: Managers might take on excessive risks to chase high returns or avoid
personal losses, jeopardizing shareholder value.
 Information Gap: Managers often have more information about the company's operations
than shareholders. This asymmetry can be exploited for personal gain or to manipulate
information to the detriment of shareholders.

Building Strong Governance
Effective corporate governance practices are crucial to managing the agency problem. These
include:
 Independent Board Oversight: A strong board with independent directors provides
objective oversight of management.
 Transparent Reporting: Clear and accurate financial reporting fosters trust and allows
shareholders to assess company performance.
 Internal Controls: Robust internal controls help prevent fraud and ensure proper financial
management.
 Shareholder Activism: Shareholders can voice concerns and influence management through
voting and engagement.

Rewarding Performance

Executive compensation design plays a vital role. Compensation packages that link pay to
performance and shareholder value creation help align management interests with those of
shareholders. Tools like performance-based compensation, stock options, and other equity-based
incentives can all contribute to this alignment.

CORPORATE VALUATION MODELS

Evaluating a company's true worth is a critical skill for investors, analysts, and financial
professionals. Corporate valuation models serve as powerful tools in this process, offering various
methodologies to assess a company's intrinsic value. These models go beyond just a price tag,
providing insights into a company's financial health, potential for growth, and overall investment
attractiveness.

By employing a combination of these models, analysts gain a well-rounded understanding of a

company's value. This comprehensive picture empowers them to make informed investment
decisions and guide strategic planning for businesses.

ASSET BASED VALUATION MODEL

Asset-based valuation is a straightforward approach that estimates a company's worth by considering

its net assets. Imagine a company like a giant warehouse – the value of everything inside (inventory,
machinery) and outside (buildings) is added up, and then the company's debts are subtracted. This
provides a snapshot of the company's value based on its tangible and intangible assets.

 Tangible Assets: These are the physical things you can see and touch, like property,
equipment, and inventory. Their current market value is considered during the valuation
process.

 Intangible Assets: These are the non-physical assets that contribute to a company's value,
such as brand recognition, patents, and trademarks. While they can't be physically held, they
can be valuable assets.

 Liabilities: These are the company's debts and obligations, like outstanding loans or
accounts payable. They are subtracted from the total asset value to arrive at the net asset
value, essentially representing the shareholders' equity.

Valuation Methods:

 Asset Accumulation Valuation: This is a straightforward method that involves meticulously

identifying and valuing each asset and liability, then summing them up to arrive at a total
value. Essentially, it's a comprehensive inventory of the company's net assets.

 Excess Earnings Valuation: This approach merges income and asset valuation. Here, the
company's earnings potential is considered alongside its assets to determine any intangible
value, such as goodwill.

Valuation Considerations:
Depreciation and Obsolescence: Assets can lose value over time due to wear and tear
(depreciation) or becoming outdated (obsolescence). These factors are taken into account to ensure
an accurate reflection of the asset's current worth.

 Intangible Assets: A Valuation Challenge: Unlike tangible assets, valuing intangible assets
like patents or brand reputation can be subjective and require specialized expertise.

The asset-based valuation provides a theoretical value based on the net assets. It's important to
remember that the actual selling price of a company can differ from this value due to factors like
market conditions or a buyer's specific motivations.

Strengths and Weaknesses:

 Pros: Asset-based valuation is particularly useful for companies in asset-intensive industries

or those facing potential liquidation.

 Cons: This approach may not fully consider a company's future earnings potential.
Additionally, valuing intangible assets can be complex and requires a skilled appraiser.
Overall, this method offers a reliable snapshot of a company's net assets but may not capture
its full potential value.

EARNING BASED VALUATION MODEL

Ever wondered how companies are priced on the stock market? Earnings-based valuation is a key
approach that sheds light on a company's worth by analyzing its profit-generating potential. This
method focuses on a company's ability to make money, making it a cornerstone of equity valuation.

 Earnings: This is the foundation – the model considers the company's profits, which can be
net income, operating income, or a metric like earnings before interest and taxes (EBIT).
Essentially, it's a measure of a company's profitability.

 Valuation Metrics: These are the tools used to translate earnings into a company's value.
Common metrics include the Price-to-Earnings (P/E) ratio, which compares a company's
stock price to its earnings per share (EPS), and the Earnings Yield, which is essentially the
inverse of the P/E ratio. Another metric, the Price-to-Earnings Growth (PEG) ratio, factors in
a company's earnings growth rate, providing a more nuanced picture of valuation relative to
its future prospects.

Methods for Measuring Earning Power

 Price-Earnings (P/E) Ratio: This popular metric reveals how much investors are willing to
pay for each dollar of a company's earnings. A high P/E ratio might indicate that the
company's stock is considered expensive relative to its current earnings.

 Price-to-Earnings Growth (PEG) Ratio: This takes the P/E ratio a step further. By
incorporating a company's earnings growth rate, the PEG ratio helps assess if a high P/E ratio
is justified by the company's future potential. A low PEG ratio might suggest the stock is
undervalued considering its growth prospects.

Factors
  Earnings Quality: Not all earnings are created equal. The model considers the sustainability
and reliability of a company's profits to ensure an accurate valuation. Earnings that are one-
time events or heavily influenced by non-recurring factors may not be a true reflection of the
company's core profitability.
 Growth Prospects: Companies with a bright future of increasing earnings tend to command
higher valuation multiples. The model considers a company's growth potential to give a more
comprehensive picture of its value.

Applications and Limitations

 Equity Valuation: Earning-based valuation is a mainstay in valuing publicly traded

companies' stocks. By analyzing a company's earnings and applying valuation metrics, it
provides insights into a company's market value relative to its profit generation.
 Limitations: While powerful, the model has limitations. It may not fully capture a
company's future earnings potential, and it doesn't consider non-earnings factors that can
affect valuation, such as industry trends or the overall health of the economy.

Comparative Analysis

 Peer Comparison: To get a broader perspective, analysts often compare a company's

valuation multiples, like P/E ratio, to its industry peers. This comparison helps assess if a
company's valuation is in line with similar companies or if it might be overvalued or
undervalued.

Special Considerations

 Adapting for Growth: For companies experiencing rapid growth, traditional earning-based
models might not be the best fit. Valuation models like the PEG ratio, which factor in
earnings growth, are more suitable for these high-growth companies.

The Risk Factor

 Risk Adjustment: Investors are aware that some companies are riskier than others. To
account for this, valuation multiples may be adjusted based on a company's risk profile.
Factors like volatility, leverage (debt), and overall market conditions can all influence this
risk adjustment.

CASH FLOW-BASED MODEL

Understanding a company's true value is a cornerstone of financial decision-making. Cash flow-

based valuation models offer a powerful lens for this purpose, focusing on a company's ability to
generate cash, the lifeblood of any business.

The Core Components

 Cash Flows: This model prioritizes a company's cash inflows and outflows. These can be
operating cash flows (cash generated from core operations), free cash flows (cash available
for distribution after reinvestment needs), or cash flows available to investors (cash available
for dividends and debt repayment).
  Discount Rate: Future cash flows are inherently less valuable than current cash. This model
addresses this by applying a discount rate, typically a company's cost of capital (reflecting
the cost of financing its operations). This effectively translates future cash flows into their
present-day worth.

Valuation Methods:

 Discounted Cash Flow (DCF) Analysis: This popular method involves meticulously
forecasting a company's future cash flows and then discounting them back to their present
value using the chosen discount rate. The sum of these discounted cash flows represents the
company's total value.
 Cash Flow Multiple Valuation: This approach leverages industry benchmarks. By applying
a multiple (like the cash flow-to-enterprise value ratio) to a company's cash flows, a quick
valuation estimate can be derived.

Key Considerations

 Cash Flow Projections: The accuracy of the valuation heavily relies on the ability to
forecast future cash flows. Factors like revenue growth, operating expenses, investments in
assets, and working capital needs all come into play.
 Discount Rate Selection: The chosen discount rate significantly impacts the valuation
outcome. It reflects the company's risk profile and the cost of obtaining capital. Factors like
the risk-free interest rate, market risk premium, and the company's beta (a measure of its
volatility relative to the market) are all considered when determining the discount rate.

Applications and Limitations:

 Corporate Finance: Cash flow-based valuation is a workhorse in corporate finance. It's used
for investment appraisal, capital budgeting decisions (evaluating potential investments),
mergers and acquisitions analysis, and corporate restructuring.
 Investment Analysis: Investors leverage cash flow-based valuation to assess the intrinsic
value of investment opportunities, including stocks, bonds, and real estate. By understanding
a company's future cash flow potential, they can make informed investment decisions.

Understanding the Impact:

Financial models are built on assumptions. Sensitivity analysis, also known as scenario analysis, is a
technique used to assess how the valuation might change under different circumstances. This
involves exploring various scenarios for revenue growth, cost structures, and discount rates to
understand the impact on the company's value.

Industry and Company Specificity

 Industry Dynamics: Cash flow-based models may need to be adapted for different
industries. Industries with high capital investment needs, predictable revenue streams, or high
growth prospects may require specific considerations within the model.
 Company-Specific Factors: A one-size-fits-all approach doesn't work in valuation. The
model should reflect the unique characteristics of each company, such as its competitive
advantage, market share, and management quality.
CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model, or CAPM for short, is a cornerstone of financial theory. It's a
framework that helps investors understand the relationship between risk and return for an
investment. CAPM essentially calculates the expected return an investor should expect based on the
inherent risk of the investment and the overall market environment.

 Risk-Free Rate: Imagine a risk-free investment, like government bonds. The return you
expect from such an investment (typically represented by the yield on these bonds) is the
risk-free rate. It serves as the baseline for comparison in CAPM.
 Market Risk Premium: Investors typically demand a higher return for taking on riskier
investments compared to risk-free ones. The market risk premium represents this additional
return expected for bearing systematic risk, or the risk inherent to the overall market.
 Beta (β): This is a key measure of an investment's sensitivity to market movements. A beta
of 1 indicates the investment's returns move exactly in line with the market. A beta greater
than 1 suggests the investment's returns are more volatile than the market, and vice versa for
a beta less than 1. Beta essentially captures the systematic risk of an investment relative to
the market.
 Expected Return: By considering the risk-free rate, the market risk premium, and the
investment's beta, CAPM helps calculate the expected return an investor can reasonably
anticipate.

The CAPM Formula

The CAPM formula uses these components to calculate the Expected Return (ER) on an investment:

ER = Rf + β (Rm - Rf)

Where:
 ER = Expected return on the investment
 Rf = Risk-free rate
 β = Beta of the investment
 Rm = Expected return on the market portfolio

Applications

 Equity Valuation: CAPM is a common tool used to determine the cost of equity capital for
publicly traded companies. This cost of equity is crucial for valuing a company's stock.
 Investment Analysis: Investors can leverage CAPM to assess the expected return on
individual stocks, bonds, and their overall portfolios. By understanding the risk-return
relationship, they can make informed investment decisions.

