Financial Management – Practice Questions

1. A Machine costs 20,000,000 and is expected to produce the following cash flow, calculate NPV if cost of
capital is 12%
Year 1 2 3 4 5 6 7 8 9 10
Cash flow 2500 2850 3750 4000 4250 4600 4600 4000 3400 2500
(000)

𝐶1 𝐶2 𝐶𝑡
Sol: 𝑃𝑉𝑜 = (1+𝑟)1
+ (1+𝑟)2
+. . . . . + (1+𝑟) 𝑡

2500 2850 3750 4000 4250 4600 4600 4000 3400 2500
= (1.12)1 + (1.12)2 + (1.12)3 + (1.12)4 + (1.12)5 + (1.12)6 + (1.12)7 + (1.12)8 + (1.12)9 + (1.12)10 = 20,184.81

𝑇 𝐶𝑡
𝑁𝑃𝑉0 = 𝐶0 + ∑ (1+𝑟) 𝑡 = -20,000 + 20,184.81 = 184.81
𝑡=1

2. A Factory costs $ 35,00,000 and have an inflow of $ 7,20,000 a year for 12 years. If the opportunity cost of
capital is 12%, what is the NPV?

Sol: NPV = PV of cash flow – Required investment

𝐶 1 7,20,000 1
PV of cash flow = [1 − ((1+𝑟)𝑡 )] = [1 − ((1.12)12 )] = 44,59,949
𝑅 0.12

NPV = 44,59,949-35,00,000 = 9,59,949

3. An investment will pay $100 at the end of each of the next 3 years, $200 at the end of year 4, $300 at the end
of year 5, and $500 at the end of year 6. If other investments of equal risk earn 8% annually, what is this
investment’s present value? & it’s future value

100 100 100 200 300 500

Sol: 𝑃𝑉0 = (1+0.08)1 + (1+0.08)2 + (1+0.08)3 + (1+0.08)4 + (1+0.08)5 + (1+0.08)6 = 923.98

𝐹𝑉0 = 100(1 + 0.08)5 + 100(1 + 0.08)4 + 100(1 + 0.08)3 + 200(1 + 0.08)2 + 300(1 + 0.08)1 +
500 = 1466.24

OR 923.98* (1.08) ^ 6 =1466.24

4. What is the present value of a perpetuity of $100 per year if the appropriate discount rate is 7%? If interest
rates in general were double and the appropriate discount rate rose to 14%, what would happen to the present
value of the perpetuity?

Sol: PV of cash flow = Cash flow/ Discount rate

If discount rate is 7% = 100/0.07 = 1428.57
If discount rate is 14% = 100/0.14 = 714.29

As the discount rate increases, the present value of perpetuity decreases.

5. XYZ bank pays 12% and compounds interest quarterly. If $1000 are deposited initially, how much shall it
grow at the end of 5 years?

0.12 5×4
Sol: 1000 (1 + ) = 1000(1.03)20 = $1806
4

6. Assume deposit in provident fund accounts earn 8% interest. You plan to deposit Rs 20,000 every year,
starting right now. You plan to make deposits each year for the next 14 years. In all, you would have made
15 deposits. How much money will be in provident fund account after 15 years?

(1+𝑟)𝑡 −1 (1+0.08)15 −1 3.172−1

Sol: FV of annuity = 𝐶 × [ 𝑟
] = 20,000 ( 0.08
) = 20,000 ( 0.08
) = 5,43,042.28

Since the deposit starts immediately, FV = 5,43,042(1.08) = 5,86,486

7. You are the lucky winner of the $30 million state lottery. You can take your prize money either as (a) 30
payments of $ 1 million per year starting today or (b) $ 15 million paid today. Which option will you choose?
If the interest rate is 8%

Sol: a) : PV of 30 payments of 1 million starting from today

Today 1 million = 1 million

$1 1 29
Next 1 million for 29 years = (1 − ( ) ) = $ 11.158
0.08 1.08

Total Value = 1+11.158 = 12.158 Million.

(b): PV of $ 15 million is $ 15 million.

Option b is preferred

8. A bond has a quoted price of $ 1,080.42. It has a face value of $1,000, a semiannual coupon of $30, and a
maturity of five years. What is current yield (Annual coupon / Price)? & What is its yield to maturity?

Sol: Current Yield = Annual Coupon / Price * 100 = 60/1080.42 * 100 = 5.55%

1 1 𝐹𝑉
P = CPN × 𝑦 [1 − (1+𝑦)𝑛 ] + (1+𝑦)𝑛

YTM = 2.1% for 6 months from excel formula rate = (10,30, -1080.42,1000)
YTM = 2.1 * 2 = 4.2%

9. KG Ltd issued a bond with a face value of $100, coupon rate 8% which has a maturity of 22 years, bond
makes a semiannual payment, if the YTM is 9% what will be its price today?

