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Questions and Answers
What is the present value of the expected cash income for Year 1?
What is the present value of the expected cash income for Year 1?
How does an increase in the discount rate affect the present value of future cash flows?
How does an increase in the discount rate affect the present value of future cash flows?
Which year has the highest present value of expected cash flows?
Which year has the highest present value of expected cash flows?
What is the formula used for calculating future value in continuous compounding?
What is the formula used for calculating future value in continuous compounding?
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What is the present value of expected cash flows for Year 4?
What is the present value of expected cash flows for Year 4?
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What implications does the rationalization of present value suggest about future cash flow evaluations?
What implications does the rationalization of present value suggest about future cash flow evaluations?
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What does 'm' approach in the continuous compounding formula when m approaches infinity?
What does 'm' approach in the continuous compounding formula when m approaches infinity?
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What is the cumulative present value of expected cash flows from Years 1 to 5?
What is the cumulative present value of expected cash flows from Years 1 to 5?
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What is the formula for calculating the future value (FV) with continuous compounding?
What is the formula for calculating the future value (FV) with continuous compounding?
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After 3 years, what is the future value of a deposit of Rs.1000 at a continuous compounding rate of 10%?
After 3 years, what is the future value of a deposit of Rs.1000 at a continuous compounding rate of 10%?
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What happens to the present value (PV) when the compounding is continuous?
What happens to the present value (PV) when the compounding is continuous?
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What does the Opportunity Cost of Capital represent?
What does the Opportunity Cost of Capital represent?
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Which statement correctly describes the relationship between nominal and effective annual interest rates?
Which statement correctly describes the relationship between nominal and effective annual interest rates?
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How is cost of capital typically determined?
How is cost of capital typically determined?
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In the formula for Effective Annual Rate (EAR), what does 'm' represent?
In the formula for Effective Annual Rate (EAR), what does 'm' represent?
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If the initial investment is Rs. 650,000, what is the purpose of calculating Net Present Value (NPV)?
If the initial investment is Rs. 650,000, what is the purpose of calculating Net Present Value (NPV)?
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If Company XYZ expects to save Rs.10 million from a renovation costing Rs.50 million, what is the expected rate of return?
If Company XYZ expects to save Rs.10 million from a renovation costing Rs.50 million, what is the expected rate of return?
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What is the value of Rs.1000 received in 10 years at a discount rate of 20% compounded continuously?
What is the value of Rs.1000 received in 10 years at a discount rate of 20% compounded continuously?
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What is the maximum return Company XYZ could earn by investing its Rs.50 million in bonds?
What is the maximum return Company XYZ could earn by investing its Rs.50 million in bonds?
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What helps determine whether a renovation or bond investment is a better option for Company XYZ?
What helps determine whether a renovation or bond investment is a better option for Company XYZ?
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When comparing investments with different compounding periods, what is crucial for standardization?
When comparing investments with different compounding periods, what is crucial for standardization?
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What is the weighted average cost of capital?
What is the weighted average cost of capital?
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Why is the cost of capital crucial for business valuation?
Why is the cost of capital crucial for business valuation?
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What happens when investors face two investments with equal risk?
What happens when investors face two investments with equal risk?
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What does the required rate of return represent?
What does the required rate of return represent?
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Which of the following is NOT considered when calculating the required rate of return?
Which of the following is NOT considered when calculating the required rate of return?
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How is the required rate of return (RRR) mathematically expressed?
How is the required rate of return (RRR) mathematically expressed?
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What does the opportunity cost of capital signify?
What does the opportunity cost of capital signify?
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What is meant by the Time Value of Money (TVM)?
What is meant by the Time Value of Money (TVM)?
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In the context of Future Value, what does compounding refer to?
In the context of Future Value, what does compounding refer to?
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Which formula correctly represents Simple Interest?
Which formula correctly represents Simple Interest?
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What is the primary focus when determining Present Value (PV)?
What is the primary focus when determining Present Value (PV)?
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What is the primary factor that determines the cost of capital?
What is the primary factor that determines the cost of capital?
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If the stated interest rate is 8% and compounded quarterly, what is affected by this compounding?
If the stated interest rate is 8% and compounded quarterly, what is affected by this compounding?
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How long will it take for Rs. 5000 to grow to Rs. 8000 at 6% annual interest compounded monthly?
