FINM7006 – Semester 2 2021 Mid-Semester Exam Solutions Note: each question has three versions, randomly chosen through Wattle for each student. Question 1 (6 marks) VERSION A This question contains multiple parts. Students should attempt ALL parts of the question. a) Do coupon paying government bonds maturing in 2030 trade in the money market or the capital market? Provide a reason for your answer (2 marks) Capital market Because the bonds mature in over one year (both now and at the time of issue) b) Your friend is about to go on a posting to a foreign country for five years. Her employer has agreed to pay her a $10,000 incentive payment to do so, which she can elect to receive now or in five years’ time on her return to Australia. She has decided to receive the $10,000 in five years, to prevent her spending it on unnecessary purchases while she is away. Do you agree with her decision? Give reasons for your answer in the context of the time value of money. (2 marks) No This is because $10,000 today is worth more than $10,000 in five years. If she receives it today she can invest it over the five years to produce a return/interest, so it can grow to more than $10,000 five years from now. c) Jane works in the financial services industry. She has an active social media presence, and for the past year she has been posting short investment recommendations to her Instagram stories such as “Buy Tesla, it will only go up”. Last month, new regulations came out that prohibit this type of financial advice from being posted on social media platforms without proper disclaimers. However, Jane decides not to change the style of her posts, as she doesn’t like the look of disclaimers and had already been making similar posts prior to the new regulations. She reasons that the stories disappear after a day so she probably won’t get caught anyway. Which one of the four parts of CFA Standards of Practice Standard I: Professionalism does Jane’s behaviour most violate? Explain why in your own words and with specific reference to Jane’s situation. (2 marks) Knowledge of the Law Jane needs to comply with all applicable regulations, from the time they are introduced. By continuing to post stories without disclaimers, she is knowingly violating this regulation. The likelihood of getting caught is irrelevant. VERSION B This question contains multiple parts. Students should attempt ALL parts of the question. a) Do company bank accepted bills issued in July 2021 and maturing in December 2021 trade in the money market or the capital market? Provide a reason for your answer (2 marks) Money market Because the bonds mature in less than one year (both now and at the time of issue) b) Your friend is about to go on a posting to a foreign country for five years. Her employer has agreed to pay her a $10,000 incentive payment to do so, which she can elect to receive now or in five years’ time on her return to Australia. She has decided to receive the $10,000 now, as she is excited by the prospect of receiving so much money and doesn’t want to wait! However, she is worried that this might not be a financially sound decision. Do you agree with her decision to receive the money now? Give reasons for your answer in the context of the time value of money. (2 marks) Yes This is because $10,000 today is worth more than $10,000 in five years. If she receives it today she can invest it over the five years to produce a return/interest, so it can grow to more than $10,000 five years from now. c) Jack is working as an investment analyst, and has been asked to perform an updated valuation analysis on a bank called M4U Ltd. His company has been covering M4U for years, and has always allocated it a positive “buy” rating, claiming it to be undervalued. Jack has uncovered some practices that he believes may result in M4U being subject to lawsuits and suspects that M4U should be downgraded to a “sell” rating. However, M4U regularly takes employees of Jack’s firm (including Jack) on expensive wine tasting weekends, and Jack believes these weekends will stop if he produces an honest report. He therefore decides to maintain the “buy” rating on the stock and keep his views to himself. Which one of the four parts of CFA Standards of Practice Standard I: Professionalism does Jack’s behaviour most violate? Explain why in your own words and with specific reference to Jack’s situation. (2 marks) Independence and Objectivity Jack should not have accepted benefits through the wine tasting weekends, or maintained the buy recommendation for fear of these weekends stopping. The weekends can be seen as reasonably compromising independence and objectivity (and clearly has in this case!) VERSION C This question contains multiple parts. Students should attempt ALL parts of the question. a) Do preference shares trade in the money market or the capital market? Provide a reason for your answer (2 marks) Capital market Because when equities (ordinary