Sol: PV of bond = PV of Coupons of all years + PV value of Bond face value

 Coupon = $100*8% = 8/2 = $4
YTM = 9%/2 = 4.5% or 0.045
N= 22*2 = 44

$100
P.V of bond face value = (1+0.045)44 = 14.42
𝐶 1 4 1
PV of coupon payments = 𝑅 [1 − ((1+𝑟)𝑡)] = 0.045 [1 − (1+0.045)44 ] = 76.07
PV of bond = 14.42 + 76.07 = $ 90.49

10. You buy a zero-coupon bond at the beginning of the year that has a face value of $1,000, a YTM of 6.3%,
and 25 years to maturity. If you hold the bond for the entire year, how much in interest income will you have
to declare on your tax return? Assume semiannual compounding.

Sol: A zero-coupon bond pays no interest but for the purpose of taxation the difference between today’s bond
value and next year bond value will be considered as Interest.

𝐹𝑉
P = (1+𝑌𝑇𝑀 𝑛
𝑛)

Face Value = $ 1,000, N = 25*2 = 50, YTM = 6.3%/2 = 3.15%

1000
𝑃1 = (1+0.0315)50 = 212.10
1000
𝑃2 = = 225.67
(1 + 0.0315)48

Interest = 225.67-212.10 = $13.57

11. Bond of Magnum ltd has the following features.

Par value: 100
Coupon rate: 14%
Years to maturity: 6 years.
What happens to the value of Magnum’s bond when the required rate of return is 14%,16% and 12%?

Sol: PV of bond = PV of Coupons of all years + PV value of Bond face value

14 1 100
14% = 0.14 [1 − (1+0.14)6 ] + (1+0.14)^6 = $ 100

14 1 100
16% = 0.16 [1 − (1+0.16)6 ] + (1+0.16)^6 = $ 92.63

14 1 100
12% = 0.12 [1 − (1+0.12)6 ] + (1+0.12)^6 = $ 108.22

12. An 8% five-year bond yields 6%. If this yield to maturity remains unchanged, what will be its price one
year hence? Assume annual coupons payments are constant and face value of $100.
 𝐶 1 𝐹𝑉
Sol: = [1 − ((1+𝑟)𝑡 )] + (1+𝑟)𝑛
𝑅

8 1 100
1st year = 0.06 [1 − (1+0.06)5 ] + (1+0.06)5
= $ 108.42
8 1 100
2nd year = 0.06 [1 − (1+0.06)4 ] + (1+0.06)4
=$ 106.93

13. Zero coupon bonds are not sensitive to interest rate swings than bonds which pay interest semiannually
because all the interest payments of Zero-coupon bonds are accumulated and paid at maturity. (True/False)

Sol: False: Zero Coupon bonds are more sensitive to interest rate swings than bonds which pay interest semi-
annually

14. R&R Enterprises just paid a dividend of $1.15. Its stock has a required rate of return of 13.4%, and
investors expect the dividend to grow at a constant 8% rate in the future. What would be the value of
stock?

𝐷𝐼𝑉1 $ 1.15×1.08
Sol: 𝑃𝑂 = = = $ 23
𝑟−𝑔 0.134−0.08

15. Last year Jaya company paid a dividend of $1.15 and expecting 30% growth rate in 1st year, 20% growth
in 2nd year, 10% growth in 3rd year and constant growth rate 8% for all years after 3 year. Stockholders
required return is 13.4%, find the value of stock.

Sol: 𝐷𝑖𝑣1 : $1.15*1.30 = $ 1.495, 𝐷𝑖𝑣2 :1.495*1.20 = $ 1.794, 𝐷𝑖𝑣3 : 1.794*1.10 = 1.9734,

Growing Perpetuity = div/r-g = 1.9734*1.08/ (0.134-0.08) = $39.468

$ 1.495 $ 1.794 $ 1.9734 $39.468

PV of Stock = (1+0.134)1 + (1+0.134)2 + (1+0.134)3 + (1+0.134)3 = $31.12

16. Pushpanjali Enterprises has 1 million shares outstanding with earnings of 2 million. The stock is selling at
10/-. The historical return on equity has been 16%. The firm retain 40% of earnings. Calculate the growth
rate and required rate of return?

Sol: Growth % = ROE x Retention rate * 100= 0.16*0.40 * 100 = 6.4%

𝐷𝑖𝑣1 1.2768
Required rate = 𝑃𝑜
+ 𝑔= 10
+ 0.064 = 0.19 𝑜𝑟 19%
Earnings = 2 million *1.064 = 2.128 million, Dividend = 2.128* 60% = 1.2768 Million

Dividend per share = 1.2768 Millions / 1 million shares = 1.2768

17. Mau corporation stock currently sells for $64.87 per share. The market requires a return of 10.5% on the
firm’s stock. If the company maintains a constant 5% growth rate in dividends, what was the most recent
dividend per share paid on the stock?