Assumptions and Limitations

 Efficient Markets: CAPM assumes markets are efficient, meaning all available information
is reflected in asset prices and investors act rationally. While this may be an idealized state,
it's a foundational assumption.
 Single-Factor Model: A key limitation is that CAPM is a single-factor model. It primarily
considers systematic risk, overlooking other sources of risk specific to individual companies
or industries.
 Static Beta: CAPM uses historical beta to assess risk. However, an investment's risk profile
may change over time. This assumption of a static beta can introduce limitations.
Criticisms and Alternatives

 Empirical Challenges: Studies have yielded mixed results regarding CAPM's effectiveness
in predicting real-world asset returns. Its accuracy can be debated.
 Alternative Models: Recognizing CAPM's limitations, other asset pricing models, like the
Arbitrage Pricing Theory (APT), have been developed to offer potentially more
comprehensive explanations of risk and return.

Risk Management and Portfolio Construction

Despite its limitations, CAPM offers valuable insights for investors:

 Portfolio Diversification: By understanding the risk-return relationship of various assets
through their betas, CAPM can guide investors in building diversified portfolios that balance
risk and return.
 Risk Management: CAPM helps investors quantify the risk associated with different
investments, enabling them to manage their risk exposure and optimize their investment
strategies.

Capital Asset Pricing Model (CAPM) is a valuable framework for understanding the relationship
between risk and return in investments. While it has limitations, CAPM equips investors with tools
for equity valuation, investment analysis, portfolio construction, and overall risk management.

ARBITRAGE PRICING THEORY (APT)

The Capital Asset Pricing Model (CAPM) laid the groundwork for understanding risk and return in
investments. However, the Arbitrage Pricing Theory (APT) takes things a step further. It's a multi-
factor asset pricing model that acknowledges the influence of a wider range of forces on asset
returns.

Beyond a Single Factor:

CAPM focuses on systematic risk, or market risk. APT expands on this by considering multiple
factors that can systematically influence asset returns. These factors can be:
 Economic Indicators: Interest rates, inflation, and economic growth all play a role.
 Industry Trends: Specific industries may face unique risk factors, such as technological
advancements or regulatory changes.
 Market Dynamics: Broad market trends, like investor sentiment or global events, can
impact asset prices.

Factor Sensitivities

APT doesn't simply acknowledge these factors; it attempts to quantify an asset's sensitivity to each
one. Similar to beta in CAPM, APT uses factor sensitivities, or betas, to measure this exposure. A
high factor sensitivity indicates an asset's returns are likely to move in response to changes in that
particular factor.

The Power of Arbitrage

APT operates under the assumption of efficient markets. This means that investors can exploit any
mispricing opportunities through arbitrage – buying undervalued assets and selling overvalued ones
– until prices reflect their true risk profile. This process helps ensure that asset prices align with their
exposure to various risk factors.

The APT Model:

The APT model mathematically captures this relationship between risk factors and expected return.
Here's a simplified representation:
E(Ri) = Rf + βi1 × (RP1) + βi2 × (RP2) + ... + βik × (RPk)
Where:
 E(Ri) = Expected return on asset i
 Rf = Risk-free rate
 βij = Beta of asset i with respect to factor j
 RPj = Risk premium associated with factor j

Applications and Benefits

 Asset Pricing: By considering multiple risk factors, APT offers a more comprehensive
approach to estimating the expected return on individual assets, portfolios, and investment
strategies.
 Risk Management: APT empowers investors to identify and manage portfolio risk more
effectively. By understanding an asset's exposure to various risk factors, investors can make
informed decisions about asset allocation and diversification.

Assumptions and Limitations

 Arbitrage Assumptions: APT relies on the presence of arbitrage opportunities, which may
not always exist in real-world markets with frictions and transaction costs.
 Factor Identification: A key challenge lies in pinpointing the most relevant risk factors and
accurately measuring their risk premiums. The selection of factors can significantly impact
the model's results.
 Model Complexity: While offering more flexibility than CAPM, APT still relies on
simplifying assumptions. It may not capture all the nuances that influence asset returns in the
real world.

Testing and Validation

The world of finance is constantly evolving, and so is APT. Researchers continuously test and refine
the model by:
 Factor Selection: Studies often involve evaluating various factors to identify those that have
the most significant explanatory power for asset returns. This ongoing process helps refine
the model's effectiveness.
 Model Evaluation: APT models are assessed based on their ability to explain historical asset
returns and predict future ones. The goal is to continuously improve the model's accuracy and
predictive power.

Integration with Investment Strategies

The insights from APT can be directly applied to investment strategies:

 Factor Investing: APT provides a theoretical foundation for factor-based investing. This
approach involves constructing portfolios that target specific risk factors believed to drive
returns.
  Portfolio Optimization: By considering multiple risk factors, APT guides investors in
optimizing their portfolios for both risk and return when making asset allocation decisions.

ECONOMIC VALUE ADDED (EVA)

Ever wondered how well a company truly performs beyond just its bottom line? Economic Value
Added (EVA) offers a powerful lens to assess a company's ability to generate wealth for its
shareholders. It goes beyond traditional profit metrics by factoring in the cost of capital invested in
the business.

 Net Operating Profit After Taxes (NOPAT): This represents a company's core
profitability, reflecting its earnings after accounting for all operating expenses and taxes.

 Total Cost of Capital (TCC): This captures the weighted average cost of all the company's
financing sources, including debt and equity. Essentially, it's the minimum return investors
expect on their investment in the company.

 Economic Value Added (EVA): This is the crux of the analysis. It's calculated by
subtracting the TCC from the NOPAT. A positive EVA indicates the company is generating
economic profit, exceeding the cost of its capital. Conversely, a negative EVA suggests the
company is destroying value for its shareholders.

The EVA Formula:

EVA is calculated using the following formula:

EVA = NOPAT - (WACC x Capital Employed)
Where:
 EVA = Economic Value Added
 NOPAT = Net Operating Profit After Taxes
 WACC = Weighted Average Cost of Capital
 Capital Employed = Total Assets - Current Liabilities

Applications and Benefits

 Performance Measurement: EVA provides a more nuanced view of a company's

performance than traditional profit metrics. It highlights whether the company is creating or
destroying value for its shareholders after accounting for the cost of capital.
 Strategic Planning: By identifying areas where EVA can be improved, companies can make
informed strategic decisions about investments, operational efficiencies, and resource
allocation, all geared towards maximizing shareholder value.
 Incentive Compensation: EVA metrics can be incorporated into executive compensation
plans, aligning management focus with creating long-term value for shareholders.

Strengths and Weaknesses of EVA

 Focus on Value Creation: EVA incentivizes companies to prioritize initiatives that generate
returns above the cost of capital, promoting sustainable wealth creation.
 Alignment of Interests: By linking performance to shareholder value creation, EVA helps
bridge the gap between management actions and long-term shareholder interests.
 Comprehensive Analysis: EVA considers both profitability and capital efficiency, offering
a more holistic picture of a company's financial health.
Limitations

 Complexity: Calculating EVA requires meticulous analysis of financial data and estimations
of the cost of capital, which can be a time-consuming and intricate process.
 Subjectivity: EVA calculations involve assumptions and judgments in determining NOPAT,
cost of capital, and capital employed. This can introduce some level of subjectivity and
variability in the final results.
 Short-Term Focus: Overemphasis on EVA might lead to short-term cost-cutting measures
that could undermine long-term growth prospects. Effective implementation requires a
balanced approach focused on sustainable value creation.

Introduction to start-up finance

Imagine a promising new business idea – it has the potential to disrupt an industry or revolutionize a
product category. But translating that idea into a thriving company requires a crucial element:
effective startup finance.

Startup Finance

Startup finance is the art and science of managing the financial resources of a new venture. It's about
allocating funds, planning for the future, budgeting strategically, and securing capital to propel the
company forward. In essence, it's the financial lifeblood that fuels innovation, sustains operations,
and ultimately, determines a startup's success in a competitive landscape.

Building a financially sound startup requires considering several key areas:

 Initial Funding: Every startup needs a launchpad. This initial capital fuels product
development, market research, and setting up operations. Funding sources can be diverse,
ranging from personal savings and bootstrapping (using minimal resources) to angel
investors, venture capitalists, crowdfunding platforms, or even government grants.
 Financial Planning: Creating a roadmap is essential. Financial projections, including
income statements, cash flow forecasts, and balance sheets, guide resource allocation,
identify potential funding shortfalls, and inform strategic decisions.
 Budgeting and Expense Management: Living within your means is paramount.
Establishing a budget and meticulously managing expenses ensure cost control, optimal
resource allocation, and financial sustainability. Negotiating with vendors, prioritizing
spending, and regularly monitoring expenses are all crucial practices.
 Revenue Generation: No income, no long-term survival. Startups need to focus on
generating revenue to sustain themselves and achieve profitability. This involves developing
a clear revenue model, crafting a pricing strategy, and implementing effective sales and
marketing initiatives to attract customers and drive sales growth.
 Capital Raising: Growth often requires additional fuel. As startups mature and expand, they
may seek further capital to scale operations, enter new markets, or develop new products.
This could involve securing investment from venture capitalists, private equity firms, or
strategic partners, or exploring debt financing options and government grants.
 Risk Management: The startup journey is not without its bumps. Market risks, operational
challenges, and financial uncertainties are all potential hurdles. Effective risk management
involves identifying these threats, implementing strategies to mitigate them, and maintaining
financial resilience to navigate unforeseen obstacles.

Challenges

Despite the immense potential, startup finance presents unique challenges:

 Limited Resources: Tight budgets are a common reality. Startups often operate with limited
financial resources, making it difficult to fund day-to-day operations, attract top talent, and
invest in growth initiatives.
 Uncertain Revenue Streams: Predicting the future is no easy feat. Uncertain market
demand, customer acquisition hurdles, and unforeseen fluctuations in revenue streams can
make it challenging to forecast cash flow and plan for growth.
 Access to Capital: Securing funding can be an uphill battle. Early-stage startups, lacking a
proven track record or substantial assets, may struggle to convince investors to finance their
ventures.
 Cash Flow Management: Cash is king. Managing cash flow effectively is critical,
especially considering uneven revenue streams, seasonal fluctuations, or unexpected
expenses that can strain liquidity and hinder growth.
 Regulatory Compliance: The rules of the game matter. Startups must navigate a complex
web of regulations, including tax laws, financial reporting standards, and industry-specific
compliance requirements. These can add administrative burdens and complexities to
financial management.

Strategies for Startup Finance

 Lean Financial Management: Embrace efficiency. Adopting a lean financial management

approach minimizes costs, conserves cash, and maximizes the impact of every resource
allocated.
 Focus on Revenue Growth: Customers are your lifeline. Prioritize revenue generation and
customer acquisition. Demonstrating a viable business model with strong customer traction is
key to attracting investors and building a sustainable, scalable business.
 Diversification of Funding Sources: Don't put all your eggs in one basket. Diversifying
funding sources reduces reliance on any single investor or financing option, providing greater
flexibility and resilience in capital raising efforts.
 Continuous Financial Monitoring: Knowledge is power. Regularly monitoring and
analyzing financial performance metrics allows startups to track progress, identify trends,
and make data-driven decisions that optimize financial outcomes.
 Risk Mitigation Strategies: Prepare for the unexpected. Implementing risk management
strategies, such as contingency planning, appropriate insurance coverage, and ensuring legal
compliance, can help startups mitigate potential risks and protect themselves from unforeseen
challenges.