How long will it take for Rs. 5000 to grow to Rs. 8000 at 6% annual interest compounded monthly?
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At what implied compound annual interest rate should one be indifferent between receiving Rs. 25,000 in 6 years or Rs. 50,000 in 12 years?
At what implied compound annual interest rate should one be indifferent between receiving Rs. 25,000 in 6 years or Rs. 50,000 in 12 years?
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What is the future value of cash-flow stream W at the end of year 5 with a compounded interest rate of 10%?
What is the future value of cash-flow stream W at the end of year 5 with a compounded interest rate of 10%?
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What is the future value of Senaya's first plan at the end of 10 years at a 7% interest rate, compounded semi-annually?
What is the future value of Senaya's first plan at the end of 10 years at a 7% interest rate, compounded semi-annually?
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What is the discount rate used to compute the present value of cash flow stream Z if the cash flows include Rs. 200 in year 1, Rs. 500 in year 3, and Rs. 300 in year 5?
What is the discount rate used to compute the present value of cash flow stream Z if the cash flows include Rs. 200 in year 1, Rs. 500 in year 3, and Rs. 300 in year 5?
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Which of the following scenarios does NOT depict the cost of capital?
Which of the following scenarios does NOT depict the cost of capital?
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Study Notes
Required Rate of Return
- The minimum percentage return an investment needs to attract investors
- Considered the opportunity cost of capital for similar risk investments
- Factors influencing Required Rate of Return:
- Overall market return
- Risk-free rate of return
- Volatility or cost of funding the project
- Calculated by: Required Rate of Return (RRR) = Risk Free Rate + Risk Premium
Cost of Capital
- The opportunity cost of investing in a specific project
- Rate of return achievable in a different investment of equal risk
- Represents the required rate of return to persuade an investor
- Cost of capital is the equivalent of required rate of return in comparable risk investments
Time Value of Money
- The difference in value between money today and in the future
- Accounts for the ability of money to grow over time
- Represented by the concepts of Future Value (compounding) and Present Value (discounting)
Future Value
- The calculated value of a present sum of money or cash flows at a specified future date
- Based on a given rate of return and compounding period
Simple Interest
- Interest paid only on the original principal amount
Present Value
- The current value of a future stream of cash flows discounted at a specific rate
- Accounts for the time value of money
- Higher discount rate leads to a lower present value
Rationalization of Present Value
- Uncertainty of future cash flows necessitates discounting
- Present value reflects the risk associated with future cash flows
- Higher discount rate reflects higher perceived risk
Continuous Compounding
- Interest is compounded continuously, resulting in the highest potential future value
- Formula for calculating Future Value: FV = PV * (e)^(i*n) - FV = Future Value - PV = Present Value - i = Interest Rate - n = Number of Years
- Formula for calculating Present Value: PV = FV / (e)^(i*n) - PV = Present Value - FV = Future Value - i = Interest Rate - n = Number of Years
Net Present Value (NPV)
- A key financial decision-making tool for project appraisal
- Compares the present value of future cash flows to the investment cost
- Positive NPV indicates a profitable investment
Effective Annual Rate of Interest
- The annual interest rate that yields the same return as a nominal rate compounded multiple times per year
- Used for comparing investments with different compounding frequencies
- Calculated by: EAR = (1 + (r/m))^m - 1 - EAR = Effective Annual Rate of Interest - r = Annual Interest Rate (Nominal Rate) - m = Number of Compounding Periods per Year
The Opportunity Cost of Capital
- The return potentially missed by choosing one investment over another with equal risk
- Represents the minimum required return that makes an investment worthwhile
- Determined by market conditions and investor risk perception
Why Opportunity Cost of Capital Matters
- Used as a discount rate for valuation purposes
- Helps determine the fair value of investments and cash flows
- Not the same as the interest rate on borrowed money
- Depends on the investment itself, not the source of funds
Additional Questions
- The text poses several practical application questions for understanding the concepts of Time Value of Money, NPV, and Effective Annual Rate of Return.
- Addressing these questions allows for deeper understanding and reinforces key concepts
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Description
Test your knowledge of key finance concepts such as the Required Rate of Return, Cost of Capital, and the Time Value of Money. Understand how these principles influence investment decisions and the overall market. This quiz covers important calculations and theories that every finance student should know.