Sol: Dividend growth model

 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 1 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 1
Po = 𝑘𝑒 − 𝑔
, 64.87 = 0.105−0.05 , Dividend 1 = 64.87*0.055 = 3.56
𝐷1 3.56
Most recent dividend i.e., Do = 1+𝑔 = 1.05
= 3.40

18. Consider the following three stocks

(a): Daniel Klein Ltd company pays a dividend of $8 per share forever.
(b): SNF India ltd is expected to pay a dividend of $ 2 next year. Thereafter, dividend growth is
expected to be 3% a year forever.
(c): FactSet Ltd stock is expected to pay dividend of 5/- next year. Thereafter, a dividend growth
is expected to be 8% a year for five years and Zero thereafter.
If the market capitalization rate for each stock is 10%, which stock is most valuable?

𝐷𝑖𝑣 8
Sol: (a) Perpetuity = 𝑃𝑜 = 𝑟
= 0.10 = $80
𝐷𝑖𝑣 2
(b) 𝑃𝑜 = 𝑟−𝑔
= 0.10−0.03
= $28.57
(c) PV(Stock) = PV (expected future dividends)
1st year = 5(1/1.1) = 4.55
2nd year = 5*1.08 (1/1.1) ^2 =4.46
3rd year = 5.4*1.08 (1/1.1) ^3=4.38
4th year = 5.83*1.08 (1/1.1) ^4=4.30
5th year = 6.30*1.08(1/1.1) ^5 = 4.22
PV of stock = 21.91

19. Google pays $ 12 as dividend (100% of earnings). Investors expected a return of 17%. Instead google pays
60% of earnings. Its current return on equity is 27%. What is the stock value when the company pays 100%
of earnings as dividend and 60% of earnings as dividend?

Sol: When company pays 100% of earnings.

𝑃𝑜 = div1/r = $ 12/0.17 = $ 70.59
When company pays 60% of earnings.
Growth = ROE * Plow back ratio. g = 0.27*0.40 = 0.108
Dividend = $12*60% = 7.2
𝑃𝑜 = 7.2/ (0.17-0.108) = $116.13

20. Sundar Ramalingam had entered into 5 Put Options and 5 Call Options in different securities, the particulars
of which are given below, along with their exercise price and actual market price on the date of exercise.
What is his position on the date of exercise? (Hint: Out of money = Lapse, At the money = No action, In
the money = Exercise)

Call Option Put Option

Security Exercise Price Actual Market Price Security Exercise Actual Market
Price Price
P 370 376 A 118 122
 Q 450 444 B 758 758
R 1790 1700 C 350 340
S 135 140 D 65 69
T 953 953 E 230 220

Sol: Call Option

Security Exercise Price Actual Market Position Action

Price
P 370 376 In the Money Exercise
Q 450 444 Out of the Money Lapse
R 1790 1700 Out of the Money Lapse
S 135 140 In the Money Exercise
T 953 953 At the Money No Action

Put Option

Security Exercise Price Actual Market Position Action

Price
A 118 122 Out of the Money Lapse
B 758 758 At the Money No Action
C 350 340 In the Money Exercise
D 65 69 Out of the Money Lapse
E 230 220 In the Money Exercise

21. You purchased one silver future contract at $3 per ounce. What would be your profit (loss) at maturity if the
silver spot price at that time is $4.10 per ounce? Assume the contract size is 5,000 ounces and there are no
transactions costs

Sol: Exercise price of contract is $3 per Ounce.

Future spot is $4.10 per Ounce.
Exercise the contract, pay $ 3 instead of $4.10. Profit = $ 4.10 - $3 = 1.10*5000 Ounces =$ 5500 Profit

22. CMC ltd shares are presently quoted at $100. 3-month call option carries a premium of $15 for a strike price
of $120, spot price on expiry date is $90. Calculate Net payoff to call holder & Call Writer

Sol: Call Option = Buy

Exercise Price = $120
Spot Price on Exercise date = $90

Payoff to Call holder = “Zero” if 𝑆𝑇 ≤ 𝑋 , Since 90 ≤ 120 Payoff = 0

Net Payoff or Profit to Call Holder = Payoff – Premium = Zero – 15 = -$15 loss

Payoff to Call Writer = Zero” if 𝑆𝑇 ≤ 𝑋, Since 90 ≤ 120 Payoff = 0

 Net Payoff to Call Writer = Payoff+ Premium = Zero+ $ 15 = $15 profit

23. A put and a call option each have an expiration date 6 months hence and an exercise price of $ 9. The
interest rate for the 6-month period is 3 per cent. If the put has a market price of $2 and the share is worth
$10 per share, what is the value of call under Put Call Parity

Sol: Value of call + PV of Exercise Price = Current Spot Price + Value of Put.

𝐸𝑃 9
𝐶+ 𝑇 = 𝑆𝑜 + 𝑃 = 𝐶 + 6 = 10 + 2
(1+𝑟𝑓 ) 1+(0.03)12
9
C= 10 + 2 − = 3.13
1.015

24. A forward contract traded on the organized exchanges and are standardized as to the contract size, the
acceptable grade of the commodity, and the contract delivery date. (True/False).

Sol: False: Forward contracts are private agreements and not traded on organized exchanges.

25. Option under which holder can exercise his right at any time before the expiry date is a European Option.
(True/False)

Sol: False: European Option can only be exercised on the expiration or maturity date.