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Present Value

Future Value

Discount Rate / Compounding Rate

Time Period

Intra Year Compounding And Discounting


ð  
    

  


Inflation Cost Of
WACC
Rate Capital

Cost of Opportunity
Equity Cost
]  
   


       

‡ Time 0 Today

‡ Time 1, 2, 3 End of Period One, Two and Three

‡ CFo Today͛s Cash Flow

‡ CF1 , CF2 , CF3 Cash Flows at the End of Periods


One, Two and Three
‡ i% Rate of Interest / Discounting /Compounding
Factor
]  

ù  
  
 

   


  
 

a


a  
a  


  
 a  

 a


 a



±
  
 

Future Value is Compounding

Present Value is Discounting


Intra Year Compounding and
Discounting

‡ FVn = PV (1+r/n)m*n

‡ Effective Interest Rate = (1+r/m)m -1

‡ m No. of compounding periods


‡ n No. of periods
Rule of ±

Doubling Period
=
(± /r) + .35
Rule of

Doubling Period
=
72/r
Example
In how much period your Rs. 10,000 becomes
Rs. 20,000 at 15% rate of interest, using

(a) Rule of 72
(b) Rule of ± .
Ans :(a) 4.8 years
(b) 4. 5 years
]  


poney has time value because you forgo


something certain today for something
uncertain tomorrow.

TRUE
]  


The uncertainty factor increases with time ʹ the


distant the cash flows, the more uncertain they
become.
.

TRUE
]  


The lower is the compounding period, the


higher is the effective rate of interest.

TRUE
]  


With high inflation rate, the interest rates


tend to increase.

TRUE
]  


One of the reasons for attributing time value to


money is that individuals prefer future

consumption to current consumption.

FALSE
]  


The nominal rate of interest is equal to the


effective rate of interest when interest is
compounded annually.

TRUE
]  


The rule of 72 is more precise (provides a better


estimate) than the rule of ± to find the period
required to double your initial amount.

FALSE
]  


Financial analysis require an explicit consideration of time


value of money because most financial problems at corporate
and individual level involves cash flows occurring at different
points in time.

TRUE
]  


fiven a principal amount of Rs. 10,000 to be invested for


months, it is better to invest in a scheme that offers 12%
annual compound interest than investing in a scheme that
earns 12% simple interest.

FALSE
]  


A bank that pays 10% interest compounded annually pays a


higher effective rate of interest than a bank that pays 10%
interest compounded quarterly.

FALSE
]  


The formula for effective rate of interest (re) is-

re= (1+r/m)n -1

FALSE
]  


An investment option that comes with specified


present value and future value after given period
has hidden rate of interest.

TRUE
]  


The present value of a mixed stream of cash flows is


the sum of the present values of the individual cash
flows.

TRUE
]  


The price of any asset today is the present value of


all the future cash flows associated with the asset.

TRUE
]  


In present value tables, all values are less than 1.

TRUE
]  


The process of compounding assumes


discounting at same rate.

TRUE
]  


poney has time value because a sum of money to be


received in future is more valuable than the same amount
today.

FALSE
]  


The compound value of any sum invested today


varies directly with rate of interest (r) and time
period (n).

TRUE
]  


Continuous compounding occurs when interest is


compounding daily.

FALSE
]  


The present value of any future sum is


inversely related with rate of interest.

TRUE
]  


Continuous compounding results in the maximum


possible future value for given rate of interest and
time period.

TRUE
]  


The process of determining present value is often


called discounting.

TRUE
]  


In simple interest, interest for each year in same.

TRUE
] 


The process of determining present value is often called


................. and is the reverse of the ................. Process.

discounting and compounding


] 


Effective annual rate of interest with half-yearly


compounding is ................. than, with quarterly
compounding.

Less
] 


Effective annual rate of interest is ................. to nominal rate


of interest, when interest is compounded annually.

equal
] 


The formula for effective annual rate of interest (re) is


.................

re = (1 + r/m)m -1
] 


The general formula for intra year compounding is


.................

FVn= (1 + r/m)mn
] 


Using the rule of 72 to find doubling period


we .................72 by ..................

divide, r
]    
 
‡ poney has time value because:
a. Individuals prefer future consumption to present
consumption.
b. poney today is more certain than money tomorrow
c. poney today is wroth more than money tomorrow in
terms of purchasing power.
d. There is a possibility of earning risk free return on money
invested today.
e. (b), (c) and (d) above.

e
]    
 
fiven an investment of Rs. 10,000 to be invested for
one year;

a.It is better to invest in a scheme that pays 10%


simple interest
b.It is better to invest in a scheme that pays 10%
annual compound interest , compounded annually
c.Both (a) and (b) provide the same return

c
]    
 
fiven an investment of Rs. 10,000 for a period of one
year, it is better to invest in a scheme that pays:

a. 12% interest compounded annually


b. 12% interest compounded quarterly
c. 12% interest compounded monthly
d. 12% interest compounded daily

d
]    
 
fiven an investment of Rs. 10,000 over a period of
two years, it is better to invest in a scheme that pays;

a.10% interest in the first year and 12% in second


year.
b.12% interest in the first year and 10% in second
year.
c. Both (a) and (b) above provide the same return

c
Practice Problem -1

An investor wants to have $1 million when she retires in 20 years. If she


can earn a 10 percent annual return, compounded annually, on her
investments, the lump-sum amount she would need to invest today to
reach her goal is closest to:

A.$100,000.
B.$117,45 .
C. $148,±44.
D. $1±1,50±
Solution-1
‡ This is a single payment to be turned into
a set future value FV=$1,000,000 in N=20
years time invested at r=10% interest rate.
PV =[ 1/(1+r) ]N FV

PV = [ 1/(1.10) ]20 $1,000,000

PV10 = [0.14864]($1,000,000)

PV10 = $148,644
Practice Problem -2
‡ A deposit of $1300 ‡ N=3
Y 
earns $33 .45 interest PV = 1300
in 3 years. If interest is PpT = 0
FV = -1±3 .45
compounded monthly, P/Y = 1
what is the effective C/Y = 12
‡ Nominal Rate = 7.7±%
rate? C/Y = 12
?
 
Practice Problem-3
‡ A deposit of $1500 ‡ N=7
Y 
grows to $42±2.04 in 7 PV = 1500
years. If the interest is PpT = 0
FV = -42±4.04
compounded quarterly, P/Y = 1
what is the effective C/Y = 4
‡ Nominal Rate = 15.2%
rate? C/Y = 4
?
  ù
Practice Problem-4
‡ % compounded ‡ Nominal = %
C/Y = 4
quarterly is equivalent ?
!"
to what effective rate? ù#
Practice Problem-5
‡ 7.5% compounded ‡ Nominal = 7.5%
C/Y = 1
annually is equivalent to ?
!"
what effective rate? $%
Practice Problem-±
‡ 10% compounded semi- ‡ Nominal = 10%
C/Y = 2
annually is equivalent to ?
!"
what effective rate?  &%
Practice Problem-7
‡ At what nominal rate ‡ N = ± years
compounded monthly Y 
will money double in ± PV = 1
years? PpT = 0
FV = 2
P/Y = 1
C/Y = 12 (compounded
monthly)
' ()Y  
Practice Problem-8
‡ At what nominal rate ‡ N = ± years
compounded monthly Y 
will money double in ± PV = 1
years? PpT = 0
FV = 2
P/Y = 1
C/Y = 12 (compounded
monthly)
' ()Y  
Practice Problem-
‡ A present value of ‡ N = (7 Years * 12) + 7
months = 1 months
$1301.± has a future Y 
PV = 1301.±0
value of $25± .2± in 7
PpT = 0
years and 7 months. FV = - 25± .2±
P/Y = 12
What is the nominal C/Y = 12
rate compounded ' ()Y ù
monthly?
Practice Problem-10
‡ A principal of $7100 has ‡ N = 10
Y 
a maturity value of PV = 7100
PpT = 0
$13, ±±.77 in 10 years.
FV = -13 ±±.77
If the interest rate is P/Y = 1
C/Y = 1
compounded annually , ' ()Y $
what is the nominal
rate?
Practice Problem-11
‡ A deposit of $1500 ‡ N = 7.5
Y 
earned $±72.45 interest PV = 1500
PpT = 0
over 7.5 years. What
FV = - 2172.45
nominal interest rate P/Y = 1
C/Y = 2
compounded semi- ' ()Y %
annually was paid on * 


the deposit?
Practice Problem-12
‡ A person opens a bank ‡ N = 3 years
account with a deposit Y 
of $150. At the end of 3 PV = 150
years there is $17 .34 PpT = 0
in the account. What FV = -17 .34
nominal interset rate ‡ 2nd I/Y
compounded quarterly P/Y = 1
was earned on the C/Y = 4
account? ' ()Y  
Practice Problem- 13
‡ A present value of ‡ N = (7 Years * 12) + 7
months = 1 months
$1301.± has a future Y 
PV = 1301.±0
value of $25± .2± in 7
PpT = 0
years and 7 months. FV = - 25± .2±
P/Y = 12
What is the nominal C/Y = 12
rate compounded ' ()Y ù
monthly?
Practice Problem-14
‡ A company͛s 2005 sales ‡ a 
  
' ()
were $100 million. If ‡ N
sales grow at 8% per ‡ I/YR 
year, how large will they ‡ PV !+ 
‡ PpT + 
be 10 years later, in
‡ a +&%ù
2015, in millions?
Practice Problem-15
‡ Suppose a U.S. ‡ 2 
  
government bond will ' ()
pay $1,000 three years ‡ N#
from now. If the going ‡ I/YR 
interest rate on 3-year
government bonds is ‡ 2 +ù
4%, how much is the ‡ PpT +
bond worth today? ‡ FV !+, 
Practice Problem-1±
‡ The U.S. Treasury offers to ‡ Y 
 
 
sell you a bond for      
$±13.81. No payments ‡ N
will be made until the ‡ Y % 
bond matures 10 years
from now, at which time ‡ PV !+ #
it will be redeemed for ‡ PpT +
$1,000. What interest ‡ FV +, 
rate would you earn if
you bought this bond at
the offer price?
Practice Problem-13
‡ Addico Corp's 2005 ‡ * -
earnings per share were ‡ *  
$2, and its growth rate ‡ I/YR  
during the prior 5 years
was 11.0% per year. If ‡ PV !+&
that growth rate were ‡ PpT +
maintained, how long ‡ FV +
would it take for
Addico͛s EPS to double?

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