Problems on time value of money (to be solved in class and as homework)

Problem 1-class (Rule of 72)

If the interest rate is 12%, what are the doubling period as per the rule of 72 and the rule of 69
respectively?
Solution:

Problem 2-Homework (Rule of 72)

If you deposit Rs. 5,000 today at 12 percent rate of interest in how many years will this amount
grow to Rs. 1,60,000? Work out this problem using the rule of 72 – do not use tables.
Solution:

Problem 3-homework (Rule of 69)

A finance company offers to give Rs. 8,000 after 12 years in return of Rs. 1,000 deposited
today. Using the rule of 69, figure out the approximate interest offered.
Solution:

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Problem 4-Class (FV)
If you invest Rs.5000 today at a compound interest of 9%, what will be its future value after
75 years?
Solution:

Problem 5-Class (FV)

If you deposited Rs. 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-
year time deposit, how much would the deposit grow at the end of ten years?
Solution:

Problem 6-Homework (FV)

Calculate the value 5 years hence of a deposit of Rs. 1,000 made today if the interest rate is
a. 8 percent
b. 10 percent
c. 12 percent
d. 15 percent

Solution:

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Problem 7-Class (PV)
What is the present value of Rs. 100,000 receivable 60 years from now, if the discount rate is
10 percent?
Solution:

Problem 8-Homework (PV)

Find the present value of Rs. 10,000 receivable after 8 years if the rate of discount is
a. 10 percent
b. 12 percent
c. 15 percent

Solution:

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Problem 9-Homework (PV)
At the time of his retirement, Mr.Jingo is given a choice between two alternatives:
(a) an annual pension of Rs. 10,000 as long as he lives and
(b) a lump sum amount of Rs. 50,000.
If Mr. Jingo expects to live for 15 years and the interest rate is 15 percent, which option appears
more attractive?
Solution:

Problem 10-class (FVA)

Fifteen annual payments of Rs. 5,000 are made into a deposit account that pays 14 percent
interest per year. What is the future value of this annuity at the end of 15 years?

Solution:

Problem 11-class (FVA)

You can save Rs. 2,000 a year for 5 years and Rs. 3,000 a year for 10 years thereafter. What
will these savings cumulate to at the end of 15 years, if the rate of interest is 10 percent?

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 Solution:

Problem 12-Homework (FVA)

Mr. Vinay plans to send his son for higher studies abroad after 10 years. He expects the cost
of these studies to be Rs. 10,00,000. How much should he save annually to have a sum of Rs.
10,00,000 at the end of 10 years, if the interest rate is 12 percent?
Solution:

Problem 13-class (PVA)

Mahesh deposits Rs. 2,00,000 in a bank account which pays 10 percent interest. How much
can he withdraw annually for a period of 15 years?
Solution:

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Problem 14-class (PVA)
What is the present value of a 5-year annuity of Rs. 2,000 at 10 percent?
Solution:-

Problem 15-class (PVA)

Mr. X deposits Rs. 1,00,000 in a bank which pays 10 percent interest. How much can he
withdraw annually for a period of 30 years? Assume that at the end of 30 years the amount
deposited will whittle down to zero.
Solution:

Problem 16-Homework (PVA)

Suppose someone offers you the following financial contract. If you deposit Rs. 20,000 with
him he promises to pay Rs. 4,000 annually for 10 years. What interest rate would you earn on
this deposit?

Solution:

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Problem 17-class (PVA and PV)
What is the present value of an income stream which provides Rs. 2,000 a year for the first five
years and Rs. 3,000 a year forever thereafter, if the discount rate is 10 percent?
Solution:

Problem 18-homework (PVA and PV)

What is the present value of an income stream which provides Rs. 1,000 at the end of year one,
Rs. 2,500 at the end of year two and Rs. 5,000 during each of the years 3 through 10 (third to
tenth year) , if the discount rate is 12 percent?
Solution:

Problem 19-class (FV and rate)

Someone promises to give you Rs. 5,000 after 10 years in exchange for Rs. 1,000 today. What
interest rate is implicit in this offer?
Solution:

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Problem 20-Homework (FVA)
A finance company advertises that it will pay a lump sum of Rs. 10,000 at the end of 6 years
to investors who deposit annually Rs. 1,000. What interest rate is implicit in this offer?
Solution:

Problem 21-Classwork (Effective annual rate)

Rahul invested Rs. 10,000 each in two banks M and N@10% pa. Bank M follows annual
compounding, whereas Bank N follows quarterly compounding. Find the amounts he will get
after 6 years from both the banks and comment.
Solution:

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Problem 22-Classwork (Loan amortisastion)
Julie borrows Rs. 10000 @12% pa from her friend Bobby promising to return the same in 5
equal annual instalments. Find the EMI value and also the amortisation table.

