Upload
yap-k-c-jefferson
View
978
Download
2
Embed Size (px)
Citation preview
1
FIN222 Tutorial 1 1st Hour Material **CQ1.5 In determining the price of a company’s shares, what are some of the external and internal factors that affect price? What is the difference between these two types of variables?
External factors that affect the company’s share price are: (1) economic shocks, such as natural disasters or wars, (2) the state of the economy, such as the level of interest rates, and (3) the business environment, such as taxes or regulations. On one hand, external factors are variables over which the management has no control. On the other hand, internal factors that affect the share price can be controlled by management to some degree, because they are company specific, such as
(1) financial management decisions (including capital budgeting decision, financing decision and working capital management decision)
(2) product quality and cost, and (3) the line of business management has selected to enter.
Overall, the three most important variables which determines the share price are
(1) the expected cash flow stream and its magnitude (which will be affected by both external and internal factors mentioned above)
(2) timing, and (3) riskiness.
CQ1.6 Identify the sources of agency costs. What are some ways a company can control these factors?
Agency costs are the costs that result from a conflict of interest between the agent and the
principal. They can either be direct, such as lavish dinners or trips, or indirect, which are usually missed investment opportunities.
A company can control these costs o by tying management compensation to company’s performance or o by the threat of corporate raiders that can take over a company not performing up to
expectations o by the competitive nature of the management labor market (top performing managers have
better alternatives than to work for poorly‐run companies.)
QP1.13 What is the business organisation form preferred by companies that require a large capital base, and why? Public Corporation. The reason is
A company can list on securities exchange, such as the Singapore Exchange (SGX) as a public
company to gain access to the public markets.
2
**QP1.16 What are some of the drawbacks to setting profit maximisation as the main goal of a company?
It is difficult to determine what is meant by profits.
Accounting profits are subject to manipulation. It does not address the size and timing of cash flows—it does not account for the time
value of money. It ignores the uncertainty of risk of cash flows.
**QP2.1 What is the role of the financial system, and what are the two major components of the financial system? The role of the financial system is to gather money from businesses and individuals that have
surplus funds to invest (Surplus units) and to channel funds to those who need them (Deficit units). (Remember that Financing decision (about how to finance) requires access to funds.)
The financial system consists of financial markets and financial institutions.
QP2.4 List the two ways in which a transfer of funds takes place in an economy. What is the main difference between these two?
Direct financing: Funds can flow directly through financial markets (eg. primary market vs
secondary market or money market vs capital market) Indirect financing: Funds can flow indirectly through intermediation markets where funds flow
through financial institutions first **QP2.8 What is a primary market? What does IPO stand for? A primary market is where new securities are sold for the first time.
o It could be new securities sold from a newly listed firm (IPO) or new securities sold from an existing company.
IPO stands for initial public offering. **QP2.16 What is a share market index? List three share market indexes.
A share market index is a tool used to measure the performance of the share market—whether the market value is on average going up or down. Some of the better known Singapore indexes are
FTSE Straits Times Index (STI) tracks the performance of the top 30 companies listed on the Singapore Exchange.
FTSE Straits Times All‐share Index comprises all companies within the top 98% by full market capitalization in the Singapore Exchange.
the Dow Jones Industrial Average is the most well known index covering 30 largest companies in US share market.
3
QP2.20 Besides Treasury notes, what are other money market instruments? In addition to government, large banks and corporations can also borrow for short‐term by issuing
money market instrument (eg. commercial paper – unsecured promissory note) Commercial paper is only backed by an issuing bank or corporation's promise to pay the face
amount on the maturity date specified on the note. Since it is not backed by collateral (specific property pledged as security) , only firms with
excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price.
**QP2.22 How do capital market instruments differ from money market instruments?
Money markets are markets in which short‐term debt instruments with maturities of less than
one year are bought and sold. Financial instruments sold in money markets have very short maturities, usually overnight to 180
days, are highly marketable in that they can be easily converted into cash and are issued by economic units of the highest credit standing such as government, firms with excellent credit rating
Capital market is the segment of the marketplace where capital goods, such as plant and equipment, are financed with equities or debt instruments with maturities of more than one year (eg.bond).