or preference shares) are issued they are assumed to last forever, and therefore have lives of over 1 year b) Your friend is about to go on a posting to a foreign country for five years. He owes the tax office $10,000, however he can choose whether to pay this amount now or in five years’ time on his return to Australia. He has decided to pay it now, in order to get it over with rather than have it hanging over his head for the next five years. Do you agree with his decision? Give reasons for your answer in the context of the time value of money. (2 marks) No This is because if he pays it now he will have to come up with the full $10,000 amount. Whereas if he pays it in 5 years, he could invest less than $10,000 now and let it grow through receiving a return/interest to $10,000 in 5 years, costing him less overall (alternatively, could argue that he would do better investing the $10,000 now, paying the tax office $10,000 in 5 years and keeping the return/interest earnt on the $10,000 over the 5 years.) c) Jill is a journalist with a popular investment blog, in which she profiles stocks she believes will produce strong returns over the next five years. She claims on her blog to have a Masters of Finance from the ANU. However, she never completed her final course in the Masters program, and therefore did not actually graduate. Jill reasons that she received High Distinctions in the other 15 of the 16 courses of the Masters program, and the course she didn’t complete was only an elective, so shouldn’t really matter. She therefore continues to market herself as having received the Masters degree. Which one of the four parts of CFA Standards of Practice Standard I: Professionalism does Jill’s behaviour most violate? Explain why in your own words and with specific reference to Jill’s situation. (2 marks) Misrepresentation By claiming to have a Masters degree that she does not actually have, Jill is misrepresenting her professional qualifications. Her readers may be relying on her advice in part because of her supposed Masters qualification. Question 2 (6 marks) VERSION A This question contains multiple parts. Students should attempt ALL parts of the question. It is the first of January, and Ryan and Laura have just had a baby girl, who they name Bryony. They have decided to put money into a bank account at periodic intervals until Bryony turns 18, in order to assist with her cost of living in adulthood. Ryan will deposit $2000 at the end of each quarter. Ryan will also put in a lump sum amount of $10,000 when he opens the account today. Laura will deposit $7,500 into the account on each of Bryony’s birthdays starting with the day she turns 2 years old. a) If both Ryan and Laura make their last deposits on Bryony’s 18th birthday, and assuming the interest rate is fixed at 3% p.a. compounded semi-annually, how much will be available immediately after their last deposits? Hint: it may help to focus on Ryan and Laura’s cash flow streams separately and then combine their values. (4.5 marks) (i) Future value of Ryan’s deposits Time 0 single CF ($10,000), plus an 18 year quarterly ordinary annuity ($2,000) n = 18*4 = 72 r? convert annual nominal rate to quarterly periodic rate via 2 step process: = �1 + � − 1 = �1 + 0.032 �2 − 1 = 0.030225 . . = (1 + )1 − 1 = (1.030225)14 − 1 = 0.00747208398 18 = 10000(1.00747208398)72 + 2000 �(1.00747208398)72 − 10.00747208398 �= $206901.7722 (ii) Future value of Laura’s deposits annual ordinary annuity ($7,500) from 2 to 18 years old n = 18-1 = 17 (one less deposit than an ordinary annuity starting today, as skips the payment on first birthday) r? re = 0.030225 (annual annuity, so use annual effective rate calculated above) 18 = 7500 �(1.030225)17 − 10.030225 � = $163522.6731 (iii) Total: (i) + (ii) = $206901.7722 + $163522.6731 = $370424.45 b) Ryan and Laura are worried that Bryony will not invest the money wisely if she receives the full amount at once. They would therefore like to arrange the money in the bank at the end of part (a) to be paid as an annual perpetuity due, with the first sum being paid at the end of the day she turns 18. If the interest rate for the perpetuity is an annual effective rate of 3% p.a., how much would Bryony receive each year from this arrangement? (1.5 marks) Present value of perpetuity due: solve for F = + → $370424.45 = + 0.03 → 370424.450.03 = 1.03 = 11112.73351.03 = $10789.06 VERSION B This question contains multiple parts. Students should attempt ALL parts of the question. It is the first of January, and Ryan and Laura have just had a baby girl, who they name Bryony. They have decided to put money into a bank account at periodic intervals until Bryony turns 21, in order to assist with her cost of living in adulthood. Ryan will deposit $6000 at the end of each semi-annum, starting with the first $6,000 payment to be made two years from today. Ryan will also put in a lump sum amount of $15,000 when he opens the