FINANCIAL

MANAGEMENT PRACTICE QUESTIONS

1. Compound Value Factor (CVF):

If you deposit Rs 55000 in a bank, which was paying a 15% rate of interest for 10
years, how much would the deposit grow at the end of 10 years?

Solution:

When we try to find out the Present value factor (PVF), we multiply the
investment by 1/ (1 + k)n . When we are trying to find Compound value factor
(CVF), we multiply the investment by (1 + k)n

So, the value of investment after 10 years would be:

55000 * (1 + 0.15) 10 = 222530

2. Future Value of Annuity or Compound Value Annuity Factor (CVAF):

If A deposits Rs 100 at the end of each year for the next 3 years in a bank, getting
a return of 10%, what would be the value of investment at the end of 3 years?

Solution:

Formula for CVAF= Annuity ( (1 + i)n -1 / interest )

Therefore, value at the end of 3 years = 100 (( 1 + 0.10 ) 3 / 0.10 ) = 331


3. Sinking Fund:

If A wants 331 at the end of 3 years on his annual investment, how much should
he invest each year to be able to get Rs 331 at the end?

Solution:

Sinking Fund is similar to CVAF, the only difference being that we have to find
the annuity amount in Sinking Fund.

Formula:

Annuity = Future Value * 1
( (1 + i)n -1 / interest )

Here, Annuity = 331 * 1
(1.10) -1 / 0.10
3

Annuity = 100

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4. Sinking Fund:

If A plans to invest Rs 10,000 today for a period of 4 years, and the interest rate
is 10%, how much income per year should he receive to recover the investment?

In this question, in order to use the formula of Sinking Fund, we need to find the
Future value of investment.

FV = 10000 ( 1 + 0.10) 4 = 14641

Now, Sinking Fund / Annuity = Future Value * 1
( (1 + i)n -1 / interest )


Sinking Fund = 10,000 * 1 / (1.10)4 -1/ 010 = 3155






5. Present Value of Annuity Factor (PVAF):


An investor will receive Rs 1000, 1500, 800, 1100 and 400 respectively each year
for the next 5 years.
Find out the present value of this stream of uneven cash flows, if the interest rate
is 8%.

Present Value = 1000 / (1.08) + 1500/ (1.08)2 + 800/ (1.08)3 + 1100/ (1.08)4 +
400/ (1.08)5
This can be calculated manually using a normal calculator.

PV = 1000 * 0.926 + 1500 * 0.857 + 800 * 0.794 + 1100 * 0.735 + 400 * 0.681 =
3927.60


6. Present Value Factor:

Calculate the Present Value of Rs 1000 received 5 years from now, assuming an
interest rate of 8%

Solution:

Formula of PVF = FV * (1/ (1 + i)n )

PVF = 1000 * 1/ (1.08)5 = 680

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7. Present Value Factor:

Ten years from now, ABC will receive a pension of Rs 3000 a year. The payment
will continue for the next 16 years. How much is the pension worth now. The
interest rate is 10%

Solution:

PVF (10 years from now) = 3000 *PVAF (16 years @ 10%) = 3000 *

3000 * (1 – 1/(1 + i)n ) / I = 23471

Therefore, the value of pension at the end of 9 years would be 23471, since first
instalment will be made at the end of 10 years and by discounting, we found the
value of annuity in the beginning of 10th year.

Now, we will discount this value to the present time period using PVF method.
23471 * 1/ (1 + 0.10) 9 = 9954

8. Internal Rate of Return (Indirect Question):

A firm makes a purchase for Rs 800,000 by making a down payment of Rs
150,000 and remaining in equal instalments of Rs 150,000 each for 6 years. What
is the rate of interest to the firm?