Problem 23-Homework (Loan amortisastion)

Gourav borrows ₹80,000 for buying a Piano at a monthly interest rate of 1.25%. The loan is to
be repaid in 12 equal monthly instalments, payable at the end of each month. Prepare a loan
amortization table.
Solution

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Page 11 of 46
 Module 3- Long Term Investment Decisions
Important formulae:
𝑛
𝑐𝑡
𝑁𝑃𝑉 = ∑ − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑟)𝑡
𝑡=1
𝑛
𝑐𝑡
∑
𝑡=1 (1 + 𝑟)𝑡
Benefit − Cost Ratio =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑛
𝑐𝑡
∑ 𝑡
𝑡=1 (1 + 𝑟)
Net benefit − Cost Ratio = −1
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Internal Rate of Return (IRR) is the value of “r” in the following equation:
𝑛
𝑐𝑡
∑ = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑟)𝑡
𝑡=1
The decision rule for IRR is: Accept if IRR is greater than the cost of capital, and Reject if IRR is less than the
cost of capital.
Average AnnualProfits(after depn and taxes)
Average Rate of Return = ( ) ∗ 100
Net Investment in the Project
Decision rule:
NPV BCR or PI NBCR Rule
Positive >1 >0 Accept
Zero =1 =0 Indifferent
Negative <1 <0 Reject

Problem 1-Class (Accounting rate of return)

Calculate the average rate of return for projects A and B from the following:
Project A Project B
Investments Rs. 20,000 Rs. 30,000
Expected Life (no salvage value) 4 years 5 years
Projected Net Income (after interest, depreciation and taxes)
Years Project A Project B
1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 ------ 1,000
6,000 10,000
If the required rate of return is 12% which project should be undertaken?

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Problem 2- Class (Accounting rate of return)
X Ltd. Is considering the purchase of a machine. Two machines E and F are available. The cost
of each machine is Rs. 60,000. Each machine has an expected life of 5 years. Net Profits before
tax and after depreciation during the expected life of the machines are given below:

Year Machine E (Rs.) Machine F (Rs.)

1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000
Following the method of Average Investment, ascertain which of the alternatives will be
more profitable. The average rate of tax may be taken at 50%.

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Problem 3 - Class (Payback Period)
A Project costs Rs.1,0,000 and yields an annual cash inflow of Rs. 20,000 for 8 years. Calculate
its pay - back period.

Problem 4 - Class (Payback Period)

Determine the pay-back period for a project which requires a cash outlay of Rs. 10,000 and
generates cash inflows of Rs. 2,000, 4,000, Rs. 3,000 and Rs. 2,000 in the first, second, third
and fourth year respectively.

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Problem 5-- Class (Payback Period)
A project cost Rs 5,00,000 and yields annually a profit of Rs. 80,000 after depreciation @12%
p.a. but before tax of 50%. Calculate the payback period. Also calculate the discounted payback
period with discounting rate of 10%.

Problem 6 -- Class (Accounting rate of return)

A Project required an investment of Rs. 5,0.0,000 and has a scrap value of Rs. 20,000 after five
years. It is expected to yield profits after depreciation and taxes during the five years amounting
to Rs. 40,000, Rs. 60,000. Rs. 70,000, Rs. 50,000 and Rs. 20,000. Calculate the average rate of
return on the investment and average rate of return on average investment.