account today. Laura will deposit $500 at the end of each month, with the first payment to be made one month from today. a) If both Ryan and Laura make their last deposits on Bryony’s 21st birthday, and assuming the interest rate is fixed at 5% p.a. compounded quarterly, how much will be available immediately after their last deposits? Hint: it may help to focus on Ryan and Laura’s cash flow streams separately and then combine their values. (4.5 marks) (i) Future value of Ryan’s deposits Time 0 single CF ($15,000), plus 6-mth ordinary annuity ($6,000) from 2-21 years n = (21*2 semi-annums)-3 = 39 (i.e. he misses the payments at 6 months, 1 year and 1.5 years compared to if ordinary annuity started today) r? convert annual nominal rate to semi-annual periodic rate via 2 step process: = �1 + � − 1 = �1 + 0.054 �4 − 1 = 0.05094533691 .. = (1 + )1 − 1 = (1.05094533691)12 − 1 = 0.02515625 6 ℎ 21 = 15000(1.02515625)(221=42) + 6000 �(1.02515625)39 − 10.02515625 �= $432595.5456 (ii) Future value of Laura’s deposits monthly ordinary annuity ($500) n = 21*12 = 252 r? convert re calculated previously to monthly rp = (1 + )1 − 1 = (1.05094533691) 112 − 1 = 0.00414942512 ℎ 21 = 500 �(1.00414942512)252 − 10.00414942512 � = $221610.5781 (iii) Total: (i) + (ii) = $432595.5456 + $221610.5781= $654206.12 b) Ryan and Laura are worried that Bryony will not invest the money wisely if she receives the full amount at once. They would therefore like to arrange the money in the bank at the end of part (a) to be paid as an annual perpetuity due, with the first sum being paid at the end of the day she turns 21. If the interest rate for the perpetuity is an annual effective rate of 4% p.a., how much would Bryony receive each year from this arrangement? (1.5 marks) Present value of perpetuity due: solve for F = + → $654206.12 = + 0.04 → 654206.120.04 = 1.04 = 26168.2448/1.04 = $25161.77 VERSION C This question contains multiple parts. Students should attempt ALL parts of the question. It is the first of January, and Ryan and Laura have just had a baby girl, who they name Bryony. They have decided to put money into a bank account at periodic intervals until Bryony turns 20, in order to assist with her cost of living in adulthood. Laura will deposit $2500 at the end of each quarter, with the first regular deposit to be made one quarter from today. Laura will also put in a lump sum amount of $12,000 when she opens the account today. Ryan will deposit $10,000 on each of Bryony's birthdays from her second birthday onwards. a) If both Ryan and Laura make their last deposits on Bryony’s 20th birthday, and assuming the interest rate is fixed at 4% p.a. compounded monthly, how much will be available immediately after their last deposits? Hint: it may help to focus on Ryan and Laura’s cash flow streams separately and then combine their values. (4.5 marks) (i) Future value of Laura’s deposits Time 0 single CF ($12,000), plus a 20 year quarterly ordinary annuity ($2,500) n = 20*4 = 80 r? convert annual nominal rate to quarterly periodic rate via 2 step process: = �1 + � − 1 = �1 + 0.0412 �12 − 1 = 0.04074154292 .. = (1 + )1 − 1 = (1.04074154292)14 − 1 = 0.01003337037 20 = 12000(1.01003337037)80 + 2500 �(1.01003337037)80 − 10.01003337037 �= $331299.9486 (ii) Future value of Ryan’s deposits annual ordinary annuity ($10,000) from 2 to 20 years old n = 20-1 = 19 (one less deposit than an ordinary annuity starting today, as skips the payment on first birthday) r? re = 0.04074154292 (annual annuity, so use annual effective rate as above) 20 = 10000 �(1.04074154292)19 − 10.04074154292 � = $278726.6674 (iii) Total: (i) + (ii) = $331299.9486 + $278726.6674 = $610026.62 b) Ryan and Laura are worried that Bryony will not invest the money wisely if she receives the full amount at once. They would therefore like to arrange the money in the bank at the end of part (a) to be paid as a monthly perpetuity due, with the first sum being paid at the end of the day she turns 20. If the interest rate for the perpetuity is a monthly periodic rate of 0.25%, how much would Bryony receive each month from this arrangement? (1.5 marks) Present value of perpetuity due: solve for F = + → $610026.62 = + 0.04 → 610026.620.0025 = 1.0025 = 1525.06654/1.0025 = $1521.26 Question 3 (6 marks) VERSION A This question contains multiple parts. Students should attempt ALL parts of the question. a) Headnovel Ltd is a social media company that has not paid dividends for many years, as it has been pursuing a highly profitable takeover strategy. However, the company has now reached a more mature stage of operations, and is planning to reintroduce dividends gradually over the coming years. The company plans to pay its next dividend of $3 per share three years from today. A second dividend of $3.50 per share is planned for five years from today, with subsequent dividends paid annually and growing at a constant rate of 2% p.a. If the required rate of return on its