FINANCIAL DECISIONS

The world of finance is brimming with choices. From individuals planning for their future to
businesses aiming for sustainable growth, financial decisions play a central role in shaping financial
well-being and achieving set objectives. Here, we delve into the various types of financial decisions
that individuals and organizations encounter:

Investment Decisions

Investment decisions revolve around allocating funds strategically to generate returns and reach
financial goals. This involves:
  Choosing Investment Vehicles: Deciding where to place your money – stocks, bonds, real
estate, or alternative investments – requires careful consideration of risk-return profiles and
alignment with your goals.
 Evaluating Risk and Reward: Every investment carries a level of risk. Investors must
assess the potential returns alongside the inherent risks before committing their funds.
 Research and Due Diligence: Meticulous research and due diligence are crucial before
investing. Understanding the ins and outs of potential investments helps mitigate risk and
make informed choices.

Financing Decisions

For businesses, financing decisions determine how to raise capital to fuel operations, investments,
and growth. These choices include:
 Debt or Equity? Companies can choose between debt financing (loans) and equity financing
(issuing shares) to raise capital. Each approach has its own advantages and disadvantages,
and the optimal choice depends on factors like risk tolerance and capital structure.
 Selecting Financing Instruments: Debt financing offers various options like loans, bonds,
or lines of credit. Equity financing involves issuing different classes of stock. Choosing the
right instrument depends on specific needs and financial health.
 Balancing Risk and Return: The capital structure, a mix of debt and equity, should be
carefully considered. A balanced approach helps optimize risk and return for the company.

Dividend Decisions

For companies with profits, dividend decisions involve how much of those earnings to distribute to
shareholders as dividends and how much to retain for reinvestment in the business. Key factors
include:
 Dividend Policy: Establishing a consistent dividend policy and payout ratio (percentage of
profits distributed) sets expectations for shareholders.
 Dividend Stability and Growth: Companies need to consider both maintaining stable
dividends and potential for future growth when making dividend decisions.
 Balancing Interests: Dividend decisions involve striking a balance between rewarding
shareholders and ensuring enough capital is retained to fund future growth initiatives.

Working Capital Management

For businesses, managing working capital – short-term assets and liabilities – is essential for smooth
operations and financial health. This involves:
 Cash Flow Management: Monitoring and optimizing the cash flow cycle, the time it takes
to convert resources into cash, is crucial for business liquidity.
 Inventory and Receivables/Payables: Balancing inventory levels, managing accounts
receivable effectively, and handling accounts payable strategically are all important aspects
of working capital management.
 Short-Term Financing Needs: Businesses may need short-term financing to bridge cash
flow gaps. Making informed decisions about such financing ensures they meet their liquidity
requirements without compromising long-term financial health.

Risk Management Decisions

Financial uncertainties are a reality. Risk management decisions involve identifying, assessing, and
mitigating potential threats to financial goals. This includes:
  Risk Identification: Understanding various financial risks, such as market risk, credit risk,
and operational risk, is the first step towards effective risk management.
 Risk Mitigation Strategies: Implementing strategies like hedging, insurance, and
diversification can help mitigate potential losses from identified financial risks.
 Ongoing Monitoring and Management: Risk management is an ongoing process.
Regularly monitoring and adapting risk mitigation strategies as circumstances evolve is
crucial for long-term financial security.

Strategic Financial Planning

Strategic financial planning involves developing a roadmap for long-term financial success, aligning
financial strategies with overall organizational goals. Key aspects include:
 Setting Financial Goals: Clearly defined financial goals provide direction and a benchmark
for measuring progress.
 Developing Budgets and Forecasts: Creating detailed budgets and financial forecasts helps
with resource allocation and future planning.
 Strategic Resource Allocation: Allocating resources strategically to support priority
initiatives is vital for achieving financial goals and realizing the organization's vision.

Personal Finance

Financial decisions are not limited to businesses. Individuals and households also make crucial
choices that impact their financial well-being. These personal financial decisions include:
 Budgeting and Expense Management: Creating a budget and managing expenses
effectively is the foundation of sound personal finance.
 Saving and Investing: Saving for retirement, education, or other goals, and investing wisely
to grow your wealth, are essential for a secure financial future.
 Managing Debt Wisely: Debt can be a useful tool, but proper management is crucial.
Making informed decisions about debt

TIME VALUE OF MONEY

Imagine having a choice: would you prefer a dollar today or a dollar tomorrow? Most people would
choose the dollar today. This simple scenario highlights a core principle in finance: The Time Value
of Money (TVM). TVM acknowledges that money has a time value – a dollar today is worth more
than a dollar tomorrow. Why? Because of its earning potential

 Present Value (PV): This represents the current worth of a future sum of money. In simpler
terms, it's how much you'd need to invest today to equal a specific amount of money in the
future, considering a certain interest rate. The concept boils down to the opportunity cost –
the potential returns you forgo by not having the money available now for investment.

 Future Value (FV): This flips the concept. It represents the value a current sum of money
will hold in the future, considering the potential growth through interest or investment
returns. Imagine your savings account – the future value reflects how your money grows over
time thanks to compound interest.
  Interest Rate (r): This is the engine of growth. The interest rate, also called the discount rate
or rate of return, determines how quickly your money grows over time. It plays a critical role
in calculating both present and future values, impacting everything from investment
decisions to loan terms and financial planning strategies.

 Time Period (n): Time is money, literally. This factor represents the duration over which the
present value grows into the future value, or vice versa, the time frame used to discount
future cash flows back to their present value. It's typically measured in years but can be
flexible depending on the financial analysis being conducted.

Real-World Applications

 Investment Valuation: Making informed investment decisions requires understanding the

present value of future cash flows an investment will generate. TVM helps assess
profitability and compare different investment options.
 Loan Amortization: Ever wondered how your monthly loan payment is calculated? TVM
plays a role here too. It helps determine the monthly payment amount or the total loan
amount based on the present value of the future cash flows used to repay the loan over time.
 Savings and Retirement Planning: Planning for your future requires estimating how much
your savings or retirement accounts will be worth in the future. TVM helps consider regular
contributions, investment returns, and the time horizon to project the future value you'll need
to meet your financial goals.
 Capital Budgeting: Businesses use TVM extensively for capital budgeting decisions. By
discounting future cash flows from long-term projects back to their present value, they can
calculate the Net Present Value (NPV) and assess the project's financial feasibility.
and accumulated amount for an investment (principal) with a simple rate over a period of time.
As you already know the money that you borrow is known as principal and the additional money
that you pay for using somebody else’s money is known as interest. The interest paid for keeping
` 100 for one year is known as the rate percent per annum. Thus if money is borrowed at the rate
of 8% per annum then the interest paid for keeping ` 100 for one year is ` 8. The sum of principal
and interest is known as the amount.
Clearly the interest you pay is proportionate to the money that you borrow and also to the period
of time for which you keep the money; the more the money and the time, the more the interest.
Interest is also proportionate to the rate of interest agreed upon by the lending and the borrowing
parties. Thus interest varies directly with principal, time and rate.
Simple interest is the interest computed on the principal for the entire period of borrowing. It is
calculated on the outstanding principal balance and not on interest previously earned. It means
no interest is paid on interest earned during the term of loan.
Simple interest can be computed by applying following formulas:
I = Pit
A=P+I
= P + Pit
= P(1 + it)
I=A–P
Here,
A = Accumulated amount (final value of an investment)
P = Principal (initial value of an investment)
i = Annual interest rate in decimal.
I = Amount of Interest
t = Time in years
Let us consider the following examples in order to see how exactly are these quantities
related.
Example 1: How much interest will be earned on ` 2000 at 6% simple interest for 2 years?
Solution: Required interest amount is given by
I=P×i×t
6
= 2,000 × ×2
100
= ` 240
Example 2: Sania deposited ` 50,000 in a bank for two years with the interest rate of 5.5% p.a.
How much interest would she earn?
Solution: Required interest amount is given by
 I=P×i×t
5.5
= ` 50,000 × ×2
100
= ` 5,500
Example 3: In example 2 what will be the final value of investment?
Solution: Final value of investment is given by
A = P(1 + it)
( 5.5 
= ` 50,000 1+ ×2
 
100
( 11 
= ` 50,000 1+
 
100 
50,000 ×111
=`
100
= ` 55,500
or
A=P+I
= ` (50,000 + 5,500)
= ` 55,500
Example 4: Sachin deposited ` 1,00,000 in his bank for 2 years at simple interest rate of 6%. How
much interest would he earn? How much would be the final value of deposit?
Solution: (a) Required interest amount is given by
I = P × it
6
= ` 1,00,000 × ×2
100
= ` 12,000
(b) Final value of deposit is given by
A=P+I
= ` (1,00,000 + 12,000)
= ` 1,12,000
Example 5: Find the rate of interest if the amount owed after 6 months is ` 1050, borrowed
amount being ` 1000.
Solution: We know A = P + Pit
i.e. 1050 = 1000 + 1000 × i × 6/12
  50 = 500 i
 i = 1/10 = 10%
Example 6: Rahul invested ` 70,000 in a bank at the rate of 6.5% p.a. simple interest rate.
He received ` 85,925 after the end of term. Find out the period for which sum was invested by
Rahul.
Solution: We know A = P (1+it)
( 6.5 
i.e. 85,925 = 70,000  1+ ×t
100 
100+6.5 t
 85,925/70,000 =
100
85,925×100
 – 100 = 6.5t
70,000

 22.75 = 6.5t
 t = 3.5
m time = 3.5 years
Example 7: Kapil deposited some amount in a bank for 7 ½ years at the rate of 6% p.a. simple
interest. Kapil received ` 1,01,500 at the end of the term. Compute initial deposit of Kapil.
Solution: We know A = P(1+ it)
( 6 15 
i.e. 1,01,500 = P  1 + × 
100 2 
( 45 
 1,01,500 = P  1+ 
100 

( 145
 1,01,500 = P  
100 
1,01,500×100
 P=
145
= ` 70,000
m Initial deposit of Kapil = ` 70,000
Example 8: A sum of ` 46,875 was lent out at simple interest and at the end of 1 year 8 months the
total amount was ` 50,000. Find the rate of interest percent per annum.
Solution: We know A = P (1 + it)
 ( 8
i.e. 50,000 = 46,875 1+i×1
 
12 
5
 50,000/46,875 = 1 + i
3
 (1.067 – 1) × 3/5 = i
 i = 0.04
 rate = 4%
Example 9: What sum of money will produce ` 28,600 as an interest in 3 years and 3 months at
2.5% p.a. simple interest?
Solution: We know I = P × it
2.5 3
i.e. 28,600 = P x ×3
100 12
2.5 13
 28,600 = P×
100 4
32.5
 28,600 = P
400
28,600×400
 P =
32.5
= ` 3,52,000
m ` 3,52,000 will produce 28,600 interest in 3 years and 3 months at 2.5% p.a. simple interest
Example 10: In what time will ` 85,000 amount to ` 1,57,675 at 4.5 % p.a. ?
Solution: We know
A = P (1 + it)
( 4.5 
 1,57,675 = 85,000 1+ ×t
 
