In this article we will discuss about:-

1. Calculation of Interest Rates and Discounting of Cash-Flows

2. Term Structure and Interest Rates.

Calculation of Interest Rates and Discounting of Cash-flows:

Time Value of Money:
The value of money received today is different from the value of money received
after some time in the future. An important financial principle is that the value of
money is time dependent.

This principle is based on the following four reasons:

Inflation:

Under inflationary conditions the value of money, expressed in terms of its

purchasing power over goods and services, declines.

Risk:

Re. 1 now is certain, whereas Re. 1 receivable tomorrow is less certain. This ‘bird-
in-the-hand’ principle is extremely important in investment appraisal.

Personal Consumption Preference:

Many individuals have a strong preference for immediate rather than delayed
consumption. The promise of a bowl of rice next week counts for little to the
starving man.

Investment Opportunities:

Money like any other desirable commodity, has a price, given the choice of Rs.
100 now or the same amount in one year’s time, it is always preferable to take the
Rs. 100 now because it could be invested over the next year at (say) 18% interest
rate to produce Rs. 118 at the end of one year.

If 18% is the best risk-free return available, then you would be indifferent to
receiving Rs. 100 now or Rs. 118 in one year’s time. Expressed another way, the
present value of Rs. 118 receivable one year hence is Rs. 100.
Simple Interest:
Simple interest is the interest calculated on the original principal only for the time
during which the money lent is being used. Simple interest is paid or earned on the
principal amount lent or borrowed.

Simple interest is ascertained with the help of the following formula:

Interest = Pnr

Amount = P(1 + nr)

Where, P = Principal

r = Rate of Interest per annum (r being in decimal)

n = Number of years

Illustration 1:

What is the simple interest and amount of Rs. 8,000 for 4 years at 12% p.a.

Solution:

Interest = Pnr

= 8,000 x 4 x 0.12 = Rs. 3,840

Amount (i.e. principal + Interest)

= P(1 + nr) = 8,000 [1+(4X0.12)]

= 8,000 (1 + 0.48)

= 8,000 x 1.48 = Rs. 11,840

Interest = Amount – Principal

= 11,840 – 8,000 = Rs. 3,840

Illustration 2:

At what rate per cent will Rs. 26,435 amount to Rs. 31.722 in 4 years?

Solution:

A = P(1 + nr)

31,722 = 26,435 (1+4x r/100)

31,722 = 26435 + 1,05,740r/100

1,057.40 r = 31,722 – 26,435

r = 5,287/1,057.40= 5

... Rate of interest = 5%

Illustration 3:

A sum deposited at a bank fetches Rs. 13,440 after 5 years at 12% simple rate
of interest. Find the principal amount.

Solution:

A = P(1 +nr)

13,440 =P (1+5 x 0.12)

13,440 = P + P0.6

1.6 P = 13,440

P = 13,440/1.6 = 8,400

... Principal amount = Rs. 8,400

Compound Interest:
If interest for one period is added to the principal to get the principal for the next
period, it is called ‘compounded interest’. The time period for compounding the
interest may be annual, semiannual or any other regular period of time.

The period after which interest becomes due is called ‘interest period’ or
‘conversion period’. If conversion period is not mentioned, interest is to be
compounded annually. The formula used for compounding of interest income over
‘n’ number of years.

A = P (1 + i)n

Where, A = Amount at the end of ‘n’ period

P = Principal amount at the beginning of the ‘n’ period

i = Rate of interest per payment period (in decimal)

n = Number of payment periods

When interest is payable half-yearly

A = P (1 + i/2 )2n

When interest is payable quarterly

A = P(1+i/4)4n

When interest is payable monthly

A = P (1+i/12)12n

When interest is payable daily

A = P(1+i/365)365n

Illustration 4:

Find out compounded interest on Rs. 6,000 for 3 years at 9% compounded

annually.
Solution:

A = P (1 + i)n

= 6,000(1 + 0.09)3

= 6,000 (1.09)3

= 6,000 x 1.29503 = Rs. 7,770

Illustration 5:

What sum will amount to Rs. 5,000 in 6 years’ time at 8 ½ % per annum.