shares is 9% p.a., what is the value of one share in Headnovel Ltd today? (2 marks) = 3(1 + )3 + 5( − )(1 + )4 = 3(1.09)3 + 3.50(0.09 − 0.02)(1.09)4 = $37.74 b) If shares in Headnovel Ltd are currently trading for $30 per share in the stock market, based on your answer in Part (a) should you buy or sell shares in Headnovel Ltd? Provide a reason for your answer. (1 mark) Buy As you can buy them for less ($30) than you believe they are worth ($37.74) c) Helen has decided to purchase shares in Pluto Inc, a high growth technology company who has not yet paid any dividends as it is channelling all retained earnings into profitable projects. However, she needs to choose between purchasing ordinary shares or preference shares in Pluto Inc. Helen is highly risk averse and would like regular cash flows from her investment to fund her interior decorating. Making reference to Helen’s specific situation, do you recommend that she purchase ordinary or preference shares in Pluto and why? Are there any disadvantages of your recommended choice that Helen should be aware of? (3 marks) Preference shares Helen has a preference for regular cash flows: preference shares pay fixed dividends whereas ordinary dividends are variable Helen is highly risk averse: preference shares rank above ordinary shares both in the payment of dividends from retained earnings and in the event of liquidation Disadvantage? Preference shares do not have voting rights attached to them VERSION B This question contains multiple parts. Students should attempt ALL parts of the question. a) Headnovel Ltd is a social media company that has not paid dividends for many years, as it has been pursuing a highly profitable takeover strategy. However, the company has now reached a more mature stage of operations, and is planning to reintroduce dividends gradually over the coming years. The company plans to pay its next dividend of $3.50 per share four years from today. A second dividend of $4 per share is planned for seven years from today, with subsequent dividends paid annually and growing at a constant rate of 3% p.a. If the required rate of return on its shares is 8% p.a., what is the value of one share in Headnovel Ltd today? (2 marks) = 4(1 + )4 + 7( − )(1 + )6 = 3.50(1.08)4 + 4(0.08 − 0.03)(1.08)6 = $52.99 b) If shares in Headnovel Ltd are currently trading for $60 per share in the stock market, based on your answer in Part (a) should you buy or sell shares in Headnovel Ltd? Provide a reason for your answer. (1 mark) Sell As you can sell them for more ($60) than you believe they are worth ($52.99) c) Anna has decided to purchase shares in Saturn Inc, a retail company that is expected to generate sizable earnings over the long term. However, she needs to choose between purchasing ordinary shares or preference shares in Saturn Inc. Anna is particularly excited by the possibility of receiving large dividends and/or capital gains in the future, and voting on decisions at Saturn’s annual general meetings. Making reference to Anna’s specific situation, do you recommend that she purchase ordinary or preference shares in Saturn and why? Are there any disadvantages of your recommended choice that Anna should be aware of? (3 marks) Ordinary shares Anna is excited by the possibility of receiving large dividends and/or capital gains: ordinary shareholders are residual owners, so if Saturn’s earnings increase, the ordinary shareholders will receive the additional benefits through higher (variable) dividends and/or higher capital gains from selling their shares. Whereas preference shareholders still get their fixed dividends. Anna wants to vote on decisions at Saturn’s annual general meetings: ordinary shares carry voting rights, whereas preference shares do not Disadvantage? Ordinary shares rank after preference shares in receiving dividends and in the event of liquidation (risky: will be worse off if Saturn performs poorly in future) VERSION C This question contains multiple parts. Students should attempt ALL parts of the question. a) Headnovel Ltd is a social media company that has not paid dividends for many years, as it has been pursuing a highly profitable takeover strategy. However, the company has now reached a more mature stage of operations, and is planning to reintroduce dividends gradually over the coming years. The company plans to pay its next dividend of $2.50 per share one year from today. A second dividend of $5 per share is planned for four years from today, with subsequent dividends paid annually and growing at a constant rate of 4% p.a. If the required rate of return on its shares is 7% p.a., what is the value of one share in Headnovel Ltd today? (2 marks) = 1(1 + ) + 4( − )(1 + )3 = 2.50(1.07) + 5(0.07 − 0.04)(1.07)3 = $138.39 b) If shares in Headnovel Ltd are currently trading for $120 per share in the stock market, based on your answer in Part (a) should you buy or sell shares in Headnovel Ltd? Provide a reason