THE TIME VALUE OF MONEY – Practice Questions

1. Calculate the present value (year 0) of the amounts set in the table, assuming
interest rates for past years and for next year is 5%, increasing to 12% right from
year 2 onwards. Which of the four investment alternatives is the most profitable?

-6 -5 -4 -3
A 40
2. Determine the best alternative using Net Present Value and 10% discount rate: 30
B
a. Cash Inflows
530
428
Payments
198
240
80
390 189
C 350
460
238
230 4 4 4
D
b. Year 1 Cash Flow = 200. 5% annual cash flow increase in each of the
following years until year 5.
c. Perpetual annual cash flows of 82.5.

3. The current interest rate in the financial markets is 5%, although the markets bet
for an increase of 50 basis points in a couple of years and an additional 50 bp
two years later. Which one of the following would be the best alternative for
your money?

a. To invest your money today at 6 years term using compound interest at

market rates.
b. To invest your money at 2 years at simple interest rate and afterwards
invest the resulting amount using compound interest at market rates.
c. To invest every 2 years at simple interest, considering the corresponding
market rates at the time.

4. Please determine the Annual Equivalent Rate and the interests received quarterly
for a deposit of 300.000 Euro per year, if the nominal annual interest rate is 3%
and interests are paid and capitalized every 3 months.

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5. A company has requested proposals to four different banks in order to invest 4
Million Euro at 2 years. The banks have submitted the following quotations:
a. 1.4% quarterly interest payment.
b. 4% annual interest rate
c. Deposit with a global interest rate of 8% for the two years.
d. Deposit with an annual interest rate of 4%, but capitalizing interests on a
quarterly basis.
Which deposit is the one that offers a higher return? What will be the total amount
of money in the deposit after two years?

6. In order to get customers, three banks are offering the following conditions for
deposits at 1 year:
a. AFG Direct: 1-month deposit at 10% nominal annual rate. The remaining
11 months at 4.0 % nominal annual rate.
b. Pentagon: 4.5 % Nominal annual rate capitalized quarterly.
c. Five-e: Increasing interest deposit starting at 4% nominal annual interest
rate in the first quarter and ending at 5.50% in the last quarter, with a
linear increase every quarter. Interests are paid and capitalized quarterly.
d. BBPA: 6-month deposit. First month at 12% nominal annual rate and the
remaining 5 months at 4.32 % nominal annual rate. At the end of the 6
months, the investor can renew the deposit in the exact same conditions.

Which deposit is offering the highest return?

7. A bank offers an interest payment of 36.000 Euros for a 200.000 Euro deposit at
4 years. Please determine the following:

a. Annual Equivalent rate if interests are paid at the end of the period
b. 6-month equivalent rate if interests are paid and capitalized twice a year
c. Nominal annual rate if Interests are paid and capitalized twice a month
d. Continuous compounding rate

8. A company issues bonds at 10 years with an annual coupon of 10% and

amortization at par value (100%). If market interest rates at the time of issuance
are 10%, what would be the price of the bond? Would it change if market
interest rates raise to 12% or decrease to 8%? Face value of the bond is € 100

9. Six years ago, a company issued an 8-year bond of 10,000 Euro face value, with
an annual coupon of 12.5%. The current price of the bond is 9,870 and the risk
free rate 12.15%. If the bond is redeemable with a premium of 10% over its face
value, please determine the discount rate (yield) that investors apply to the bond.

10. The final payment of a zero-coupon bond at 18 months is 10,000 Euro. Please
calculate the price at which the bond will be issued, if interest rate is 5%. What
would be the price if the interests raise to 7%?

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11. A company is analyzing a project with the following cash flows: Co= -10.000;
C1= 7.000; C2=4.500; C3=3.000; C4=-1.000. Using a discount rate of 5%,
calculate the financial viability of the Project according to the following criteria:
a. NPV
b. IRR
c. Payback
d. Profitability Index

12. Please calculate the cash flows, IRR and Profitability Index of the following 2-
year Project:
Initial Investment: 25,000 Euro
NPV 10,000 Euro
Discount Rate: 6%
Payback: 1.5 years

13. A firm has to choose among two mutually exclusive projects:

• Project X requires an initial payment of €30,000, an additional payment
of €15,000 at the end of year 1, and a final payment of €40,000 at the end
of the second year. At the same time, it foresees cash inflows of €35,000
and €50.000 in the first and second year respectively. The company
receives a public subvention of €12.000 at the beginning of the Project
while the residual value of the project is € 3,000.
• Project Y involves cash outflows of €10.000, 12.000 and 35.000 in years
0, 1 and2 respectively, while cash inflows € 20.000 and € 40.000 in years
1 and2 respectively. The residual value is estimated at € 8, 000.
Please determine the best investment and discuss the alternatives based on the
IRR.