A = P (1 + i)n

= 5,000 (1 +0.085)6

= 5,000 (1.085)6

= 5,000 x 1.63147 = Rs. 8,157

Illustration 6:

Find the compound interest on Rs. 2,500 for 15 months at 8% compounded

quarterly.

Solution:

A = P(1+ i/4 )4n

= 2,500 (1+ 0.08/4)4×125

= 2,500 (1+ 0.02)5

= 2,500 (1.02)5

Let x = (1.02)5
... log x = 5 log 1.02 = 5×0.0086 = 0.0430

... x = antilog 0.0430 = 1.104

... A = 2,500 x 1.04 = Rs. 2,760

Compound Interest = 2,760 – 2,500 = Rs. 260

Illustration 7:

Find the present value of Rs. 2,000 due in 6 years if money is worth
compounded semiannually.

Solution:

A = P (1+i/2)2n

2,000 = P (1+0.05/2)2×6

2,000 = P (1.025)12

Log 2,000 = log P +12 log 1.025

3.30103 = log P +12 x 0.01072

Log p = 3.30103 – 0.12864

Log p = 3.17239 = 3.1724

P = antilog 3.1724

P = Rs. 1,487.30

... The required present value is Rs. 1,487.30

Compounded interest = 2,000- 1,487.30 = Rs. 512.70

Present Value:
It is a method of assessing the worth of an investment by inverting the
compounding process to give present value of future cash flows. This process is
called ‘discounting’.

The present value of ‘P’ of the amount ‘A’ due at the end of ‘n’ conversion periods
at the rate ‘i’ per conversion period.

The value of ‘P’ is obtained by solving the following equation:

P = A (1 + i)n

Illustration 8:

Ascertain the present value of an amount of Rs. 8,000 deposited now in a

commercial bank for a period of 6 years at 12% rate of interest.

Solution:

P = A/(1 + i)n

8,000 = A/(1 + i)n

8,000 = A/(1 + 0.12)6

8,000 = A/1.97382

A = 8,000 x 1.97382 = Rs. 15,791

Illustration 9:

Find out the present value of Rs. 10,000 to be required after 4 years if the
interest rate is 6%.

Solution:

An amount Rs. 7,921 to be deposited into bank to get Rs. 10,000 at the end of 4
years at interest rate of 6%.
Calculation of Discount Factors:

The exercise involved in calculating the present value is known as ‘discounting’

and the factors by which we have multiplied the cash flows are known as the
‘discount factors’.

The discount factor is given by the following expression:

Where ‘i’ is the rate of interest per annum and ‘n’ is the number of years over
which we are discounting.

Discounted cash-flow is an evaluation of the future cash-flows generated by a

capital project, by discounting them to their present day value. The discounting
technique converts cash inflows and outflows for different years into their
respective values at the same point of time, allows for the time value of money.

Illustration 10:

A firm can invest Rs. 10,000 in a project with a life of three years. The
projected cash inflow are as follows:

The cost of capital is 10% p.a. Should the investment be made?

Solution:
Since the net present value is positive, investment in the project can be
made.

The present value of future cashflow can also be ascertained

as follows:

Firstly the discount factors can be calculated based on Re. 1 received in with ‘i’
rate of interest in 3 years.

Compounding Rate and Capitalising Rate -The compounding rate is used in

project evaluation to determine the present value of past investment / cashflow,
whereas the capitalising rate is applied in the reverse process of discriminating
present value of future cash flows. Both considers the time value of money.

Annuity:
An annuity is a cashflow, either income or outgoings, involving the same sum in
each period. An annuity is the payment or receipt of equal cashflows per period for
a specified amount of time. For example, when a company set aside a fixed sum
each year to meet a future obligation, it is using annuity.

The time period between two successive payments is called ‘payment period or
‘rent period. The word ‘annuity’ is broader in sense, which includes payments
which can be annual, semiannual, quarterly or any other fixed length of time.
Annuity does not necessarily mean payment taken to be one year.

Future Value of Ordinary Annuity – An ordinary annuity is one in which the

payments or receipts occur at the end of each period. In a five year ordinary
annuity, the last payment is made at the end of the fifth year.
Where,

A = Annual or future value which is the sum of the compound amounts of all
payments

P = Amount of each installment

i = Interest rate per period

n = Number of periods

Illustration 11:

Mr. X is depositing Rs. 2,000 in a recurring bank deposit which pays 9% p.a.
compounded interest. How much amount Mr. X will get at the end of 5th year.