Solution:

In this question, the initial outflow is Rs 150,000; annual outflows are Rs
150,000 for 6 years and present value of investment made is Rs 800,000. So, we
need to equate them as follows:

800,000 = 150,000 (paid in time zero) + 150,000 * PVAF @ x% for 6 years.
Using Hit and trial: at 10%, the right hand side would be:
150,000 + 150,000 * PVAF
150,000 + 150,000 * (1 – 1/(1 + i)n ) / I = 150,000 + 150,000 *4.33 = 799950
(this is almost equal to 800,000. Therefore, the answer is 10% only.)

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In hit and trial, sometimes you might arrive at the exact answer in one go
as well. A small difference of Rs 50 can be ignored here unless the answer
choices do not contain values near 10% like 10.06% or 10.13% et cetera)

9. Annuity- Time Value of Money:

A company wants to buy a machinery costing Rs 20,00,000. The company makes
15% down payment and borrows the remaining at 9% interest rate. The loan is
to be repaid in 8 equal annual installments beginning 4 years from now. What is
the size of the required annual loan repayments?

Solution:
The firm pays Rs 300,000 and borrows Rs 1700,000. Compound Interest occurs
over the entire 11 years of life of the loan.

Method to calculate time period- since first installment starts at the end of 4th
year and there are 8 installments, the time period comes out to be 11 years.

We have to find out annuity payments from 4th year onwards. To do that, first
calculate the value of 1700,000 at the end of 3 years. It will be the PV of annuity
starting from 4th year onwards.

FV = PV (1 + r) n

FV = 1700,000 (1.09)3 = 2201550

Now, applying the following formula of annuity, we can calculate the yearly
installment:
PV = Annuity * (1 – 1/(1 + i)n) / i

Annuity = 2201500/ 5.535 = 397750

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10. Bond Valuation:

An Investor in purchasing a bond that pays 8% per year on Rs 1000 principal or
face value. The bond will mature in 20 years. Redemption value is Rs 1000. What
is the maximum amount that should be paid by the investor if required rate of
return is 10%

Solution:

PV = Interest * (PVAF for 20 years @ 10%) + redemption value (PVF at 10% 20
years)

PV = 80 * (1 – 1/(1 + i)n) / I + 1000 * 1/ (1.10)20

PV = 681.12 + 149 = 830.12

Thus, the equilibrium market value of the bond should be 830.12. this is the
maximum price that the investor can pay.


11. Compounded Annuity Factor: (CVAF= Annuity ( (1 + i)n -1 / interest )

A company offers to refund an amount of Rs 44650 at the end of 5 years for a
deposit of Rs 6000 made annually. Find out the implicit rate of interest offered
by the company.

Solution:
Applying the formula-
CVAF= Annuity ( (1 + i)n -1 / interest)

44650 = 6000 ( (1 + i)n -1 / interest)
By hit and trial, we can identify the nearest value of i. In this case, it comes out to
be 20%. So the implicit rate of interest is 20%

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12. Capital Budgeting decision:

ABC is trying to decide whether it should replace a manually operated machine
with a fully automatic version of the same machine. The existing machine,
purchased 10 years ago, has a book value of Rs 140,000 and remaining life 10
years. Salvage value is Rs 40,000. Maintenance expenses on the present machine-
Rs 20,000 per year. The company has been offered Rs 100,000 for the old
machine with trade for the new machine which costs rs 220,000 before exchange
price. Its life is 10 years and salvage value is 20,000. Installation expense- Rs
40,000. Annual savings on the new machine is Rs 80,000. No annual maintenance
charges. The tax rate is 40% depreciation is straight line. Should the investor buy
the new machine?
The required rate of return is 10%

Solution:
Answers of this type need to be divided into initial cash outflow (assuming that
new machine is purchased); regular incremental cash outflows or inflows and
terminal cash outflow or inflow.