100

1,57,675 100 + 4.5 t

=
 85,000 100
1,57,675 
 4.5t = ×100 – 100
L 85,000 

85.5
 t= = 19
4.5
m In 19 years ` 85,000 will amount to ` 1,57,675 at 4.5% p.a. simple interest rate.
Choose the most appropriate option (a) (b) (c) or (d).
1. S.I on ` 3,500 for 3 years at 12% p.a. is
(a) ` 1,200 (b) ` 1,260 (c) ` 2,260 (d) none of these
2. P = 5,000, R = 15, T = 4 ½ using I = PRT/100, I will be
(a) ` 3,375 (b) ` 3,300 (c) ` 3,735 (d) none of these
3. If P = 5,000, T = 1, I = ` 300, R will be
(a) 5% (b) 4% (c) 6% (d) none of these
4. If P = ` 4,500, A = ` 7,200, than Simple interest i.e. I will be
(a) ` 2,000 (b) ` 3,000 (c) ` 2,500 (d) ` 2,700
5. P = ` 12,000, A = ` 16,500, T = 2 ½ years. Rate percent per annum simple interest
will be
(a) 15% (b) 12% (c) 10% (d) none of these
6 P = ` 10,000, I = ` 2,500, R = 12 ½% SI. The number of years T will be
(a) 1 ½ years (b) 2 years (c) 3 years (d) none of these
7. P = ` 8,500, A = ` 10,200, R = 12 ½ % SI, t will be.
(a) 1 yr. 7 mth. (b) 2 yrs. (c) 1 ½ yr. (d) none of these
8. The sum required to earn a monthly interest of ` 1,200 at 18% per annum SI is
(a) ` 50,000 (b) ` 60,000 (c) ` 80,000 (d) none of these
9. A sum of money amount to ` 6,200 in 2 years and ` 7,400 in 3 years. The principal and rate of
interest are
(a) ` 3,800, 31.58% (b) ` 3,000, 20% (c) ` 3,500, 15% (d) none of these
10. A sum of money doubles itself in 10 years. The number of years it would triple itself is
(a) 25 years. (b) 15 years. (c) 20 years (d) none of these

4.4.2 Compound Interest

We have learnt about the simple interest. We know that if the principal remains the same for the
entire period or time then interest is called as simple interest. However in practice the method
according to which banks, insurance corporations and other money lending and deposit taking
companies calculate interest is different. To understand this method we consider an example :
Suppose you deposit ` 50,000 in ICICI bank for 2 years at 7% p.a. compounded annually. Interest
will be calculated in the following way:
INTEREST FOR FIRST YEAR
I = Pit
7
= ` 50,000 × × 1 = ` 3,500
100
INTEREST FOR SECOND YEAR
For calculating interest for second year principal would not be the initial deposit. Principal for
calculating interest for second year will be the initial deposit plus interest for the first year.
Therefore principal for calculating interest for second year would be
= ` 50,000 + ` 3,500
= ` 53,500
7
Interest for the second year = ` 53,500 × ×1
100
= ` 3,745
Total interest = Interest for first year + Interest for second year
= ` (3,500 + 3,745)
= ` 7,245
This interest is ` 245 more than the simple interest on ` 50,000 for two years at 7% p.a. As you
must have noticed this excess in interest is due to the fact that the principal for the second year
was more than the principal for first year. The interest calculated in this manner is called compound
interest.
Thus we can define the compound interest as the interest that accrues when earnings for each
specified period of time added to the principal thus increasing the principal base on which
subsequent interest is computed.
Example 11: Saina deposited ` 1,00,000 in a nationalized bank for three years. If the rate of
interest is 7% p.a., calculate the interest that bank has to pay to Saina after three years if interest
is compounded annually. Also calculate the amount at the end of third year.
Solution: Principal for first year ` 1,00,000
Interest for first year = Pit
7
= 1,00,000 × ×1
100
= ` 7,000
Principal for the second year = Principal for first year + Interest for first year
= ` 1,00,000 + ` 7,000
= ` 1,07,000
 7
Interest for second year = 1,07,000 × ×1
100
= ` 7,490
Principal for the third year = Principal for second year + Interest for second year
= 1,07,000 + 7,490
= 1,14,490
7
Interest for the third year = ` 1,14,490 × ×1
100
= ` 8,014.30
Compound interest at the end of third year
= ` (7,000 + 7,490 + 8,014.30)
= ` 22,504.30
Amount at the end of third year
= Principal (initial deposit) + compound interest
= ` (1,00,000 + 22,504.30)
= ` 1,22,504.30
Difference between simple interest and compound interest
Now we can summarize the main difference between simple interest and compound interest.
The main difference between simple interest and compound interest is that in simple interest the
principal remains constant throughout whereas in the case of compound interest principal goes
on changing at the end of specified period. For a given principal, rate and time the compound
interest is generally more than the simple interest.

4.4.3 Conversion period

In the example discussed above the interest was calculated on yearly basis i.e. the interest was
compounded annually. However in practice it is not necessary that the interest be compounded
annually. For example in banks the interest is often compounded twice a year (half yearly or
semi annually) i.e. interest is calculated and added to the principal after every six months. In
some financial institutions interest is compounded quarterly i.e. four times a year. The period at
the end of which the interest is compounded is called conversion period. When the interest is
calculated and added to the principal every six months the conversion period is six months. In
this case number of conversion periods per year would be two. If the loan or deposit was for five
years then the number of conversion period would be ten.
Typical conversion periods are given below:
Conversion period Description Number of conversion
period in a year
1 day Compounded daily 365
1 month Compounded monthly 12
3 months Compounded quarterly 4
6 months Compounded semi annually 2
12 months Compounded annually 1

4.4.4 Formula for compound interest

Taking the principal as P, the rate of interest per conversion period as i (in decimal), the number
of conversion period as n, the accrued amount after n payment periods as An we have accrued
amount at the end of first payment period
A1 = P + P i = P ( 1 + i ) ;
at the end of second payment period
A2 = A 1 + A 1 i = A 1 ( 1 + i )
=P(1+i)(1+i)
= P ( 1 + i)2 ;
at the end of third payment period
A3 = A 2 + A 2 i
= A2 (1 + i)
= P(1 + i)2 (1 + i)
= P(1 + i)3
An = An-1 + An-1 i
= An-1 (1 + i)
= P (1 + i) n-1 ( 1 + i)
= P(1+ i)n
Thus the accrued amount An on a principal P after n conversion periods at i ( in decimal)
rate of interest per conversion period is given by
An = P ( 1 + i)n
Annual rate of interest
where, i =
Number of conversion periods per year

Interest = An – P = P ( 1 + i )n – P
= P FL(1+i)n - 1l
n is total conversions i.e. t x no. of conversions per year
Note : Computation of A shall be quite simple with a calculator. However compound interest
table and tables for at various rates per annum with (a) annual compounding ; (b) monthly
compounding and (c) daily compounding are available.
Example 12: ` 2,000 is invested at annual rate of interest of 10%. What is the amount after two
years if compounding is done (a) Annually (b) Semi-annually (c) Quarterly (d) monthly.
Solution: (a) Compounding is done annually
Here principal P = ` 2,000; since the interest is compounded yearly the number of conversion
periods n in 2 years are 2. Also the rate of interest per conversion period (1 year) i is 0.10
An = P ( 1 + i )n
A2 = ` 2,000 (1 + 0.1)2
= ` 2,000 × (1.1)2
= ` 2,000 × 1.21
= ` 2,420
(b) For semiannual compounding
n=2×2 =4
0.1
i = = 0.05
2
A4 = 2,000 (1+0.05)4
= 2,000 × 1.2155
= ` 2,431
(c) For quarterly compounding
n=4×2 =8
0.1
i = = 0.025
4
A8 = 2,000 (1+ 0.025)8
= 2,000 × 1.2184
= ` 2,436.80
(d) For monthly compounding
n = 12 × 2 = 24, i = 0.1/12 = 0.00833
A24 = 2,000 (1 + 0.00833)24
= 2,000 × 1.22029
= ` 2,440.58
Example 13: Determine the compound amount and compound interest on ` 1000 at 6%
compounded semi-annually for 6 years. Given that (1 + i)n = 1.42576 for i = 3% and n = 12.
 0.06
Solution: i= = 0.03; n = 6 × 2 = 12
2
P = 1,000
Compound Amount (A12) = P ( 1 + i )n
= ` 1,000(1 + 0.03)12
= 1,000 × 1.42576
= ` 1,425.76
Compound Interest = ` (1,425.76 – 1,000)
= ` 425.76
Example 14: Compute the compound interest on ` 4,000 for 1½ years at 10% per annum
compounded half- yearly.
Solution: Here principal P = ` 4,000. Since the interest is compounded half-yearly the number of
conversion periods in 1½ years are 3. Also the rate of interest per conversion period (6 months) is
10% x 1/2 = 5% (0.05 in decimal).
Thus the amount An (in `) is given by
An = P (1 + i )n
A3 = 4,000(1 + 0.05)3
= 4,630.50
The compound interest is therefore ` (4,630.50 - 4,000)
= ` 630.50
To find the Principal/Time/Rate
The Formula An = P( 1 + i )n connects four variables An, P, i and n.

Similarly, C.I.(Compound Interest) = P FL(1 + i) – 1l⎦ connects C.I., P, i and n. Whenever three out
n

of these four variables are given the fourth can be found out by simple calculations.
Examples 15: On what sum will the compound interest at 5% per annum for two years
compounded annually be ` 1,640?
Solution: Here the interest is compounded annually the number of conversion periods in two
years are 2. Also the rate of interest per conversion period (1 year) is 5%.
n=2 i = 0.05
We know
C.I. = P F(1+i )n – 1l
IL I⎦
 1,640 = P F(1+0.05)2 -1l
IL I⎦
 1,640 = P (1.1025 – 1)
1,640
 P= = 16,000
0.1025
Hence the required sum is ` 16,000.
Example 16: What annual rate of interest compounded annually doubles an investment in 7
1
years? Given that 27 = 1.104090
Solution: If the principal be P then An = 2P.
Since An = P(1+ i)n
 2P = P (1 + i )7
 2 1/7 = ( 1 + i )
 1.104090 = 1 + i
 i = 0.10409
m Required rate of interest = 10.41% per annum
Example 17: In what time will ` 8,000 amount to ` 8,820 at 10% per annum interest compounded
half-yearly?
10
Solution: Here interest rate per conversion period (i) = %
2
= 5% (= 0.05 in decimal)
Principal (P) = ` 8,000
Amount (An) = ` 8,820
We know
An = P ( I + i )n
 8,820 = 8,000 (1 + 0.05)n
8,820
 = (1.05)n
8,000
 1.1025 = (1.05)n
 (1.05)2 = (1.05)n
 n=2
Hence number of conversion period is 2 and the required time = n/2 = 2/2 = 1 year
Example 18: Find the rate percent per annum if ` 2,00,000 amount to ` 2,31,525 in 1½ year interest
being compounded half-yearly.
Solution: Here P = ` 2,00,000
Number of conversion period (n) = 1½ × 2 = 3
Amount (A3) = ` 2,31,525
We know that
A3 = P (1 + i)3
 2,31,525 = 2,00,000 (1 + i) 3
2,31,525
2,00,000 = (1 + i)
3