Capital market instruments are less liquid or marketable therefore carry more risk. **QP2.28 Imagine you borrow $500 from your roommate, agreeing to pay her back the $500 plus 7 percent nominal interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total amount you will have to pay her back in a year? How much of the interest payment is the result of the real rate of interest?
Real = Nominal –Inflation = 7%‐4.25% = 2.75% You will pay her back $535 ($500 x 1.07) in one year, of which $13.75 will be a result of the
real interest rate ($500 x 0.0275).
4
3rd Hour Material Do CQ5.7 after QP 6.30.
**QP5.5 Your bank pays 5 per cent interest semi‐annually on your savings account. You don’t expect
the current balance of $2700 to change over the next 4 years. How much money can you expect to have at the end of this period?
0 4 years
├────────────────────┤ PV = $2700 FV = ? Amount invested today = PV = $2700 Return expected from investment = i = 5% Duration of investment = n = 4 years Frequency of compounding = m = 2 Value of investment after 4 years = FV4
2 4
4
8
0.051 2700 1
2
2700 (1.025)
=$3289.69
mni
FV PVm
QP 5.12 Tracy Chapman is saving to buy a house in 5 years time. She plans to put down 20 per cent deposit at that time, and she believes that she will need $70000 for the downpayment. If Tracy can invest in a fund that pays 9.25 per cent annually, how much will she need to invest today?
0 5 years
├────────────────────┤ PV = ? FV = $70 000
Amount needed for down payment after 5 years = FV5 = $70 000 Return expected from investment = i = 9.25% Duration of investment = n = 5 years Amount to be invested today = PV
5
70000
(1.0925)1
$44977.03
nn
FVPV
i
5
**QP5.15: You are in desperate need of cash and turn to your uncle who has offered to lend you some money. You decide to borrow $1300 and agree to pay back $1500 in 2 years. Alternatively, you could borrow from your bank that is charging 6.5 per cent interest. Should you go with your uncle or the bank? 0 2 years
├────────────────────┤ PV = $1300 FV = $1500
Amount to be borrowed = PV = $1300 Amount to be paid back after 2 years = FV2 = $1500 Interest rate on investment = i = ? Duration of investment = n = 2 years. Present value of investment = PV
2
2
1
15001300
1
15001 1 1538
1300
1 1538 1
nn
FVPV
( )
( i) .
.
i=7.42%
i
i
i
You should go with the bank borrowing, as the bank is offering a lower lending rate.
QP5.30 Jason has $2400 that he is hoping to invest. His brother approached him with an
investment opportunity that could double his money in 4 years. What interest rate would the investment have to yield in order for Jason’s brother to deliver on his promise?
Solution: 0 4 years
├────────────────────┤ PV = $2400 FV = $4800 Amount invested in project = PV = $2400 Expected return three years from now = FV =$4800 Investment period = n = 4 years To calculate the expected rate of return, we set up the future value equation.
44
4
4
14
1
4800 2400 1
48001
2400
2 000 1 0 1892
FV PV ( )
( )
( )
( . ) .
18.92%
i
i
i
i
6
**QP6.6 Present value with multiple cash flows: Biomedical Pty Ltd expects the following cash flow stream over the next 5 years. The company discounts all cash flows at a 23 per cent discount rate. What is the present value of this cash flow stream?
0 23% 1 2 3 4 5 ├───────┼────────┼───────┼────────┼───────┤ ‐$1133676 ‐$978452 $275455 $878326 $1835444
2$384,711.7
94.651951.43.38373809.14802537.64673980.921687
)23.1(
1835444
)23.1(
878326
)23.1(
275455
)23.1(
978452
)23.1(
676,11335432
PV
**QP6.7 Present value of an ordinary annuity: An investment opportunity requires a payment
of $750 for 12 years, starting a year from today. If your required rate of return is 8 per cent, what is the value of the investment today?
Solution:
0 8% 1 2 3 11 12 ├───────┼────────┼───────┼………………┼───────┤ $750 $750 $750 $750 $750
Annual payment = CF = $750 No. of payments = n = 12 Required rate of return = 8% Present value of investment = PVA12
12
11
(1 )
750 11
0.08 (1.08)
n n
CFPVA
i i
$5,652.06
1 2 3 4 5 ‐$1133676 ‐$978452 $275455 $878326 $1835444
7
QP6.13 Calculating annuity payment: The Bridge Bar & Grill has a 7‐year loan of $23500 with Bankwest. It plans to repay the loan in 7 equal instalments starting today. If the rate of interest is 8.4 per cent, how much will each payment be worth?