Initial cash outflow-
Cost of the new machine 220,000
+ installation expense 40,000
- trade in for old machine 100,000
tax saving (capital gain tax) 16000
144000 (outflow)
(The old machine has a book value of 140,000 but is sold away for Rs
100,000. Thus, there is a capital loss of Rs 40,000. This capital loss will save
tax to the extent of 40% i.e. 16000)


Subsequent cash flows (incremental):

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Cost saving (inflow) every year 80,000

Repairs not required 20,000
Incremental depreciation (14000)
(given in note)
net saving with new machine 86000
tax @ 40% 34400
saving after tax 51600
depreciation 14000
(add back to find cashflow because depreciation is non-cash in nature)

Annual cash saving = 65600

Terminal Cash flow:
Scrap value = 20,000

If we wish to find out whether this is a good investment or not, we need to see its
NPV.
Outflow= 144000
Inflows = 65600 for 10 years + 20,000 in the 10th year

PV of Inflows = 65600 * PVAF (10%, 10 years) + 20,000 * (10%, 10 years)

PV = 65600 * (1 – 1/(1 + i)n ) / I + 20,000 * 1/ (1.10)10


PV = 65600 * 6.14 + 20,000 * 0.38
PV of inflows = 402784 + 7710 = 410494
NPV = PV of inflow – PV of outflow = 410494 – 144000 = 266494 positive

The project should be accepted because NPV is positive.

NOTE:
Depreciation:

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On old machine= (140,000- 40,000) / 10 = 10,000

On new machine= (220,000 + 40,000 – 20,000) / 10 = 24000


13. Net Present Value:

Machine A costs Rs 100,000 payable immediately. Machine B costs Rs 120,000
payable half now and remaining after one year. The cash receipts from both
machines are as follows:

Year Machine A Machine B
1 20,000 ---
2 60,000 60,000
3 40,000 60,000
4 30,000 80,000
5 20,000 ---

Which machine should be taken. Required rate of return is 7%

Solution:

The machine with higher NPV is more profitable and hence beneficial.

PV of cash outflows:
A = 100,000
B = 60,000 + 60,000 * 1/ (1.07)1 = 116074

PV of cash inflows every year:

A = 20,000 *1/ (1.07)1 + 60,000 * 1/ (1.07)2 + 40,000 * 1/ (1.07)3 + 30,000 * 1/
(1.07)4 + 20,000 *1/ (1.07)5
A = 140870

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B = 60,000 *1/ (1.07)2 + 60,000 * 1/ (1.07)3 + 80,000 * 1/ (1.07)4

B = 162380

NPV of both projects:
A = 40870
B = 46280

Machine B has higher NPV, so it should be selected. Also, Machine B recovers the
money in 4 years only. EAM method will also favour Machine B


14. Internal Rate of Return:
The cost of a project is Rs 10,000. Yearly cash inflows are 1000, 1000, 2000 and
10,000 at the end of year 1, 2, 3 and 4.
Compute IRR if opportunity cost of the project is 14%

Solution:

Cash outflow = Rs 10,000

At IRR, the cash outflow is equal to PV of cash inflows-

10,000 = 1000 * 1/ (1 + k)1 + 1000 * 1/ (1 + k)2 + 2000 * 1/ (1 + k)3 + 10,000 * 1/
(1 + k)4
Using Hit and trial, at 10%, PV of inflows is:

1000 * 0.909 + 1000 * 0.826 + 2000 * 0.751 + 10,000 * 0.683 = 10067

The NPV is positive at 10%. We can increase the rate of return to find out a value
with negative NPV. Thus, at 11%, NPV is
1000 * 0.901 + 1000 * 0.812 + 2000 * 0.731 + 10,000 * 0.659 = 9765

NPV = -235

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IRR = L + A *(H-L)/(A-B)
IRR = 10% + 67 *1/ 67 – (-235) = 10.22%
If the opportunity cost is more than IRR, the project is to be rejected.

15. Internal Rate of Return:

Outflow of two projects is given as 100,000 each. Project A earns a cash inflow of
Rs 30,000 for 5 years and Project B earns a cash inflow of 40,000 for 5 years.
What is the IRR of both projects?