14. A company is considering the following projects:

a. Initial investment €:15 Million. Cash Flows of 3.2 and 16.2 million each
year.
b. Initial investment € 20 Million. Return on investment 57% in year 1 and
62% in the second year.
If the company has 10 million in cash and can borrow the rest at 2 years and 4%
annual interest rate, select the best project based on NPV and Payback (with a
maximum of two years) for the different the discount rate scenarios.

15. What is the discount rate of a company that prioritizes investment A over B.
Please explain the rationale.
A: C0 = -50 ; C1 = 110; C3 = 5
B: C0 = -50 ; C1 = 40; C3 = 80

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16. Calculate the IRR and the profitability index of the following projects for a
discount rate of 10%. ¿Which one is preferable?
Co C1 C2
A -10,000 10,000 1,000
B -10,000 1,000 12,000

17. A company has to decide between two projects with the following cash flows:
Co C1 C2 C3
Project A -40,000 40,000 10,000 5,000
Project B -20,000 15,000 10,000 5,000

If we know that Project A’s IRR is 27.3% and Project B’s IRR is 28.9%, discuss
the best investment alternative using NPV and payback.

18. The cash flows from two mutually excluding projects are as follows
Co C1 C2 C3
Project A -40,000 20,000 15,000 15,000
Project B -50,000 10,000 20,000 40,000

Calculate the payback and the profitability index for each project using a 8%
discount rate. Which project would you choose? Why? What could be the reason
to stay with Project A?

19. We have two potential investments:

c. Term: 2 years. Inicial investment €:37,316. Cash Flows before taxes:
94,456 and 14,000 respectively. Tax rate: 50%.
d. Term: 2 años. Initial investment €25,000 (from which, we only have
20,000 available). Return on investment: 41,6% in the first year and
129,6% in the second year. In order to afford the investment we need to
borrow from the bank at an 8% interest rate. The investment is tax free.
Please select the most appropriate investment based on the following criteria:
Payback, IRR and NPV.

20. Using the NPV and IRR rules, a company has to decide which one of the
following investments is more profitable:
C0 C1 C2 C3
Máquina A -28.700 € 12.200 € 14.884 € 15.798 €
Máquina B -37.500 € 9.750 € 16.900 € 43.940 €
Máquina C -43.000 € 37.500 € 12.500 € 9.766 €

a. What are the discount rate values that make only one investment affordable?
Which one?
b. What are the discount rate values that make two of the investments
profitable? Which ones?
c. What is the maximum discount rate that makes the 3 projects e profitable?
d. Determine the best investment, if the company only has €20,000 € and it can
borrow an additional € 10.000.

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21. Based on the table, the finance director of Global Investments chose project A,
using a discount rate of 10%. ¿Why did he take A if B had a higher profitability
index? ¿Is B the best alternative in any case?

C0 C1 C2 Prof. Index NPV

Project A -1.000 € 1.000 € 500 € 1,32 322 €
Project B -500 € 500 € 400 € 1,57 285 €

22. A firm’s treasurer forecasted the following cash flows for 3 different projects:

Project A Project B Project C

Year 0 -100.000 € -200.000 € -100.000 €
Year 1 70.000 € 130.000 € 75.000 €
Year 2 70.000 € 130.000 € 60.000 €

For a 12% annual discount rate:

a. Calculate the Profitability Index of the 3 projects
b. Calculate NPV.
c. If they are independent. ¿Which one is the best according to the PI?
d. Same question if they are mutually exclusive
e. If the budget for the 3 projects is limited to € 300.000 and projects
cannot be split. Which one would you choose?

23. A fast food chain has the possibility to open restaurants in Spain, UK and
Germany. Using a 10% discount rate, the finance director wants to know where
to invest according to the following parameters:
f. Payback (number of years)
g. Profitability Index

Million Euro Spain UK Germany

Year 0 -10 -15 -20
Year 1 12 8 12
Year 2 1 13 14

If he has to open only one restaurant, which one would it be?

If he has a limited budget of 40 Million Euro, how many restaurants will be
opened? Where?

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24. A Spanish wine company willing to open new markets is thinking on investing
in Argentina or Chile. The winery in Argentina requires a total investment of 20
Million Euro and depending on weather conditions it will return cash flows of 5
and 10 Million in year 1 and 2 respectively with mild weather, or 3 Million and
6 Million with adverse climate. The investment in Chile is 25 Million and the
expected cash flows are the same as Argentina, however these cash flows are not
taxed 30% as they are the ones in Argentina due to the new export duty. The
company has 10 Million cash on hand and can borrow the rest at 2 years paying
12% interest in Chile and 10% in Argentina. The estimated residual value of the
winery at the end of the two years will be equal to the investment, except for the
case of bad weather conditions in Chile, where it would loose 40% of its value.
If the likelihood of severe frosts in Chile is 20% and 10% in Argentina,
determine the best country to invest using a discount rate of 10%.