 1.157625 = (1 + i) 3
 (1.05)3 = (1 + i)3
 i = 0.05
i is the Interest rate per conversion period (six months) = 0.05 = 5% &
Interest rate per annum = 5% × 2 = 10%
Example 19: A certain sum invested at 4% per annum compounded semi-annually amounts to
`78,030 at the end of one year. Find the sum.
Solution: Here An = 78,030
n = 2×1=2
i = 4 × 1/2 % = 2% = 0.02
P(in `) = ?
We have
An = P(1 + i)n
 A2 = P(1 + 0.02)2
 78,030 = P (1.02)2
78,030
 P =
(1.02)2
= 75,000
Thus the sum invested is ` 75,000 at the begining of 1 year.
Example 20: ` 16,000 invested at 10% p.a. compounded semi-annually amounts to ` 18,522.
Find the time period of investment.
Solution: Here P = ` 16,000
An = ` 18,522
i = 10 × 1/2 % = 5% = 0.05
 n = ?
We have A n = P(1 + i)n
 18,522 = 16,000(1+0.05)n
18,522
 = (1.05)n
16,000
 (1.157625) = (1.05)n
 (1.05)3 = (1.05)n
 n= 3

1
Therefore time period of investment is three half years i.e. 1 years.
2
Example 21: A person opened an account on April, 2011 with a deposit of ` 800. The account
paid 6% interest compounded quarterly. On October 1 2011 he closed the account and added
enough additional money to invest in a 6 month time-deposit for ` 1,000, earning 6% compounded
monthly.
(a) How much additional amount did the person invest on October 1?
(b) What was the maturity value of his time deposit on April 1 2012?
(c) How much total interest was earned?
Given that (1 + i)n is 1.03022500 for i=1½ % n = 2 and (1+ i)n is 1.03037751 for i = ½ % and n =
6.
Solution: (a) The initial investment earned interest for April-June and July- September quarter
F l
i.e. for two quarters. In this case i = 6/4 = 1½ % = 0.015, n n = 6  4 = 2
IL 12 I⎦

and the compounded amount = 800(1 + 0.015)2

= 800 × 1.03022500
= ` 824.18
The additional amount invested = ` (1,000 - 824.18)
= ` 175.82
(b) In this case the time-deposit earned interest compounded monthly for six months.
6
Here i = = 1/2 % = (0.005) n = 6 and P = ` 1,000
12
= 6 × 12
12
Maturity value = 1,000(1+0.005)6
Thus if we compound the interest more than once a year effective interest rate for the year will be
more than actual interest rate per annum. But if interest is compounded annually effective interest
rate for the year will be equal to actual interest rate per annum.
So effective interest rate can be defined as the equivalent annual rate of interest compounded
annually if interest is compounded more than once a year.
The effective interest rate can be computed directly by following formula:
E = (1 + i)n – 1
Where E is the effective interest rate
i = actual interest rate in decimal
n = number of conversion period
Example 22: ` 5,000 is invested in a Term Deposit Scheme that fetches interest 6% per
annum compounded quarterly. What will be the interest after one year? What is effective rate of
interest?
Solution: We know that
I = P F(1+i)n —1l
IL I⎦
Here P = ` 5,000
i = 6% p.a. = 0.06 p.a. or 0.015 per quarter
n = 4
and I = amount of compound interest
putting the values we have
I = ` 5,000 F(1+0.015)4 —1l
IL I⎦
= ` 5,000 × 0.06136355
= ` 306.82
For effective rate of interest using I = PEt we find
306.82 = 5,000 × E × 1.
306.82
 E =
5000
= 0.0613 or 6.13%
Note: We may arrive at the same result by using
E = (1+i)n – 1
 E = (1 + 0.015)4 – 1
= 1.0613 – 1
= .0613 or 6.13%
We may also note that effective rate of interest is not related to the amount of principal. It is
related to the interest rate and frequency of compounding the interest.
Example 23: Find the amount of compound interest and effective rate of interest if an amount of
` 20,000 is deposited in a bank for one year at the rate of 8% per annum compounded semi
annually.
Solution: We know that
I = P F(1+i)n —1l
IL I⎦
here P = ` 20,000
i = 8% p.a. = 8/2 % semi annually = 0.04
n =2
I = ` 20,000 F(1+0.04)2 —1l
IL I⎦
= ` 20,000 × 0.0816
= ` 1,632
Effective rate of interest:
We know that
I = PEt
 1,632 = 20,000 × E × 1
1632
 E = = 0.0816
20000
= 8.16%
Effective rate of interest can also be computed by following formula
E = (1 + i)n -1
= (1 + 0.04)2 -1
= 0.0816 or 8.16%
Example 24: Which is a better investment 3% per year compounded monthly or 3.2% per year
simple interest? Given that (1+0.0025)12 =1.0304.
Solution: i = 3/12 = 0.25% = 0.0025
n = 12
E = (1 + i)n - 1
= (1 + 0.0025)12 - 1
= 1.0304 – 1 = 0.0304
= 3.04%
Effective rate of interest (E) being less than 3.2%, the simple interest 3.2% per year is the better
investment.
Choose the most appropriate option (a) (b) (c) or (d).
1. If P = ` 1,000, R = 5% p.a, n = 4; What is Amount and C.I. is
(a) ` 1,215.50, ` 215.50 (b) ` 1,125, ` 125
(c) ` 2,115, ` 115 (d) none of these
2. ` 100 will become after 20 years at 5% p.a compound interest of
(a) ` 250 (b) ` 205 (c) ` 165.33 (d) none of these
3. The effective rate of interest corresponding to a nominal rate 3% p.a payable half yearly is
(a) 3.2% p.a (b) 3.25% p.a (c) 3.0225% p.a (d) none of these
4. A machine is depreciated at the rate of 20% on reducing balance. The original cost of the
machine was ` 1,00,000 and its ultimate scrap value was ` 30,000. The effective life of the
machine is
(a) 4.5 years (appx.) (b) 5.4 years (appx.)
(c) 5 years (appx.) (d) none of these
5. If A = ` 1,000, n = 2 years, R = 6% p.a compound interest payable half-yearly, then
principal (P) is
(a) ` 688.50 (b) ` 885 (c) 800 (d) none of these
6. The population of a town increases every year by 2% of the population at the beginning of
that year. The number of years by which the total increase of population be 40% is
(a) 7 years (b) 10 years (c) 17 years (app) (d) none of these
7. The difference between C.I and S.I on a certain sum of money invested for 3 years at 6% p.a
is ` 110.16. The principle is
(a) ` 3,000 (b) ` 3,700 (c) ` 12,000 (d) ` 10,000
8. The useful life of a machine is estimated to be 10 years and cost ` 10,000. Rate of depreciation
is 10% p.a. The scrap value at the end of its life is
(a) ` 3,486.78 (b) ` 4,383 (c) ` 3,400 (d) none of these
9. The effective rate of interest corresponding a nominal rate of 7% p.a convertible quarterly is
(a) 7% (b) 7.5% (c) 5% (d) 7.18%
10. The C.I on ` 16000 for 1 ½ years at 10% p.a payable half -yearly is
(a) ` 2,222 (b) ` 2,522 (c) ` 2,500 (d) none of these
11. The C.I on ` 40000 at 10% p.a for 1 year when the interest is payable quarterly is
(a) ` 4,000 (b) ` 4,100 (c) ` 4,152.51 (d) none of these
12. The difference between the S.I and the C.I on ` 2,400 for 2 years at 5% p.a is
(a) ` 5 (b) ` 10 (c) ` 16 (d) ` 6
13. The annual birth and death rates per 1,000 are 39.4 and 19.4 respectively. The number of
years in which the population will be doubled assuming there is no immigration or emigration
is
(a) 35 years. (b) 30 years. (c) 25 years (d) none of these
14. The C.I on ` 4,000 for 6 months at 12% p.a payable quarterly is
(a) ` 243.60 (b) ` 240 (c) ` 243 (d) none of these

In many cases you must have noted that your parents have to pay an equal amount of money
regularly like every month or every year. For example payment of life insurance premium, rent
of your house (if you stay in a rented house), payment of housing loan, vehicle loan etc. In all
these cases they pay a constant amount of money regularly. Time period between two consecutive
payments may be one month, one quarter or one year.
Sometimes some people received a fixed amount of money regularly like pension rent of house
etc. In all these cases annuity comes into the picture. When we pay (or receive) a fixed amount of
money periodically over a specified time period we create an annuity.
Thus annuity can be defined as a sequence of periodic payments (or receipts) regularly over a
specified period of time.
There is a special kind of annuity also that is called Perpetuity. It is one where the receipt or
payment takes place forever. Since the payment is forever we cannot compute a future value of
perpetuity. However we can compute the present value of the perpetuity. We will discuss later
about future value and present value of annuity.
To be called annuity a series of payments (or receipts) must have following features:
(1) Amount paid (or received) must be constant over the period of annuity and
(2) Time interval between two consecutive payments (or receipts) must be the same.
Consider following tables. Can payments/receipts shown in the table for five years be called
annuity?
Table - 4.1 Table - 4.2
Year end Payments/Receipts (`) Year end Payments/Receipts (`)
I 5,000 I 5,000
II 6,000 II 5,000
III 4,000 III –
IV 5,000 IV 5,000
V 7,000 V 5,000
 Table - 4.4
Year end Payments/Receipts (`)
I 5,000
II 5,000
III 5,000
IV 5,000
V 5,000
We can see that first payment/receipts takes place at the end of first year therefore it is an
annuity regular.
(2) Annuity Due or Annuity Immediate: When the first receipt or payment is made today
(at the beginning of the annuity) it is called annuity due or annuity immediate. Consider
following table:
Table - 4.5
In the beginning of Payment/Receipt (`)
I year 5,000
II year 5,000
III year 5,000
IV year 5,000
V year 5,000
We can see that first receipt or payment is made in the beginning of the first year. This type
of annuity is called annuity due or annuity immediate.