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Problem 7 -- Class (Net Present Value)
From the following information calculate the net present value of the two projects and suggest
which of the two projects should be accepted assuming a discount rate of 10%
Project X Project Y
Initial Investment Rs. 20,000 Rs.30,000
Estimated Life 5 Years 5 Years
Scrap Value Rs. 1,000 Rs.2,000

The Profits before depreciation and after taxes (cash flows) are as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000

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Problem 8-- Class (Net Present Value)
A company is considering investment in a project that costs Rs.2,00,000. The project has an
expected life of 5 years and zero salvage value. The company uses straight line method of
depreciation. The company’s tax rate is 40%. The estimated earnings before depreciation and
before tax from the project are as follows:
Earnings before depreciation Present value factor at
Year
and tax (Rs.) 10%
1 70,000 0.909
2 80,000 0.826
3 1,20,000 0.751
4 90,000 0.683
5 60,000 0.621
You are required to calculate the net present value at 10% and advise the company

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Problem 9 -- Class (IRR)-Ignore
Problem 10-- Class (IRR)-Ignore
Problem 11 -- Class (Profitability index)
The initial cash outlay of a project is Rs. 50,000 and it generates cash inflows of Rs. 20,000,
Rs. 15,000 Rs. 25,000 and Rs. 10,000 in four years. Using present value index method, appraise
profitability of the proposed investment assuming 10% rate of discount.

Year Cash Inflows PVF@10% PV

1 20000 0.909
2 15000 0.826
3 25000 0.751
4 10000 0.683

Problem 12- PAYBACK and NPV-Homework

A choice is to be made between 2 competing projects which require an equal investment of
Rs. 50000 and are expected to generate net cash flows as under:
Project I Project II
End of year 1 25000 10000
End of year 2 15000 12000
End of year 3 10000 18000

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 End of year 4 NIL 25000
End of year 5 12000 8000
End of year 6 6000 4000
The cost of capital of the company is 10%.
Which project proposal should be chosen and why? Evaluate the project proposals under
Payback period and Discounted cash flow method, pointing out their relative merits and
demerits
SOLUTION:

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PROBLEM – 13: ALL METHODS-Homework
A company is considering an investment proposal to install a new machine. The project will
cost Rs. 50000 and will have a life span of 5 years and no salvage value. The company’s tax
rate is 50% and no investment allowance is required. The firm uses straight line method of
depreciation. The estimated net income before depreciation and tax from the proposed
investment proposal is as follows:
Year Net income before depreciation and tax
1 10000
2 11000
3 14000
4 15000
5 25000

Compute the following:

1. Pay - back period 2. Average rate of return 3. NPV at 10% discount rate 4. Profitability index
at 10% discount rate

SOLUTION:

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Additional problems

PROBLEM - 01:
An engineering company is considering the purchase of a new machine for its immediate expansion program.
There are 3 possible machines suitable for the purpose. Their details are as follows:

Machines 1 2 3
Capital cost 300000 300000 300000
Sales (at standard price) 500000 400000 450000
Net Cost of Production:
Direct Materials 40000 50000 48000
Direct Labour 50000 30000 36000
Factory Overheads 60000 50000 58000
Administration Costs 20000 10000 15000
S & D Costs 10000 10000 10000

The economic life of machine 1 is 2 years, while it is 3 years for the other two. The scrap values are as Rs.
40000, Rs. 25000 and Rs. 30000 respectively.
Sales are expected to be at the rates shown for each year during the full economic life of the machines. The
costs relate to annual expenditure resulting from each machine.
Tax to be paid is expected at 50% of the net earnings of each year. It may be assumed that all payables and
receivables will be settled promptly, strictly on cash basis with no outstanding from one accounting year to
another. Interest on capital has to be paid at 8% per annum.
You are requested to show which machine would be the most profitable investment on the principle of ‘pay
back method’NPV (class):

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The Alpha Co. Limited is considering the purchase of a new machine. 2 alternative machines (A and B) have
been suggested, each having an initial cost Rs. 400000 and requiring Rs. 20000 as additional working capital
at the end of 1st year. Earnings after tax are expected to be as follows:
Year Machine A Machine B

1 40000 120000
2 120000 160000
3 160000 200000
4 240000 120000
5 160000 80000

The company has a target of return on capital of 10% and on this basis, you are required to compare the
profitability of the machines and state which alternative you consider financially preferable.
Note: The following table gives the present value of Re. 1 due in ‘n’ number of years:

Year Present value at 10%

1 0.91
2 0.83
3 0.75
4 0.68
5 0.63

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