25. CastilAir, a new low-cost airline, just opened the route Valladolid- Paris. The
firm is uncertain on whether to buy 2 large aircrafts at 300 Million euro each or
5 small ones at 150 million euro each. Provided that the passenger load factor
exceeds 80%, the cash flow forecast for the large airplanes of three years is 450
million per aircraft in the initial period. Otherwise, it will be 350 million euro.
Due to the higher repair activity, in the second period of three years, the cash
flows decrease to 375 and 270 million, respectively. On the other hand, the
smaller aircrafts can generate 185 million if the demand reaches a 70% load
factor and 160 million if lower. For the next period cash flows decrease to 165
and 155 million respectively. For the next six years, the probability of a load
factor of 80% or higher in the large aircrafts is 70%, while a 70% load factor in
the small ones has a probability to occur of 80%. If the tri annual discount rate is
10%, please discuss the best alternative for CastilAAir.

26. A Spanish bank has two alternatives to expand in Peru:

a. To create their own branch network.
b. To sign a joint venture with a local bank.
The horizon of the investment is 2 years and due to the high country risk the
discount rate is 20%. The probabilities of success in the frist year are 60% for
their own network and 70% for the joint venture. In case of success, the bank
would keep the same policy in the second year. In case of failure, the bank
should decide on weather to leave the market or look for an alliance with another
Spanish bank.
The creation of their own network involves an investment of 50 million, while
the joint venture only requires 20 million. The cost of opening branches is
estimated at 800 million per year, while the other alternative will consume 900
million the first year and 400 million the second. Leaving the market has a cost
of 10 Million and no income. The strategic alliance with the Spanish bank would
have an annual cost of 500 Million.
The success of any of the alternatives will represent cash inflows of 2,000
Million the first year. As to the second year, keeping the strategy will bring
1,800 million while going to the joint venture will only produce 1.500 million.
The failure of any alternative will bring only 1,000 million the first year. On the
other hand the strategic alliance’s cash inflows will amount to 1,5000 Million. .
¿Which ones are the acceptable alternatives? ¿Which strategy is better? ¿What
NPV does it have?

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27. A group of students received 50 Million Euro financing from a venture capital in
order to invest in a rafting company based in the Duero river. The proceeds will
be used for the acquisition of the rafts. The probabilities of a high, medium and
low demand in the firs year of activity are 50%, 40% and 10% respectively. In
an scenario of high demand, it exist the possibility of increasing the offer in the
second year by adding more rafts or shifting to canoes, although in that case the
key question is not the demand (enough to meet the offer) but the possibility of
suffering a drought (30% for that year), which would make impossible the
navigation in the river. If the demand for the first year is on the average, the
decision for next year could be either increase the number of rafts or keep them
unchanged, provided that the drought could finally impact the results. Lastly, if
the demand is low in the first year, the students believe the business can be sold
to the venture capital for 40 Million Euro. Based on the 3 scenarios, the cash
flow generated in the first year would be 60, 45 and 30 million euro
respectively. With regard to the second year, if they increase the number of rafts
and there is water enough, cash flow could reach 50 Million, while it will
decrease to 5 million if drought. Since canoes require a higher water level but
there are more expensive, the cash flow can be estimated in 45 million with
water and 15 million with draught. If the decision is not to add more boats, then
the cash flow is estimated at 40 million with water and 10 million with draught.
Due to the multiple options, some students were more inclined to invest the
money in a mutual fund and spend the summer elsewhere. To this extent, the
bank had recommended a fund with 80% probabilities of producing a 30%
return in the next couple of years, except in case of financial crisis, where return
would decrease to 5%. The discount rate used by the Venture Capital for this
type of business was 7%. Please indicate the best option to your student
colleagues.

28. In order to increase capacity, a company should invest 300 M Euro. The firm
can get financing either through a bank loan at 2 years (returning the principal at
the end of the second year) or issuing bonds with the same maturity as the loan.
The loan will pay an interest rate indexed to inflation plus 3%. On the other
hand, bondholders will received a fixed interest of 7% in the first year and 5%
the second year. According to the company the probability of a 2% inflation in
the first year was 70% while the likelihood of a 3% inflation was 30%. For the
second year however, the chances for a 3% or a 4% inflation were 80/20
respectively. If the company wants to evaluate both alternative using a 5%
discount rate, ¿What is the present cost of the different alternatives? ¿What is
the best way of financing?