Future value is the cash value of an investment at some time in the future. It is tomorrow’s value
of today’s money compounded at the rate of interest. Suppose you invest ` 1,000 in a fixed deposit
that pays you 7% per annum as interest. At the end of first year you will have
` 1,070. This consist of the original principal of ` 1,000 and the interest earned of ` 70. ` 1,070 is
the future value of ` 1,000 invested for one year at 7%. We can say that ` 1000 today is worth `
1070 in one year’s time if the interest rate is 7%.
Now suppose you invested ` 1,000 for two years. How much would you have at the end of the
second year. You had ` 1,070 at the end of the first year. If you reinvest it you end up having `
1,070(1+0.07)= ` 1144.90 at the end of the second year. Thus ` 1,144.90 is the future value of `
1,000 invested for two years at 7%. We can compute the future value of a single cash flow by
applying the formula of compound interest.
We know that
An = P(1+i)n
Where A = Accumulated amount
n = number of conversion period
i = rate of interest per conversion period in decimal
P = principal
Future value of a single cash flow can be computed by above formula. Replace A by future value
(F) and P by single cash flow (C.F.) therefore
F = C.F. (1 + i)n
Example 25: You invest ` 3000 in a two year investment that pays you 12% per annum. Calculate
the future value of the investment.
Solution: We know
F = C.F. (1 + i)n
where F = Future value
C.F. = Cash flow = ` 3,000
i = rate of interest = 0.12
n = time period = 2
F = ` 3,000(1+0.12)2
= ` 3,000×1.2544
= ` 3,763.20

4.7.1 Future value of an annuity regular

Now we can discuss how do we calculate future value of an annuity.
Suppose a constant sum of ` 1 is deposited in a savings account at the end of each year for four
years at 6% interest. This implies that ` 1 deposited at the end of the first year will grow for three
years, ` 1 at the end of second year for 2 years, ` 1 at the end of the third year for one year and `
1 at the end of the fourth year will not yield any interest. Using the concept of compound interest
we can compute the future value of annuity. The compound value (compound amount) of ` 1
deposited in the first year will be
A3 = ` 1 (1 + 0.06)3
= ` 1.191
The compound value of ` 1 deposited in the second year will be
A2 = ` 1 (1 + 0.06)2
= ` 1.124
The compound value of ` 1 deposited in the third year will be
A1 = ` 1 (1 + 0.06)1
= ` 1.06
and the compound value of ` 1 deposited at the end of fourth year will remain ` 1.
The aggregate compound value of ` 1 deposited at the end of each year for four years would be:
` (1.191 + 1.124 + 1.060 + 1.00) = ` 4.375
This is the compound value of an annuity of ` 1 for four years at 6% rate of interest.
The above computation is summarized in the following table:
Table 4.6
End of year Amount Deposit (`) Future value at the end of
fourth year (`)
0 – –
1 1 1 (1 + 0.06)3 = 1.191
2 1 1 (1 + 0.06)2 = 1.124
3 1 1 (1 + 0.06)1 = 1.060
4 1 1 (1 + 0.06)0 = 1
Future Value 4.375

The computation shown in the table can be expressed as follows:

A (4, i) = A (1 + i)0 + A (1 + i) + A(1 + i)2 + A( 1 + i)3
i.e. A (4, i) = A LF1+ (1+i) +(1+i)2 +(1 + i)3 l⎦

In above equation A is annuity, A (4, i) is future value at the end of year four, i is the rate of
interest shown in decimal.
We can extend above equation for n periods and rewrite as follows:
A (n, i) = A (1 + i)0 + A (1 + i)1 +............................ +A (1 + i)n-2 + A (1 + i)n-1
Here A = Re.1
Therefore
A (n, i) = 1 (1 + i)0 + 1 (1 + i)1 + .......................... +1 (1 + i)n-2 + 1 (1 + i)n-1
= 1 + (1 + i)1 + .......................... + (1 + i)n-2 + (1 + i)n-1
[a geometric series with first term 1 and common ratio (1+ i)]
1. F1-(1+i)n l
= L ⎦
1-(1+i)
 1-(1+i)n
=
-i
(1+i)n -1
=
i
If A be the periodic payments, the future value A(n, i) of the annuity is given by
F (1+i)n —1l
A(n, i) = A II I
L i ⎦I
Example 26: Find the future value of an annuity of ` 500 made annually for 7 years at interest
rate of 14% compounded annually. Given that (1.14)7 = 2.5023.
Solution: Here annual payment A = ` 500
n= 7
i = 14% = 0.14
Future value of the annuity
F l
A(7, 0.14) = 500 I (1+0.14) -1 I
7

IL (0.14) I⎦
500×(2.5023-1)
=
0.14
= ` 5,365.35
Example 27: ` 200 is invested at the end of each month in an account paying interest 6% per year
compounded monthly. What is the future value of this annuity after 10th payment? Given that
(1.005)10 = 1.0511
Solution: Here A = ` 200
n = 10
i = 6% per annum = 6/12% per month = 0.005
Future value of annuity after 10 months is given by
F l
A(n, i) = A I(1+i) —1 I
n

IL i I⎦
F l
A(10, 0.005) = 200 I (1+0.005) -1 I
10

IL 0.005 I⎦

= 200 IF1.0511-1lI
IL 0.005 I⎦
 = 200  10.22
= ` 2,044

4.7.2 Future value of Annuity due or Annuity Immediate

As we know that in Annuity due or Annuity immediate first receipt or payment is made today.
Annuity regular assumes that the first receipt or the first payment is made at the end of first
period. The relationship between the value of an annuity due and an ordinary annuity in case of
future value is:
Future value of an Annuity due/Annuity immediate = Future value of annuity regular x (1+i)
where i is the interest rate in decimal.
Calculating the future value of the annuity due involves two steps.
Step-1 Calculate the future value as though it is an ordinary annuity.
Step-2 Multiply the result by (1+ i)

Example 28: Z invests ` 10,000 every year starting from today for next 10 years. Suppose interest
rate is 8% per annum compounded annually. Calculate future value of the annuity. Given that (1
+ 0.08)10 = 2.15892500.
Solution: Step-1: Calculate future value as though it is an ordinary annuity.
Future value of the annuity as if it is an ordinary annuity
F l
` 10,000I (1+0.08) -1 I
10
=
IL 0.08 I⎦

= ` 10,000 × 14.4865625
= ` 1,44,865.625
Step-2: Multiply the result by (1 + i)
= ` 1,44,865.625 × (1+0.08)
= ` 1,56,454.875

We have read that future value is tomorrow’s value of today’s money compounded at some
interest rate. We can say present value is today’s value of tomorrow’s money discounted at the
interest rate. Future value and present value are related to each other in fact they are the reciprocal
of each other. Let’s go back to our fixed deposit example. You invested ` 1000 at 7% and get
` 1,070 at the end of the year. If ` 1,070 is the future value of today’s ` 1000 at 7% then ` 1,000 is
present value of tomorrow’s ` 1,070 at 7%. We have also seen that if we invest ` 1,000 for two
years at 7% per annum we will get ` 1,144.90 after two years. It means ` 1,144.90 is the future
value of today’s ` 1,000 at 7% and ` 1,000 is the present value of ` 1,144.90 where time period is
two years and rate of interest is 7% per annum. We can get the present value of a cash flow
(inflow or outflow) by applying compound interest formula.
The present value P of the amount An due at the end of n period at the rate of i per interest period
may be obtained by solving for P the below given equation
An = P(1 + i)n
A n
i.e. P = (1+i)n

• Computation of P may be simple if we make use of either the calculator or the present value
1
table showing values of for various time periods/per annum interest rates.
(1+i)n
1
• For positive i the factor (1+i)n is always less than 1 indicating thereby future amount has

smaller present value.

Example 29: What is the present value of ` 1 to be received after two years compounded annually
at 10% interest rate?
Solution: Here An = `1
i = 10% = 0.1
n= 2
An
Required present value =
(1+i)n
1
=
(1+0.1)2
1
= = 0.8264
1.21
= ` 0.83
Thus ` 0.83 shall grow to ` 1 after 2 years at 10% interest rate compounded annually.
Example 30: Find the present value of ` 10,000 to be required after 5 years if the interest rate be
9%. Given that (1.09)5=1.5386.
Solution: Here i = 0.09 = 9%
n =5
An = 10,000
 An
Required present value =
(1+ i)n
10,000
=
(1+0.09)5
10,000
= = ` 6,499.42
1.5386
4.8.1 Present value of an Annuity regular: We have seen how compound interest technique
can be used for computing the future value of an Annuity. We will now see how we compute
present value of an annuity. We take an example, Suppose your mom promise you to give you `
1,000 on every 31st December for the next five years. Suppose today is 1st January. How much
money will you have after five years from now if you invest this gift of the next five years at 10%?
For getting answer we will have to compute future value of this annuity.
But you don’t want ` 1,000 to be given to you each year. You instead want a lump sum figure
today. Will you get ` 5,000. The answer is no. The amount that she will give you today will be less
than ` 5,000. For getting the answer we will have to compute the present value of this annuity.
For getting present value of this annuity we will compute the present value of these amounts and
then aggregate them. Consider following table:
Table 4.7
Year End Gift Amount (`) Present Value [An / (1 + i)n ]
I 1,000 1,000/(1 + 0.1) = 909.091
II 1,000 1,000/(1 + 0.1)2 = 826.446
III 1,000 1,000/(1 + 0.1)3 = 751.315
IV 1,000 1,000/(1 + 0.1)4 = 683.013
V 1,000 1,000/(1 + 0.1)5 = 620.921
Present Value = 3,790.86
Thus the present value of annuity of ` 1,000 for 5 years at 10% is ` 3,790.79
It means if you want lump sum payment today instead of ` 1,000 every year you will get
` 3,790.79.
The above computation can be written in formula form as below.
The present value (V) of an annuity (A) is the sum of the present values of the payments.
A A A A A
m V = + + + +
(1+ i)1 (1+ i)2 (1+ i)3 (1+ i)4 (1+ i)5
We can extend above equation for n periods and rewrite as follows:
A A A A
V = + +……….+ + (1)
(1+ i)1 (1+ i)2 (1+ i)n—1 (1+ i)n ...........................
 1
multiplying throughout by we get
(1 + i)
V A A A A
= + +………..+ + (2)
(1 + i) (1 + i)2 (1+ i)3 (1+ i)n (1+ i)n+1 .......................
subtracting (2) from (1) we get
V A A
V– = –
(1+ i) (1 + i)1 (1+ i)n+1
A
Or V (1+ i) – V = A –
(1+ i)n
F 1 l
Or I
Vi = A 1 — n II
L (1 + i) ⎦
F (1 + i)n — 1 l
I
m V = A II n I = A.P(n, i)
L i(1 + i) ⎦
( 1 + i) n - 1
Where, P(n, i) =
i( 1 + i) n

V
Consequently A = which is useful in problems of amortization.
P(n, i)
A loan with fixed rate of interest is said to be amortized if entire principal and interest are paid
over equal periods of time by way of sequence of equal payment.
V
A= can be used to compute the amount of annuity if we have present value (V), n the
P(n,i)
number of time period and the rate of interest in decimal.
Suppose your dad purchases a car for ` 5,50,000. He gets a loan of ` 5,00,000 at 15% p.a. from a Bank
and balance 50,000 he pays at the time of purchase. Your dad has to pay whole amount of loan in 12
equal monthly instalments with interest starting from the end of first month.
Now we have to calculate how much money has to be paid at the end of every month. We can
compute equal instalment by following formula
V
A=
P(n,i)

Here V = ` 5,00,000
n = 12
 0.15
i= = 0.0125
12
(1+i)n-1
P (n, i)=
i(1+i)n

12
(1+0.0125) -1
P (12, 0.0125) = 12
0.0125(1+0.0125)
1.16075452 - 1
=
0.0125 × 1.16075452

0.16075452
= = 11.079
0.01450943
5, 00, 000
m A = = ` 45130.43
11.079
Therefore your dad will have to pay 12 monthly instalments of ` 45,130.43.
Example 31: S borrows ` 5,00,000 to buy a house. If he pays equal instalments for 20 years and
10% interest on outstanding balance what will be the equal annual instalment?
Solution: We know
V
A=
P(n, i)

Here V = ` 5,00,000
n = 20
i = 10% p.a.= 0.10
V 5,00,000
m A= =`
P(n, i) P(20, 0.10)
5,00,000
=` [P(20, 0.10) = 8.51356 from table 2(a)]
8.51356
= ` 58,729.84
Example 32: ` 5,000 is paid every year for ten years to pay off a loan. What is the loan amount if
interest rate be 14% per annum compounded annually?
Solution: V = A.P.(n, i)
Here A = ` 5,000
n = 10
 i = 0.14
V = 5000 × P(10, 0.14)
= 5000 × 5.21611 = ` 26,080.55
Therefore the loan amount is ` 26,080.55
Note: Value of P(10, 0.14) can be seen from table 2(a) or it can be computed by formula derived in
preceding paragraph.
Example 33: Y bought a TV costing ` 13,000 by making a down payment of ` 3000 and agreeing
to make equal annual payment for four years. How much would be each payment if the interest
on unpaid amount be 14% compounded annually?
Solution: In the present case we have present value of the annuity i.e. ` 10,000
(13,000-3,000) and we have to calculate equal annual payment over the period of four years.
We know that
V = A.P (n, i)
Here n = 4 and i = 0.14
V
A =
P(n, i)

10,000
=
P(4, 0.14)
10,000
= [from table 2(a)]
2.91371
= ` 3,432.05
Therefore each payment would be ` 3,432.05

4.8.2 Present value of annuity due or annuity immediate

Present value of annuity due/immediate for n years is the same as an annuity regular for (n-1)
years plus an initial receipt or payment in beginning of the period. Calculating the present value
of annuity due involves two steps.
Step 1: Compute the present value of annuity as if it were a annuity regular for one period
short.
Step 2: Add initial cash payment/receipt to the step 1 value.

