Www.iobmalawi.com



FINANCIAL CONCEPTS A

A SOLUTIONS AND MODEL ANSWERS FOR DRAFT EXAMINATION

NOVEMBER 2012

SECTION A

Question 1 (15 marks)

To convert nominal interest rate to effective interest rate, we say that the interest is earned at nominal rate of interest i(m) , convertible mthly, if

[pic]

where i(m) is nominal rate of interest (APR)

m number of time compounded in a period (usually 12 time in a year or monthly)

i is the effective rate of interest

Therefore:

a) ANSWER= 8.24%

[pic]

Meaning 8.24% is the effective

b) ANSWER= 8.16%

[pic]

Meaning 8.16% is the effective

c) ANSWER 8.30%

Therefore

[pic]

Meaning 8.30% is the effective

Question 2 (15 marks)

a) PV= PMT[pic]=MK131.22

b) PV= PMT[pic](1 + 0.7)=MK140.41

c) FV= PMT[pic]=MK172

Question 3 (15 marks)

a) In the amortization method, the borrower repays the lender by means of installment payments at periodic intervals. Typically this method is used with individual borrowers. Examples include car loan and mortgage repayment, like in the question. While In the sinking fund method, the borrower repays the lender by means of a lump-sum payment at the end of the term of the loan. The borrower pays interest on the loan in installments over this period. It is also assumed that the borrower makes periodic payments into a fund, called a “sinking fund”, which will accumulate to the amount of the loan to be repaid at the end of the term of the loan.

Therefore the mortgage repayments of Fred’s mortgage are using the loan ammortisation method. 2 marks

b) ANSWER: MK1,264

financial calculator

Inputs: 360 0.58% 190,000 - ?

N I PV FV PMT

=30yrs X 12mths =360 @ 7% p.a. ÷12=0.58%

|HP12C |Display | |

|f FIN CLX |0 | |

| g BEG | | |

|30 g n |360 | |

|7 g i |0.58 | |

|190000 CHS PV |-190000 | |

|Press PMT |1,264 | |

c) Interest accrues (accumulates) as either; simple interest or compound interest.

Simple interest is interest that accrues linearly. In other words, it grows by a certain fraction of the principal per time period. Calculation of accrued interest of most debt uses simple interest. Once an interest payment is made, the lender can reinvest it elsewhere. In case the lender reinvests it in the original investment, interest will start accruing on this interest.

Compound interest, is interest which is regularly added to the debt (compounded). Interest is then calculated not only over the principal, but also over the interest that has been added to the debt before, in other words, it is calculated over the total amount owed. With compound interest, the frequency of compounding influences the total amount of interest paid over the life of the loan. Mortgages usually use this type of interest accrual.

d) ANSWER: 1.85%

Real rate of interest = [pic] where i be the annual effective rate of interest, and r rate of inflation

Therefore;

Real rate of interest = [pic]=0.0185 =1.85%

3 marks

Question 4 (15 marks)

There are a variety of reasons which explain why lenders charge interest for the use of their money:

Deferred consumption and Time value of money: When money is loaned the lender delays spending the money on consumption goods. Most people would choose to have money in the present rather than money in the future. When asked to lend their current money in exchange for a promise to repay that money in the future, most lenders will agree only if they are repaid more than they originally lent. In effect, the interest rate is the payment for the use of money over time.

Alternative investments. The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. In other words, lending incurs an opportunity cost due to the possible alternative uses of the lent money.

Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this loss in value.

Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.

Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realise.

Taxes. Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

SECTION B

Question 5 (20 marks)

Investment decisions; advising on the allocation of funds in terms of the total amount of assets, composition of Non-current and current assets, and the consequent risk profile of the choices. Example; The finance manager will usually chair the asset liability committee to arrive at the ideal Balance Sheet for the bank.

Financing decisions, responsible for raising funds, choosing from a wide variety of institutions and markets, with each source of finance having different features as regards cost, availability, maturity and risk. Example-Where to source funds from (savings deposits, short term investment/fixed deposits.

Treasury Management, the management of cash will fall under the guidance of the financial manager. Banks have to manage their cash/liquidity levels to obtain an optimal return on their investments at the same time ensuring that the bank has sufficient funds to meet their clients’ demands for cash withdrawals as well as meeting the Liquidity Reserve Requirement set by the Central Bank. Example-Daily cash position and daily cash/deposit ratio calculation

Risk management, Investment, financing and Treasury decisions cause risk exposure to the bank. The financial manager needs to manage the underlying risks by making the right risk management decisions. Example-assessment of a short term investment option before committing funds.