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29. Calculate the annual amortization amounts of a 10,000 Euro loan at 4 years
paying a 5% annual interest rate. Calculate the outstanding capital amount after
the first payment, the interest amount paid in the second year, the amortization
amount in the third year and the total capital amortized after the third annual
payment.

30. On January 1st 2006, Mr. X borrowed 60,000 Euro from Bank A at 5% interest
rate and amortization in 6 years with annual constant payments. Unfortunately,
after the second annual payment Mr X passed away, then the inheritors proposed
to the Bank two alternatives:

a. Unique single payment three years later

b. Cash payment of a quarter of the capital pending and the rest in four
years with annual constant payments at the end of each year.

Determine the unique single amount to be paid and the annual constant
payments.

31. A company receives a 20 year loan, which should be amortized based on the
American method with annual payments of 2,400 Euro. In parallel, and in order
to minimize cash flow risks at the end of the loan, the company has opened a
deposit at an annual interest rate of 4.5%, If the annual interest rate of the loan is
7%, determine the loan amount.

32. An American company has negotiated a US$ 48,000 loan with a bank based on
monthly equal principal payments (Italian method) in one year. The interest rate
is 75 basis points over the Fed prime rate, which is 2.5%. Determine the
amortization payments.

33. In order to buy a 900,000 Euro house in two and a half years, we start a savings
program of 8,000 Euro a month. The bank is paying a 6% nominal interest. The
remaining amount will be financed by the bank through a loan in the following
conditions:
- Equal total annual payments
- Effective Annual Rate: 7,5%
- Term: 10 years
Please calculate the principal payments every year. Same exercise with equal
principal payments.

34. A student wants to buy a 24,000 Euro VW Golf , all inclusive. In order to
finance the acquisition, the car dealer suggest a 20% down payment and 36
equal monthly quotas. If nominal interest rate applied is 9%, calculate the
monthly payments ,the total interests paid and the Annual Equivalent Rate
applied.

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35. A firm is forced to choose between two machines A and B, both with the same
capacity and performance although with different design. Machine A costs
€15,000 and will last three years. It also costs €5,000 per year to run. Machine B
is an economy model costing only €10,000, but it will last only two years and
costs €6,000 per year to run. These are real cash flows forecasted in euro of
constant purchasing power. If real discount rate is 6%, calculate the best option
for the firm. How would be the calculation in nominal terms if the annual
inflation expected is 5%?

36. A project requires an initial investment of € 1,200 Million, while cash flows are
estimated at 800 and 700 Million in year 1 and year 2 respectively. Please obtain
NPV and IRR in the following scenarios:
h. Market interest rate:4%
i. Annual inflation: 3%
j. Annual inflation increases to 4% from year 2 onwards.

37. A company issues 1 million 2-year bonds with 100 Euro face value and 6%
annual coupon. If the issuing expenses are 2 million Euro, calculate the effective
cost of the issuing, the cost after taxes, the real cost after inflation and the cost
after taxes and inflation. Tax rate: 30%. Inflation: 2.5%

38. The debt of company is based on short-term credits of 1 Million Euro, long-
term loans o 4 Million and an average amount of bonds outstanding of 10
Million. The average interests it pays are 4% for the credits, 5% for the loans
and 6% for the bonds. If inflation rate is 2.5% and the effective tax rate that the
company pays is 30%, calculate the after tax cost of debt, the real cost of debt
after inflation and the cost after taxes and inflation.

39. A company issues 10.000 bonds at 1.000 Euro each, with an annual coupon of
5%, redeemeable with a 10% premiun. If issuing expenses amount to 5% of the
total amount and tax rate is 30%. Calculate:
a. The cost of debt before taxes and inflation
b. The cost of debt after taxes
c. The cost of debt after taxes and inflation, assuming inflation rate of 3%

40. On January 1st 2009, the finance director of a company acquired 5-year bonds
issued 3-years ago, face value 100 € and annual coupon of 5 Euro. If the bond
price was 99, what is the market interest rate that investors are applying to the
bond? If he wants to sell the bond 3 months later and market interest rates at that
time are 4.5%, what would be the price of each bond? What is the return on the
investment for the company? Assuming 2% inflation and 30% taxes, calculate
the return after taxes and inflation.

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41. A company wants to invest at 1 year in fixed income. The choices are 3
different 10-year bonds with same rating. Bond A is a zero-coupon, which pays
€ 1,000 at maturity. Bond B bears an 8% interest and pays € 8 annual coupon.
Bond C bears a 10% interest and pays €10 annual coupon.
k. Assuming IRR is 9% for all bonds, calculate their theoretical prices.
l. If the company expects IRR to be 9% at the beginning of next year,
¿what would they be at that time the current theoretical prices? ¿What is
the return before taxes during the period?
m. Same if IRR is 8% at the beginning of next year.

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