Example 34: Suppose your mom decides to gift you ` 10,000 every year starting from today for
the next five years. You deposit this amount in a bank as and when you receive and get 10% per
annum interest rate compounded annually. What is the present value of this annuity?
Solution: It is an annuity immediate. For calculating value of the annuity immediate following
steps will be followed:
Step 1: Present value of the annuity as if it were a regular annuity for one year less i.e. for four
years
= ` 10,000 × P (4, 0.10)
= ` 10,000 × 3.16987
= ` 31,698.70
Step 2: Add initial cash deposit to the step 1 value
` (31,698.70+10,000) = ` 41,698.70

It is the fund credited for a specified purpose by way of sequence of periodic payments over a
time period at a specified interest rate. Interest is compounded at the end of every period. Size of
the sinking fund deposit is computed from A = P.A(n, i) where A is the amount to be saved, P the
periodic payment, n the payment period.

Example 35: How much amount is required to be invested every year so as to accumulate
` 300000 at the end of 10 years if interest is compounded annually at 10%?
Solution: Here A = 3,00,000
n = 10
i = 0.1
Since A = P.A (n, i)
300000 = P.A.(10, 0.1)
= P × 15.9374248
3,00,000
m P = = ` 18,823.62
15.9374248
This value can also be calculated by the formula of future value of annuity regular.
We know that
(1+i)n -1
A(n i) = A  
i
L 
(1 + 0.1)10 – 1
300000 = A  
L 0.1 
300000 = A×15.9374248
3,00,000
A =
15.9374248
= ` 18,823.62
4.10.1 Leasing
Leasing is a financial arrangement under which the owner of the asset (lessor) allows the user of
the asset (lessee) to use the asset for a defined period of time(lease period) for a consideration
(lease rental) payable over a given period of time. This is a kind of taking an asset on rent. How
can we decide whether a lease agreement is favourable to lessor or lessee, it can be seen by
following example.
Example 36: ABC Ltd. wants to lease out an asset costing ` 3,60,000 for a five year period. It has
fixed a rental of ` 1,05,000 per annum payable annually starting from the end of first year. Suppose
rate of interest is 14% per annum compounded annually on which money can be invested by the
company. Is this agreement favourable to the company?
Solution: First we have to compute the present value of the annuity of ` 1,05,000 for five years at
the interest rate of 14% p.a. compounded annually.
The present value V of the annuity is given by
V = A.P (n, i)
= 1,05,000 × P(5, 0.14)
= 1,0,5000 × 3.43308 = ` 3,60,473.40
which is greater than the initial cost of the asset and consequently leasing is favourable to the
lessor.
Example 37: A company is considering proposal of purchasing a machine either by making full
payment of ` 4,000 or by leasing it for four years at an annual rate of ` 1,250. Which course of
action is preferable if the company can borrow money at 14% compounded annually?
Solution: The present value V of annuity is given by
V = A.P (n, i)
= 1,250 × P (4, 0.14)
= 1,250 × 2.91371 = ` 3,642.11
which is less than the purchase price and consequently leasing is preferable.
4.10.2 Capital Expenditure (investment decision)
Capital expenditure means purchasing an asset (which results in outflows of money) today in
anticipation of benefits (cash inflow) which would flow across the life of the investment. For
taking investment decision we compare the present value of cash outflow and present value of
cash inflows. If present value of cash inflows is greater than present value of cash outflows decision
should be in the favour of investment. Let us see how do we take capital expenditure (investment)
decision.
Example 38: A machine can be purchased for ` 50000. Machine will contribute ` 12000 per year
for the next five years. Assume borrowing cost is 10% per annum compounded annually.
Determine whether machine should be purchased or not.
Solution: The present value of annual contribution
V = A.P(n, i)
= 12,000 × P(5, 0.10)
= 12,000 × 3.79079
= ` 45,489.48
which is less than the initial cost of the machine. Therefore machine must not be purchased.
Example 39: A machine with useful life of seven years costs ` 10,000 while another machine
with useful life of five years costs ` 8,000. The first machine saves labour expenses of ` 1,900
annually and the second one saves labour expenses of ` 2,200 annually. Determine the preferred
course of action. Assume cost of borrowing as 10% compounded per annum.
Solution: The present value of annual cost savings for the first machine
= ` 1,900 × P (7, 0.10)
= ` 1,900 × 4.86842
= ` 9,249.99
= ` 9,250
Cost of machine being ` 10,000 it costs more by ` 750 than it saves in terms of labour cost.
The present value of annual cost savings of the second machine
= ` 2,200 × P(5, 0.10)
= ` 2,200 × 3.79079
= ` 8,339.74
Cost of the second machine being ` 8,000 effective savings in labour cost is ` 339.74. Hence the
second machine is preferable.
4.10.3 Valuation of Bond
A bond is a debt security in which the issuer owes the holder a debt and is obliged to repay the
principal and interest. Bonds are generally issued for a fixed term longer than one year.
The bond insuer enters into contract with bondholder to pay interest.
Example 40: An investor intends purchasing a three year ` 1,000 par value bond having nominal
interest rate of 10%. At what price the bond may be purchased now if it matures at par and the
investor requires a rate of return of 14%?
Solution: Present value of the bond
100 100 100 1,000
= + + +
(1+0.14)1 (1 + 0.14)2 (1 + 0.14)3 (1+0.14)3
= 100 × 0.87719 + 100 × 0.769467 + 100 × 0.674 972 + 1,000 × 0.674972
= 87.719+ 76.947+ 67.497+ 674.972
= 907.125
Thus the purchase value of the bond is ` 907.125
Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and
continue indefinitely or perpetually. Fixed coupon payments on permanently invested
(irredeemable) sums of money are prime examples of perpetuities.
The formula for evaluating perpetuity is relatively straight forward. Two points which are
important to understand in this regard are:.
(a) The value of the perpetuity is finite because receipts that are anticipated far in the future
have extremely low present value (today’s value of the future cash flows).
(b) Additionally, because the principal is never repaid, there is no present value for the principal.
Therefore, the price of perpetuity is simply the coupon amount over the appropriate discount
rate or yield.

4.11.1 Calculation of multi period perpetuity:

The formula for determining the present value of multi-period perpetuity is as follows:
R R R R ∞
PVA∞ = + + +.......+ =Σ R
=
R
(1+i) (1+i) (1+i)
1 2 3 ¥ n
(1+i) n=1 (1+i) i

Where:
R = the payment or receipt each period
i = the interest rate per payment or receipt period
Example 41: Ramesh wants to retire and receive ` 3,000 a month. He wants to pass this monthly
payment to future generations after his death. He can earn an interest of 8% compounded
annually. How much will he need to set aside to achieve his perpetuity goal?
Solution:
R = ` 3,000
i = 0.08/12 or 0.00667
Substituting these values in the above formula, we get

` 3,000
PVA =
0.00667

= ` 4,49,775
If he wanted the payments to start today, he must increase the size of the funds to handle the
first payment. This is achieved by depositing ` 4,52,775 (PV of normal perpetuity + perpetuity
received in the beginning = 4,49,775 + 3,000) which provides the immediate payment of
` 3,000 and leaves ` 4,49,775 in the fund to provide the future ` 3,000 payments.
4.11.2 Calculation of Growing Perpetuity:
A stream of cash flows that grows at a constant rate forever is known as growing perpetuity.
The formula for determining the present value of growing perpetuity is as follows:

R R(1+ g) R(1+ g)2 R(1+ g)∞

PVA = 1
+ 2
+ 3
+ ..... + ∞

(1+ i) (1+ i) (1+ i) (1+ i)

∞
R(1 + g)n–1 R
=
Σ (1 + i)n i–g
n=1

Example 42: Assuming that the discount rate is 7% per annum, how much would you pay to
receive ` 50, growing at 5%, annually, forever?
Solution:

R 50
PVA = = = 2,500
i-g 0.07 – 0.05

Where
R = Cash flow stream, i = interest rate or discount rate, g = growth rate in interest
Calculating Rate of Return:
1) Calculating the rate of return provides important information that can be used for future
investments. For example, if you invested in a stock that showed a substantial gain after
several months of performance, you may decide to purchase more of that stock. If the stock
showed a continual loss, it may be wise to conduct research to find a better-performing
stock.
2) calculating the rate of return is that it allows you to gauge your investment and decision-
making skills. Investments that create a gain or profit are great. However, if you continually
make investments at a loss, then you may want to change your investment strategies. A
great attribute of successful business people is knowing how and when to make investments,
as is knowing when to change strategies. With a firm grasp of calculating the rate of return,
you can manage and monitor your investments at various stages to determine the outcome
of your investments. This leads to a higher level of confidence and the skills necessary to be
a savvy investor.
Net Present Value Technique (NPV): The net present value technique is a discounted cash flow
method that considers the time value of money in evaluating capital investments. An investment
has cash flows throughout its life, and it is assumed that a rupee of cash flow in the early years
of an investment is worth more than a rupee of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent net cash
inflows after the initial investment to their present values (the time of the initial investment is
year 0).
Determining Discount Rate
Theoretically, the discount rate or desired rate of return on an investment is the rate of return the
firm would have earned by investing the same funds in the best available alternative investment
that has the same risk. Determining the best alternative opportunity available is difficult in
practical terms so rather that using the true opportunity cost, organizations often use an alternative
measure for the desired rate of return. An organization may establish a minimum rate of return
that all capital projects must meet; this minimum could be based on an industry average or the
cost of other investment opportunities. Many organizations choose to use the overall cost of
capital or Weighted Average Cost of Capital (WACC) that an organization has incurred in raising
funds or expects to incur in raising the funds needed for an investment.
The net present value of a project is the amount, in current value of rupees, the investment earns
after paying cost of capital in each period.