0 1 2 3 4 5 6(=the beginning of Year 7) ├─────┼─────┼─────┼──────|──────┼──────┤
CF CF CF CF CF CF CF PVAn = $23,500 n = 7; i = 8.4%
Present value of annuity due= $23,500 Return on investment = i = 8.4% Payment required to meet target = CF Type of annuity = Annuity due Using the PVA equation:
7
7
123,500 1 (1 )
(1 )
123,500 1 (1 0.084)
0.084 (1 0.084)
23,500*0.084
11 (1.084)
(1.084)
n
CFPVofAnnuityDue i
i i
CF
CF
CF
$4,221.07
Each payment made by Bridge Bar & Grill will be $4221.07, starting today.
**QP6.14 Perpetuity: Your grandfather is retiring at the end of next year. He would like to ensure
that he, and after he dies, his heirs receive a payment of $10,000 a year forever, starting when he retires. If he can invest at 6.5 per cent, how much does need to invest to receive the desired cash flow?
Solution:
Annual payment needed = CF = $10,000 Investment rate of return = i = 6.5% Term of payment = Perpetuity Present value of investment needed = PV
10000PV of Perpetuity
0.065
CF
i
$153,846.15
8
**QP6.18 Growing perpetuity: You are evaluating a growing perpetuity product from a large financial services company. The product promises an initial payment of $20000 at the end of this year and subsequent payments that will thereafter grow at a rate of 3.4 per cent annually. If you use a 9 per cent discount rate for investment products, what is the present value of this growing perpetuity?
Solution:
Cash flow at t = 1 = CF1 = $20000 Annual growth rate = g = 3.4% Discount rate = i = 9% Present value of growing perpetuity = PVA∞
6$357,142.8
)034.009.0(
20000
)(1
gi
CFPVA
**QP6.26 Present value of an annuity due: Sharon Kabana has won a lottery and will receive a
payment of $89729.45 every year, starting today for the next 20 years (assume the final payment occurs at the beginning of Year 20). If she invests the proceeds at a rate of 7.25 per cent, what is the present value of the cash flows that she will receive?
Solution:
0 7.25% 1 2 3 19 20 ├───────┼────────┼───────┼………………┼───────┤
CF = $89729.45 at the beginning of each year
Annual payment = CF = $89729.45 Type of annuity = Annuity due No. of payments = n = 20 Required rate of return = 7.25% Present value of investment = PVA20
20
11 (1 )
(1 )
89729.45 11 (1.0725)
0.0725 (1.0725)
n
CFPVofAnnuityDue i
i i
$999,999.95 $1,000,000
9
**QP6.30 Effective annual rate: You are considering three alternative investments: (1) a 3‐year bank term deposit paying 7.5 per cent interest compounded quarterly; (2) a 3‐year bank term deposit paying 7.3 per cent interest compounded monthly; and (3) a 3‐year bank term deposit paying 7.75 per cent interest compounded annually. Which investment has the highest effective annual rate?
Solution: (1) Interest rate on term deposit = i = 7.5%
Frequency of compounding = m = 4 Effective annual rate = EAR
%71.710771.1
14
075.011
m1
4
mi
EAR
(2) Interest rate on term deposit = i = 7.3%
Frequency of compounding = m = 12 Effective annual rate = EAR
%55.710755.1
112
073.011
m1
12
mi
EAR
(3) Interest rate on term deposit = i = 7.75%
Frequency of compounding = m = 1 Effective annual rate = EAR
%75.710775.1
11
0775.011
m1
1
mi
EAR
The three‐year bank term deposit paying 7.75 per cent interest compounded annually has the highest effective yield.
CQ5.7 If you were given a choice of investing in an account that paid quarterly interest and one that paid
monthly interest, which one should you choose and why?
Because this is an investment decision, NOT borrowing decision, one should pick the account that pays interest more frequently (as long as the interest rates are the same). This allows for the interest earned in the earlier periods to earn interest and the investment to grow more.