Solution:

Illustration 12:

Find the future value of ordinary annuity Rs. 4,000 each six months for 15
years at 5% p.a. compounded semiannually.

Solution:

A = P/I [1+i)n-1]

Where, P = Rs. 4,000

i = 0.05/2 = 0.025

n = 15 x 2 =30
A = 4,000/0.025 [(1 + 0.025)30 – 1]

A = 4,000/ 0.025 [(1.025)30-1]

Let x = (1.025)30

Log x = 30 log 1.025

= 30 x 0.0107 = 0.321

x = antilog 0.321 = 2.094

A = 4,000 /0.025 (2.094 – 1)

= 1,60,000 x 1.094 = Rs. 1,75,040

Present Value of Ordinary Annuity:

The present value of an ordinary annuity is the sum of the present value of a series
of equal periodic payments.

V = P/I [1-(1+i)-n]

Where, V = Present value of annuity

Illustration 13:

Mr. Y is depositing Rs. 8,000 annually for 4 years, in a post office savings
bank account at an interest of 5% p.a. Find the present value of annuity.

Solution:

V = P/I [1- (1+i)-n]

P = Rs. 8,000 i = 0.05 n = 4

V = 8,000/0.05 [1-(1+0205)-4]

= 1,60,000 [1 – (1.05) -4]

Let x = (1.05) -4

Log x = – 4 log 1.05

= – 4 X 0.0212 = – 0.0848

= – 1 + 1 – 0.0848 = 1.9152

x = antilog (1.9152) = 0.8226

V = 1,60,000 x (1 – 0.8226)

= 1,60,000 x .1774 = Rs. 28,384

Present Value of Deferred Annuity – An annuity where the first payment is

delayed beyond one year, the annuity is called a ‘deferred annuity’.

The present value ‘V’ of a deferred annuity ‘P’ to begin at the end of ‘m’ years and
to continue for ‘n’ years is given by:

Calculation of present value by applying the above formula would be extremely

tedious. The simple way of calculation is presented in the following illustration:

Illustration 14:

Z Ltd. intend to invest Rs. 15,000 per annum at the end of years 5, 6, 7 and i of
12%. Find out the present value of the deferred annuity payments.

Solution

Present Value of Perpetuity:

A perpetuity is a financial instrument that promises to pay an equal cash flow per
period forever, that is, an infinite series of payments and principal amount never be
repaid.

The present value of perpetuity is calculated with the following formula:

V = P/i

Illustration 15:

X Ltd. had taken a freehold land for an annual rent of Rs. 1,200. Find out the
present value of freehold land which is enjoyable in perpetuity if the interest
rate is 8% p.a.

Solution:

Amortisation:
Amortisation is the gradual and systematic writing off of an asset or an account
over a period. The amount on which amortisation is provided is referred to as
‘amortizable amount. Depreciation accounting is form of amortisation applied to
depreciable assets. Depletion is a form of amortisation in case of wasting assets.

The gradual repayment or redemption of loan or debentures is also referred to as

amortisation. Sinking fund method and Insurance policy method are used for
systematic writing-off of an asset or redemption of bonds and other long-term debt
instruments. Present value of an annuity interest factors can be used to solve a loan
amortisation problem, where the objective is to determine the payments necessary
to pay off or amortise a loan.

Illustration 16:

Mr. Balu has borrowed a loan of Rs. 5,00,000 to construct his house which
repayable in 12 equal annual instalments the first being paid at the end of first
year. The rate of interest chargeable on this loan is (a 4% p.a. compounded.
How much of equal annual installments payable to amortize the said loan.
V = P/I [1-(1+i)-n]

V = Rs. 5,00,000 I = 0.04 n = 12

5,00,000 = P/0.04 [1-(1+4)-12]

5,00,000 = P/0.04 [1-(1.04)-12]

Let x = (1.04)-12

Log x = -12 log 1.04

= -12 x 0.0170 = -0.204

= -1 + 1 – 0.204 = 1.796

X = antilog 1.796 = 0.6252

5,00,000 = p/0.04 (1-0.6252)

5,00,000 = P/0.04 x 0.3748

5,00,000 = P x 9.37

P = 5,00,000/9.37 = Rs. 53,362

Sinking Fund:

It is a kind of reserve by which a provision is made to reduce a liability, e.g.,

redemption of debentures or repayment of a loan. A sinking fund is a form of
specific reserve set aside for the redemption of a long-term debt. The main purpose
of creating a sinking fund is to have a certain sum of money accumulated for a
future date by setting aside a certain sum of money every year.