Net present value = Present value of net cash inflow – Total net initial investment
Since it might be possible that some additional investment may also be required during the life
time of the project then appropriate formula shall be:
Net present value = Present value of cash inflow – Present value of cash outflow
The steps to calculating net present value are:-
1. Determine the net cash inflow in each year of the investment.
2. Select the desired rate of return or discounting rate or Weighted Average Cost of Capital.
3. Find the discount factor for each year based on the desired rate of return selected.
4. Determine the present values of the net cash flows by multiplying the cash flows by respective
the discount factors of respective period called Present Value (PV) of Cash flows
5. Total the amounts of all PVs of Cash Flows
Decision Rule:
If NPV > 0 Accept the Proposal
If NPV < 0 Reject the Proposal
Example 43: Compute the net present value for a project with a net investment of
` 1,00,000 and net cash flows year one is ` 55,000; for year two is ` 80,000 and for year three
is ` 15,000. Further, the company’s cost of capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]
Choose the most appropriate option (a) (b) (c) or (d).
1. The present value of an annuity of ` 3000 for 15 years at 4.5% p.a CI is
(a) ` 23,809.41 (b) ` 32,214.60 (c) ` 32,908.41 (d) none of these
2. The amount of an annuity certain of ` 150 for 12 years at 3.5% p.a C.I is
(a) ` 2,190.28 (b) ` 1,290.28 (c) ` 2,180.28 (d) none of these
3. A loan of ` 10,000 is to be paid back in 30 equal instalments. The amount of each installment
to cover the principal and at 4% p.a CI is
(a) ` 587.87 (b) ` 587 (c) ` 578.30 (d) none of these
4. A = ` 1,200 n = 12 years i = 0.08, V = ?
 
Using the formula V = A 1 - 1 value of v will be
i  (1 + i)n 
L 
(a) ` 3,039 (b) ` 3,990 (c) ` 9,930 (d) 9,043.30
5. a = ` 100 n = 10, i = 5% find the FV of annuity
Using the formula FV = a / {1 + i) n – 1}, FV is equal to
(a) ` 1,258 (b) ` 2,581 (c) ` 1,528 (d) none of these
6. If the amount of an annuity after 25 years at 5% p.a C.I is ` 50,000 the annuity will be
(a) ` 1,406.90 (b) ` 1,047.62 (c) ` 1,146.90 (d) none of these
7. Given annuity of ` 100 amounts to ` 3137.12 at 4.5% p.a C. I. The number of years
will be
(a) 25 years (appx.) (b) 20 years (appx.) (c) 22 years (d) none of these
8. A company borrows ` 10,000 on condition to repay it with compound interest at 5% p.a
by annual installments of ` 1000 each. The number of years by which the debt will be
clear is
(a) 14.2 years (b) 10 years (c) 12 years (d) none of these
9. Mr. X borrowed ` 5,120 at 12 ½ % p.a C.I. At the end of 3 yrs, the money was repaid along
with the interest accrued. The amount of interest paid by him is
(a) ` 2,100 (b) ` 2,170 (c) ` 2,000 (d) none of these
10. Mr. Paul borrows ` 20,000 on condition to repay it with C.I. at 5% p.a in annual installments
of ` 2000 each. The number of years for the debt to be paid off is
(a) 10 years (b) 12 years (c) 11 years (d) 14.2 years
11. A person invests ` 500 at the end of each year with a bank which pays interest at 10%
p. a C.I. annually. The amount standing to his credit one year after he has made his yearly
investment for the 12th time is.
 (a) ` 11,761.36 (b) ` 10,000 (c) ` 12,000 (d) none of these
12. The present value of annuity of ` 5,000 per annum for 12 years at 4% p.a C.I. annually is
(a) ` 46,000 (b) ` 46,850 (c) ` 15,000 (d) ` 46,925.40
13. A person desires to create a fund to be invested at 10% CI per annum to provide for a prize
of ` 300 every year. Using V = a/I find V and V will be
(a) ` 2,000 (b) ` 2,500 (c) ` 3,000 (d) none of these

 Time value of money: Time value of money means that the value of a unity of money is
different in different time periods. The sum of money received in future is less valuable
than it is today. In other words the present worth of money received after some time will
be less than a money received today.
 Interest: Interest is the price paid by a borrower for the use of a lender’s money. If you
borrow (or lend) some money from (or to) a person for a particular period you would pay
(or receive) more money than your initial borrowing (or lending).
 Simple interest: is the interest computed on the principal for the entire period of borrowing.
I = Pit
A=P+I
I =A–P
Here, A = Accumulated amount (final value of an investment)
P = Principal (initial value of an investment)
i = Annual interest rate in decimal.
I = Amount of Interest
t = Time in years
 Compound interest as the interest that accrues when earnings for each specified period of
time added to the principal thus increasing the principal base on which subsequent interest
is computed.
Formula for compound interest:
An = P ( 1 + i)n
where, i = Annual rate of interest
n = Number of conversion periods per year
Interest = An – P = P ( 1 + i )n – P
n is total conversions i.e. t x no. of conversions per year
 Effective Rate of Interest: The effective interest rate can be computed directly by following
formula:
E = (1 + i)n– 1
 Where E is the effective interest rate
i = actual interest rate in decimal
n = number of conversion period
 Future value of a single cash flow can be computed by above formula. Replace A by future
value (F) and P by single cash flow (C.F.) therefore
F = C.F. (1 + i)n
 Annuity can be defined as a sequence of periodic payments (or receipts) regularly over a
specified period of time.
Annuity may be of two types:
(i) Annuity regular: In annuity regular first payment/receipt takes place at the end of
first period.
(ii) Annuity Due or Annuity Immediate: When the first receipt or payment is made today
(at the beginning of the annuity) it is called annuity due or annuity immediate.
 If A be the periodic payments, the future value A(n, i) of the annuity is given by

F l
A(n, i) = A I(1+i) —1 I
n

IL i I⎦

 Future value of an Annuity due/Annuity immediate = Future value of annuity regular x

(1+i) where i is the interest rate in decimal.
 The present value P of the amount An due at the end of n period at the rate of i per interest
period may be obtained by solving for P the below given equation
An = P(1 + i)n
An
i.e. P=
(1+i)n
 Present value of annuity due or annuity immediate: Present value of annuity due/
immediate for n years is the same as an annuity regular for (n-1) years plus an initial
receipt or payment in beginning of the period. Calculating the present value of annuity
due involves two steps.
Step 1: Compute the present value of annuity as if it were a annuity regular for one period
short.
Step 2: Add initial cash payment/receipt to the step 1 value.
 Sinking Fund: It is the fund credited for a specified purpose by way of sequence of periodic
payments over a time period at a specified interest rate. Interest is compounded at the end
of every period. Sizeof the sinking fund deposit is computed from A = P.A(n, i) where A is
the amount to be saved the periodic payment, n the payment period.
 Exercise 4(a)
1. (b) 2. (a) 3. (c) 4. (d) 5. (a) 6. (b)
7. (a) 8. (c) 9. (a) 10. (c)
Exercise 4(b)
1. (a) 2. (c) 3. (c) 4. (b) 5. (a) 6. (c)
7. (d) 8. (a) 9. (d) 10. (b) 11. (c) 12. (d)
13. (a) 14. (a)
Exercise 4(c)
1. (b) 2. (a) 3. (c) 4. (d) 5. (a) 6. (b)
7. (b) 8. (a) 9. (b) 10. (d) 11. (a) 12. (d)
13. (c)
Exercise 4(d)
1. (b) 2. (a) 3. (c) 4. (d) 5. (a) 6. (a)
7. (c) 8. (a)

1. The difference between compound and simple interest at 5% per annum for 4 years on
` 20,000 is `
(a) 250 (b) 277 (c) 300 (d) 310
2. The compound interest on half-yearly rests on ` 10,000 the rate for the first and second years
being 6% and for the third year 9% p.a. is `. .
(a) 2,200 (b) 2,287 (c) 2,285 (d) None
3. The present value of ` 10,000 due in 2 years at 5% p.a. compound interest when the interest
is paid on yearly basis is ` .
(a) 9,070 (b) 9,000 (c) 9,061 (d) None
4. The present value of ` 10,000 due in 2 years at 5% p.a. compound interest when the interest
is paid on half-yearly basis is ` .
(a) 9,070 (b) 9,069 (c) 9,061 (d) None
5. Johnson left ` 1,00,000 with the direction that it should be divided in such a way that his
minor sons Tom, Dick and Harry aged 9, 12 and 15 years should each receive equally after
attaining the age 25 years. The rate of interest being 3.5%, how much each son receive after
getting 25 years old?
 (a) 50,000 (b) 51,994 (c) 52,000 (d) None
6. In how many years will a sum of money double at 5% p.a. compound interest?
(a) 15 years 3 months (b) 14 years 2 months
(c) 14 years 3 months (d) 15 years 2 months
7. In how many years a sum of money trebles at 5% p.a. compound interest payable on half-
yearly basis?
(a) 18 years 7 months (b) 18 years 6 months
(c) 18 years 8 months (d) 22 years 3 months
8. A machine depreciates at 10% of its value at the beginning of a year. The cost and scrap
value realized at the time of sale being ` 23,240 and ` 9,000 respectively. For how many
years the machine was put to use?
(a) 7 years (b) 8 years (c) 9 years (d) 10 years
9. A machine worth ` 4,90,740 is depreciated at 15% on its opening value each year. When its
value would reduce to ` 2,00,000?
(a) 4 years 6 months (b) 4 years 7 months
(c) 4 years 5 months (d) 5 years 7 months approximately
10. A machine worth ` 4,90,740 is depreciated at 15% of its opening value each year. When its
value would reduce by 90%?
(a) 11 years 6 months (b) 11 years 7 months
(c) 11 years 8 months (d) 14 years 2 months approximately
11. Alibaba borrows ` 6 lakhs Housing Loan at 6% repayable in 20 annual installments
commencing at the end of the first year. How much annual payment is necessary.
(a) ` 52,420 (b) ` 52,419 (c) ` 52,310 (d) ` 52,320
12. A sinking fund is created for redeming debentures worth ` 5 lakhs at the end of 25 years.
How much provision needs to be made out of profits each year provided sinking fund
investments can earn interest at 4% p.a.?
(a) ` 12,006 (b) ` 12,040 (c) ` 12,039 (d) ` 12,035
13. A machine costs ` 5,20,000 with an estimated life of 25 years. A sinking fund is created to
replace it by a new model at 25% higher cost after 25 years with a scrap value realization of
` 25000. what amount should be set aside every year if the sinking fund investments
accumulate at 3.5% compound interest p.a.?
(a) ` 16,000 (b) ` 16,500 (c) ` 16,050 (d) ` 16,005
14. Raja aged 40 wishes his wife Rani to have ` 40 lakhs at his death. If his expectation of life is
another 30 years and he starts making equal annual investments commencing now at 3%
compound interest p.a. how much should he invest annually?
 (a) 84,448 (b) 84,450 (c) 84,449 (d) 84,080
15. Appu retires at 60 years receiving a pension of 14,400 a year paid in half-yearly installments
for rest of his life after reckoning his life expectation to be 13 years and that interest at 4%
p.a. is payable half-yearly. What single sum is equivalent to his pension?
(a) 1,45,000 (b) 1,44,900 (c) 1,44,800 (d) 1,44,700

1. (d) 2. (d) 3. (a) 4. (c) 5. (d) 6. (b)

7. (d) 8. (c) 9. (d) 10. (d) 11. (c) 12. (a)
13. (c) 14. (d) 15. (b)

Note : In most cases Loan payment dues are made at the end of the period only, i.e Annuity
Regular . Questions based on Annuity applications can be solved using the Annuity Regular
method . For knowledge purpose students may try another method viz., Annuity Due.