Solution:

Project A-
PV of Outflow= 100,000
PV of inflow = 30,000 * (1 – 1/(1 + i)n ) / I
For IRR, outflow is equal to inflows.
Using hit and trial method, at 15%, PV of Inflow = 30,000 * 3.352 = 100564
At 16%, PV of inflows = 30,000 * 3.274 = 98228

Interpolating between 15 and 16, IRR comes to be
IRR = L + A *(H-L)/(A-B)
15% + 564 *1/ 564 – (1772) = 15.24%

Similarly for Project B can also be calculated



16. Yield to maturity:

Consider a Rs 100 par value bond. The current market price is Rs 85. Maturity
period is 9 years and coupon rate is 8%. Find out the rate of return earned by the
investor on this bond

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Solution:
To measure YTM-
PV of cash outflow (B0) = PV of inflows
85 = 8 * PVAF (9 years, @ ytm) + 100 * PVF (9 years, @ ytm)

Hit and Trial method can now be used to find out YTM (similar to IRR)


17. A Rs 5000 bond with a 10% coupon rate matures in 8 years and currently sells at
97%. Is this bond a desirable investment for an investor whose required rate of
return is 11%

Answer:

PV = Interest (1/ 1 + .11)1 +…(1/ 1 + .11)8 + (5000/ 1 +0.11)8 = 4743

Current price in the market = 5000 * 97% = 4850

Since the bond is available at a higher price than its present value, it is not
desirable

18. Mrs. Laxmi bought 10% p.a. Bonds of ABC Limited for Rs.105/- each, the face
value being Rs.100/- each, with maturity date being exactly 3 years after the date
of acquisition. Assuming market rate of return being 12% p.a., the per bond
present value of the inflow will be:

a. Rs. 130.00
b. Rs. 95.30
c. Rs. 102.70
d. Rs. 87.90
e. Rs. 114.40

Answer:

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Interest = 10% on 100 = Rs. 10

Time period = 3 years
Market return (k) = 12% p.a.
Present value = I/ (1+ .12)1 + I/ (1 + .12)2 + I/ (1 +.12)3 + 100/(1 +.12)3

8.93 + 7.97 + 7.12 + 71.18 = 95.20

19. Mr. Mohan bought bonds of the face value of Rs.1000/- each at a discount of 10%
on face value, bearing coupon@ 10% p.a., residual tenure for redemption at par
being exactly 2 years from the date of acquisition. What is the IRR?
a. 11.11%
b. 18.12%
c. 12.12%
d. 16.18%
e. 15.25%


Answer:

To solve this question, we need to understand 2 formulas-

Formula 1: find the approx. value of IRR by using the formula~~

Kd = (I (1-tax) + (redemption value – present value in the market)/Number of

years)/ (redemption value + present value )/2

By using this formula here, we get:

100 + (1000-900)/2 / (1000 + 900)/2 = 150 / 950 = 0.1578 or 15.78 %

so , we know that IRR will be around this figure.

Now, we find out present values of the bond at 15% and 16%, assuming IRR as
given (hit and trial):

At 15%, present value comes out to be 918.7

At 16%, it is 903.73

We need to get the %age IRR at 900, for that one % should be above 900 and

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another below 900, as~~ 900 = 100/(1 + k)1 + 100/ (1 +k)2 + 1000/ (1 + k)2

At 17%, present value is 889.03

So, we have 16% and 17%, 16% being above 900 and 17% being below 900:

Using the 2nd formula:

IRR= lower % + (PV at lower %age – 900)/ (PV at lower % - PV at Higher %age)
* difference between %ages

IRR = 16% + 903.73 – 900/ 903.73 – 889.03 * 1

IRR= 16.25%

The nearest answer is 16.18%

20. The following data is available for XYZ ltd.

Sales = 200,000
Variable cost @30% = 60,000
Contribution = 200,000 – 60,000 = 140,000
Fixed cost = 100,000
EBIT = 140,000 – 100,000 = 40,000
Interest = 5000
PBT = 35000