It is a kind of specific reserve. Whatever the object or the method of creating such
a reserve may be, every year a certain sum of money is invested in such a way that
with compound interest, the exact amount to wipe off the liability or replace the
wasting asset or to meet the loss, will be available. The amount to be invested
every year can be known from the compound interest annuity tables.
Alternatively, an endowment policy may be taken out which matures on the date
when the amount required will be paid by the insurance company.

The advantage of this method is that a definite amount will be available while in
the case of investment of funds in securities then exact amount may not be
available on account of fall in the value of securities. After the liability is
redeemed, the sinking fund is no longer required and as it is the undistributed
profit, it may be distributed to the shareholders or may be transferred to the
General Reserve Account.

Illustration 17:

A machine costs Rs. 3,00,000 and its effective life is estimated to be 6 years. A
sinking fund is created for replacing the machine at the end of its effective life
time when its scrap realizes a sum of Rs. 20,000 only. Calculate to the nearest
hundreds of rupees, the amount which should be provided, every year, for the
sinking if it accumulates at 8% p.a. compounded annually.

Solution:

For accumulation in sinking fund at compound rate we have:

A =P/i [(1+i)n-1]

A = 3,00,000 – 20,000 = 2,80,000

i = 0.08

n =6

2,80,000 = P/0.08 [(1+0.08)6 -1]

2,80,000 = P/0.08 [(1.08)6-1]

2,80,000 = P/0.08 (1.586874 -1)

2,80,000 = P/0.08 x 0.586874

2,80,000 = P x 7.33593
P = 2,80,000/7.33593 = Rs. 38,168

Term Structure and Interest Rates:

Interest Rates:
The interest rate is an important consideration for a modern finance manager in
taking investment and finance decisions. Interest rates are the measure of cost of
borrowing. The interest rates of a country will also influence the foreign exchange
value of its own currency. Interest rates are taken as a guide in making investments
into shares, debentures, deposits, real estates, loan lending etc.

The interest rates differ in different market segments due to the following reasons:

(a) Risk:

Borrowers carrying high risk will pay higher rates of interest than the borrowers
with less risk.

(b) Size of Loan:

The higher amounts of deposits carry higher interest than small deposits.

(c) Profit on Re-Lending:

Financial intermediaries make their profits from re-lending at a higher rate of

interest than the cost of their borrowing.

(d) Type of Financial Asset:

Different types of financial assets attract different types of interest. For example
deposit in a public sector bank carries interest rate of 10%, but a deposit in a
private sector company may attract an interest rate of 15%.

(e) International Interest Rates:

The rate of interest may vary from country to country due to differing rates of
inflation, Government policies and regulations, foreign exchange rates etc.

Nominal and Real Rates of Interest:

The nominal rates of interest are the actual rates of interest paid. The real rates of
interest are the rates of interest adjusted for the inflation. The real rate is, therefore,
a measure of the increase in the real wealth, expressed in terms of buying power, of
the investor or lender.

The real rate of interest is calculated as follows:

Real rate of interest = 1 + Nominal rate of interest/1 + Rate of inflation -1

Illustration 18:

The nominal rate of interest is 12% and the rate of inflation is 5%. What is
the real rate of interest?

Solution:

Real rate of interest = 1+0.12/1+0.05 -1 = 1.12/1.052-1 = 1.067 -1 = 0.067

... Real rate of interest = 6.7%

Simply, the real rate of interest is calculated as follows:

Real rate of interest = Nominal rate of return – Rate of inflation = 12% -5% = 7%

The real rate of interest will usually be positive, although when the rate of inflation
is very high, because the lenders will want to earn a real return and will therefore
want nominal rates of interest to exceed the inflation rate. A positive real rate of
interest adds to an investor’s real wealth from the income he earns from his
investments.