Question 6 (20 marks)

a) Annuities are essentially series of fixed payments required from you or paid to you at a specified frequency over the course of a fixed period of time while perpetuity is an annuity where the number of years has no limit. (2 marks)

b) N= 17.54 (Given I=8%, PV=500,000, PMT=50,000, FV=0)

financial calculator

Inputs: ? 0.667 - 500000 0

N I PV FV

8.0 p.a. ÷12 = 0.667%

|HP12C |Display | |

|f FIN CLX |0 | |

| g BEG | | |

|8.0 g i |0.667 | |

|500000 CHS PV |-500000 | |

|500000 PMT |50000 | |

|0 FV |0 | |

|Press N |17.54 | |

c) N=6, I=6%, PMT=1,000, FV=15000, PV=5,974.77

d) I=11%,PV=2.00, PMT=0 FV=4.00,N=6.64

Question 7

a) COMPARISON OF NPV AND IRR

NPV

← It recognises that K1 today is worth more than K1 tomorrow.

← In conditions where projects are independent, it maximises shareholder utility. Projects with a positive NPV should be accepted since they increase shareholder wealth, while those with negative NPVs decrease shareholder wealth.

← It takes into account investment size-absolute amounts of wealth change.

← The NPV is not as intuitively understandable as a percentage measure.

← It can handle non-conventional cash flows.

← additivity is possible: because present values are all measured in today’s Ks they can be added together. Thus the returns (NPVs) of a group of projects can be calculated.

IRR

Also takes into account the time value of money.

In situations of non-mutual exclusivity, shareholder wealth is maximised if all projects with a yield higher than the opportunity cost of capital are accepted, while those with a return less than the time value of money are rejected.

Fails to measure, in terms of absolute amounts of wealth changes. It measures percentage returns and this may cause ranking problems in conditions of mutual exclusivity, i.e. the wrong project may be rejected.

← It is easier to communicate a percentage return than NPV to other managers and employees, who may not be familiar with the details of project appraisal techniques. This appeal should not be underestimated.

← Non conventional cash flows cause problems

← Additivity is not possible.

b)

i) Zapamwamba’s IRR

First, recognise that annuities are present (to save a lot of time).

Project A: Try 15% -420,000 + 150,000 x 2.855 = +MK8, 250

Try 16% -420,000 + 150,000 x 2.7982 = -MK270

IRR = 15 +[pic]

Project B: Try 31% and 32%

Points in time Cash flows (K) Discounted cash flows(K) Discounted cash flows(K)

Yearly intervals at 31% at 32%

0 Now -100,000 -100,000 -100,000

1(1 year from now) +75,000 [pic] = 57,252 [pic] 56,818

2 +75,000 [pic] = 43,704 [pic] 43,044

+956 -138

IRR = 31 +[pic]

ii) NPV:

Project A

-420,000 + 150,000 x 3.0373 = +MK35, 595

Project B

-100,000 + 75,000 x 1.6901 = +MK26, 758

iii)

|PERIOD |IRR |NPV |

|PROJECT A MK’000 |15.97% |MK35,595 |

|PROJECT B MK’000 |31.87% |MK26,758 |

If the projects were not mutually exclusive, Zapamwamba would be advised to accept both. If the firm has to choose between them, on the basis of the IRR calculation it would select B, but, if NPV is used, project A is the preferred choice. In mutually exclusive situations with projects generating more than the required rate of return, NPV is the superior decision-making tool. It measures in absolute amounts of money rather than in percentages and does not have the theoretical doubts about re-investment rate of return on intra-project cash inflows.

Question 8

a) CUMIPMT(17.75%/12,240,3000000,1,12,0) = MK531,116.95

b) Inputs: 240 1.479 3000000 0 ?

N I PV FV PMT

20 years x 12 months 17.75%÷12 = 1.479

|HP12C |Display | |

|f FIN CLX |0 |Clear all financial registers |

|20 g n |240 |Period expressed in months |

|17.75 g i |1.48 |Interest rate expressed in months |

|3000000 CHS PV |-3000000 |PV=principal debt |

|Press PMT |45722.97 |Monthly payments |

|14 f AMORT |575,232.22 |Total interest portion for the 1st 14 payments |

| 1 f AMORT | 44,091.50 |The interest portion in the 13th payment |

c) PPMT(17.75%/12,100,240,3000000,0,0)= 5,767.57

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download