Find out:

a. using the concept of financial leverage, by what percentage will the

taxable income increase if EBIT increases by 6%
b. Using the concept of operating leverage, by what percentage will EBIT
increase if there is 10% increase in sales

Answer:

To find the answer, we need to calculate operating and financial leverage

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Operating leverage = contribution/ EBIT

Financial leverage = EBIT/ PBT (formulas are given in notes)

Operating leverage = 140,000/ 40,000 = 3.5

Financial leverage = EBIT/ PBT = 40,000/35000 = 1.14

a. If EBIT increases by 6%, taxable income will increase by 6 * 1.14 = 6.86%

b. If sales increases by 10%, EBIT will increase by 10 * 3.5 = 35%

21. ABC ltd issues 12.5% debentures of face value of Rs 100 each, redeemable at the
end of 7 years. The debentures are issued at a discount of 5% and floatation cost
is estimated to be 1%. Find out the cost of capital of debentures given that the
firm has 40% tax rate.

Answer:

PV/ B0 = 100 – 5% - 1% = 94

Interest = 12.5(1 – 0.4) = 7.5 (40% is reduced due to taxation)

Applying formula 1, find the approx. value of IRR by using the formula~~

Kd = (I (1-tax) + (redemption value – present value in the market)/Number of

years)/ (redemption value + present value )/2

By using this formula here, we get:

Kd = 7.5 + (100 – 94)/ 7 / (100 +94)/2 = 8.61%

so , we know that IRR will be around this figure.

Now, we find out present values of the bond at 8% and 9%, assuming IRR as
given (hit and trial):

At Kd = 8%,

PV/B0 = 7.5/ (1.08)1-7 + 100/ (1.08)7 = 97.35

At Kd = 9%

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PV/B0 = 7.5/ (1.09)1-7 + 100/ (1.09)7 = 92.45

Both the above figures lie on either side of 94, thus now we apply formula 2,

IRR = lower % + (PV at lower %age – 94)/ (PV at lower % - PV at Higher %age) *
difference between %ages

IRR = 8% + (97.35 – 94)/ (97.35 -92.45) * 1

IRR = 8.68%

22. Calculate debt equity ratio from the following data:

Total assets = Rs 1,25,000
Total debt = Rs 1,00,000
Current liabilities = Rs 50,000

Answer:

Debt equity ratio = long term debt / shareholders funds or equity

Long term debt = total debt – current liabilities = 1,00,000 – 50,000 = 50,000

Shareholders funds = total assets – total debt = 25,000

Debt equity = 50,000/ 25000 = 2:1

23. Calculate proprietary ratio from the following:

Equity share capital = 200,000

Reserves= 250,000

Balance in statement of profit and loss account = 1,50,000

12% debentures= 16,00000

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current liabilities = 680,000

net fixed assets = 21,00,000

long term trade investments = 2,00,000

current assets = 8,80,000

Answer:

proprietary ratio = shareholders funds/ total assets

shareholders funds = equity + reserves + profit and loss balance = 600,000

total assets = 3180,000

proprietary ratio = 600,000/ 3180,000= 18.86%

24. Financial leverage:

The sales of A ltd are given as 500. Variable cost is 40% of sales. Fixed costs are
Rs 150. Interest expense is Rs 50

Find out Financial leverage of A ltd.

Solution:
FL = EBIT/ PBT = 150/ 100 = 1.5

25. Financial leverage:
The sales of P ltd are given as Rs 10,00,000. Variable cost is 60% and fixed
expenses are 200,000. Interest on loan is 10% on 10,00,000. Tax rate is given as
30%. Find out Financial leverage.

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Solution:
FL = EBIT/ PBT = 200,000/ 100,000 = 2

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