Interest Rates, Capital Gains and Losses:

The increase or decrease in the value of stock is calculated as follows:

Real value of stock = Face value of stock x Nominal rate of stock/Market Nominal
rate

Illustration 19:
The long-term guilts issued by the Government with a face value of Rs. 100
and the coupon rate is 10%.

Calculate the resale value of guilts in the following situations:

(a) If the market nominal rate rises to 15%:

Resale value of stock = Rs. 100 x 10%/15% = Rs. 66.67

If the investor sells his stock we will incur a capital loss of Rs. 33.33 (le. Rs. 100 –
Rs. 66.67)

(b) If the Market nominal rate falls to 7%:

Resale value of stock = Rs. 100 x 10%/7% = Rs. 142.86

If the investor sells his stock he will get a capital gain of Rs. 42.86 (i.e. Rs. 100 –
Rs. 142.86)

Interest Rates and Share Prices:

The shares and debt instruments are alternative ways of investment. If the interest
rates on debt instruments fall, shares become more attractive to buy. As demand
for shares increases, their prices rise too, and so the dividend return gained from
them fall in percentage terms. If interest rates went up, the shareholder would
probably want a higher return from his shares and share prices would fall.

Changes in Interest Rates and Financing Decisions:

The changes in interest rates will have strong impact on financing decisions taken
by a Finance manager.

Financial strategy to be followed when interest rates are low:

(i) Borrow more moneys at fixed rate of interest to increase the company’s gearing
and to maximize return on equity.

(ii) Borrow long-term funds rather than short-term funds.

(iii) Replace the high cost debt with low cost debt.
Financial strategy to be followed when interest rates are higher:

(a) Raise funds by issue of equity shares and to stay away from raising debt
finances.

(b) Debt finance can be taken for short-term rather than long-term.

(c) Surplus liquid assets can profitably be invested by switching of investments

from equity shares to interest bearing investments.

(d) Reduce the need to borrow funds by selling unwanted and inefficient assets,
keep the stocks and debtors balances at lower levels etc.

(e) New projects need to be given careful consideration, which must be able to earn
the increased cost of financing the projects.

Theories on Term Structure of Interest Rates:

The term structure of interest rates and the levels of interest rates are obviously of
prime importance. We will consider first the nature of the different types of interest
rates.

The most commonly quoted interest rates in the financial markets are:

(a) The bank’s base rate.

(b) The interbank lending rate.

(c) The treasury bill rate.

(d) The yield on long-dated gilt-edged securities.

The term structure of interest rates describes the relationship between interest rates
and loan maturities. Three theories have been advanced to explain the term
structure of interest rates:

Expectations Theory:

It asserts that in equilibrium the long-term rate is a geometric average of today’s

short-term rate and expected short-term rates in the long run.
Liquidity Preference Theory:

The future is inherently uncertain, thus the pure expectations theory must be
modified. In a world of uncertainty investors will in general prefer to hold short-
term securities because they are more liquid in the sense that they can be converted
to cash without danger of loss of principal. Investor will, therefore, accept lower
yields on short-term securities.

Borrowers will react in exactly the opposite way from investors. Business
borrowers generally prefer long-term debt because short-term subjects a firm to
greater dangers of having to refund debt under adverse conditions. Accordingly
firms are willing to pay a higher rate, other things held constant, for long-term
funds than for short-term funds.

Market Segmentation Theory:

This theory admits the liquidity preference argument as a good description of the
behaviour of investors of short-term. Certain investors with long-term liabilities
might prefer to buy long-term bonds because, given the nature of their liabilities,
they find certainty of income highly desirable.

Borrowers typically relate the maturity of their debt to the maturity of their assets.
Thus the market segmentation theory characterizes market participants’ maturity
preferences and interest rates are determined by supply and demand in each
segmented market, with each maturity constituting a segment.

Each of these theories carries some validity, and each must be employed to help
explain the term structure of interest rates.

Yield to Maturity:
Yield to maturity means the rate of return earned on security if it is held till
maturity. This can be presented in a graph called ‘yield to maturity curve’ which
represents the interest rates and the maturity of a security.

The term structure of interest rates refers to the way in which the yield on a
security varies according to the term of borrowing that is the length of time until
debt will be repaid as shown by the ‘yield curve’.

Yield Curves to Maturity of Debt

In figure 22.1 yield is measured on the vertical axis and term to maturity is on the
horizontal axis. Often the yield curve is upward sloping i.e., short-term securities
yield less than long-term securities (curve A). Sometimes it is rather flat, short-
term yields equal long-term yields (curve B).

And sometimes the yield curve is even downward sloping, short-term interest rates
are above long- term rates (curve C). Normally, the longer the term of an asset to
maturity, the higher the rate of interest paid on the asset.

In the normal situation, yield to maturity curve is upward sloping for the following
reasons:

(a) The risk is more in holding securities for a longer period than short period. This
is due to conditions of business which cannot be predicted with accuracy and hence
the investors holding long-term securities prefer to be compensated for the
additional risk than on the shorter term securities.

(b) In the long-term securities the funds of the investors are tied up for long periods
and for this the investors naturally expects for higher return than the short-term
securities.

The basic expectations theory maintains that the shape of the yield curve is
determined by investors’ expectations of future short-term interest rates. In
particular, if short-term rates are expected to rise, the yield curve will be upward
sloping, while if short-term rates are expected to fall, the yield curve will be
downward sloping.

A specific result is that long-term rates are averages of current and expected future
short-term rates.

The relationship between maturity and yields is also known as the ‘term structure
of interest rates’ and yield curve is represented as follows:

(i) Yield curves have an upward slope when long maturity bonds have higher
interest rates than short maturity bonds.

(ii) Yield curves have a downward slope when short maturity bonds have higher
interest rates.
Decomposing the Yield Curve

Factors Determining Yields:

The general level of yields on stocks is determined by a complex of factors:

(a) Level of Interest Rates:

A change in interest rates will affect security prices and yields as follows:

1. A fall in interest rates brings about a rise in the price of fixed interest securities
and a fall in yields.

2. A rise in interest rates has the opposite effect.

(b) Borrower’s Financial Standing:

The Government offers absolute security for its debts so that yields on gilt-edged
are the finest in the market and establish a standard for other yields. Since the
standing of other borrowers is lower, investors expect higher yields. This
difference is known as the ‘yield differential’ or ‘yield gap’.

(c) Duration of the Loan:

The element of risk increases with the duration of the loan so that, investors expect
higher yields on long-term bonds than for short, by way of compensation.

(d) General Outlook of Economy:

A bullish outlook for industry or the prospect of inflation and high rates of interest
will cause investors to switch to equities to depress the prices of gilts and to raise
their yields.

(e) Political Events:

Prices and yields are also influenced by political events, e.g., changes of
Government, industrial unrest, publication of trade figures, international crises or
any events likely to affect business confidence etc.

Yield of Stocks:
The prospective purchaser of gilt-edged stocks will compare the return, or ‘yield,
of the investment with its opportunity cost, i.e. what it could earn elsewhere at
current interest rates.

Two yields may be calculated as follows:

Flat Yield:

This is the annual return on the investment. It is appropriate for irredeemable

stocks. Suppose 14 per cent undated bonds of Rs. 100 are quoted at Rs. 80.

Then:

Coupon rate Rs. 14

Flat yield = Coupon rate/Market price x 100 = Rs.14/Rs. 80 x 100 = 17.5%

Redemption Yield:

The true return on dated stocks must include the rate of interest and any capital
gain which results from differences between their cost and redemption price.

Suppose 12 per cent conversion bonds redeemable at par in 2010 were quoted at
Rs. 84 in 2009 then:

Flat yield = Rs. 12/Rs.84 x 100 = 14.29%

In addition, the investor will make a capital gain of Rs. 16 over six years since the
bond was redeemable for Rs. 100 in 2010.

Capital gain may be expressed as an annual yield for the period. In practice this is
found in actuarial tables, which allow for compounding, but it may be estimated as
follows:

Capital gain/Years to redemption = Rs. 16/6years = Rs. 2.266 p.a.i.e., 2.66% on

bond value of Rs.100

Redemption yield = Flat yield p.a. + Capital gain p.a. = 14.29% + 2.66% =
16.95%.