for your answer. (1 mark) Buy As you can buy them for less ($120) than you believe they are worth ($138.39) c) Helen has decided to purchase shares in Pluto Inc, a high growth technology company who has not yet paid any dividends as it is channelling all retained earnings into profitable projects. However, she needs to choose between purchasing ordinary shares or preference shares in Pluto Inc. Helen is highly risk averse and would like regular cash flows from her investment to fund her interior decorating. Making reference to Helen’s specific situation, do you recommend that she purchase ordinary or preference shares in Pluto and why? Are there any disadvantages of your recommended choice that Helen should be aware of? (3 marks) Preference shares Helen has a preference for regular cash flows: preference shares pay fixed dividends whereas ordinary dividends are variable Helen is highly risk averse: preference shares rank above ordinary shares both in the payment of dividends from retained earnings and in the event of liquidation Disadvantage? Preference shares do not have voting rights attached to them Question 4 (7 marks) VERSION A This question contains multiple parts. Students should attempt ALL parts of the question. Some time ago, you invested in some coupon paying Treasury Bonds that mature at the end of December, 2030. The bonds have a face value of $1000 and pay semi-annual coupons at a rate of 6% p.a. a) It is now the end of September 2021 and you are considering selling your bonds to help fund the renovation of your home. If the yield is 4% p.a., what is the current price of one bond? (4 marks) Sep-21 Dec-21 Jun-22 Dec-22 … Dec-29 Jun-30 Dec-30 C C C C C C+F ? = # .. = 0.06 ∗ 10002 = $30 = # .. = 0.042 = 0.02 ( 6 ℎ) 1: (19 ) 21 = + �1−(1+)−(−1) � + (1+)(−1) = 30 + 30 �1−(1.02)−18 0.02 � + 1000(1.02)18 = $1179.920313 2: ℎ ( 3 ℎ 6) 21 = 21(1+) = 1179.920313(1.02)(36) = $1168.30 b) You decided not to sell your bonds in part (a), and have now moved forward in time to the end of June 2024, and a coupon has just been paid. If the bond yield is now 5%, what is the new price of one bond? (2 marks) = # .. = 0.052 = 0.025 ( 6 ℎ); 13 payments remaining 24 = �1−(1+)− � + (1+) = 30 �1−(1.025)−130.025 � + 1000(1.025)13 = $1054.92 c) Based on your answer to part (b), explain why the bond’s price at the end of June 2024 is either higher or lower than the bond’s face value. (1 mark) B > F Interest the lender receives is more than they require Therefore, the excess interest is given back to the borrower by lending more at the start than the face value repaid at maturity VERSION B This question contains multiple parts. Students should attempt ALL parts of the question. Some time ago, you invested in some coupon paying Treasury Bonds that mature at the end of December, 2030. The bonds have a face value of $2000 and pay semi-annual coupons at a rate of 4% p.a. a) It is now the end of April 2023 and you are considering selling your bonds to help fund the renovation of your home. If the yield is 6% p.a., what is the current price of one bond? (4 marks) Apr-23 Jun-23 Dec-23 Jun-24 … Dec-29 Jun-30 Dec-30 C C C C C C+F ? = # .. = 0.04 ∗ 20002 = $40 = # .. = 0.062 = 0.03 ( 6 ℎ) 1: (16 ) 23 = + �1−(1+)−(−1) � + (1+)(−1) = 40 + 40 �1−(1.03)−15 0.03 � + 2000(1.03)15 = $1801.241298 2: ℎ ( 2 ℎ 6) 23 = 23(1+) = 1801.241298(1.03)(26) = $1783.58 b) You decided not to sell your bonds in part (a), and have now moved forward further in time to the end of December 2024, and a coupon has just been paid. If the bond yield is now 7%, what is the new price of one bond? (2 marks) = # .. = 0.072 = 0.035 ( 6 ℎ); 12 payments remaining 24 = �1−(1+)− � + (1+) = 40 �1−(1.035)−120.035 � + 2000(1.035)12 = $1710.10 c) Based on your answer to part (b), explain why the bond’s price at the end of December 2024 is either higher or lower than the bond’s face value. (1 mark) B < F Interest the lender receives is less than they require to lend Therefore the additional interest will be paid by lending less at the start than the face value repaid at maturity (interest comes from (1) coupons and (2) F – B) VERSION C This question contains multiple parts. Students should attempt ALL parts of the question. Some time ago, you invested in some coupon paying Treasury Bonds that mature at the end of December, 2030. The bonds have a face value of $500 and pay semi-annual coupons at a rate of 2% p.a. a) It is now the end of June 2022 and a coupon has just been paid. You are considering selling your bonds to help fund the renovation of your home. If the yield is 4% p.a., what is the current price of one bond? (2 marks) ? = # .. = 0.02 ∗ 5002 = $5 → 17 = # .. = 0.042 = 0.02 ( 6 ℎ) 22 = �1−(1+)− � + (1+) = 5 �1−(1.02)−170.02 � + 500(1.02)17 = $428.54 b) You decided not to sell your bonds in part (a), and have now moved forward further in time to the end of February 2025. If the bond yield is now 1%, what is the new price of one bond? (4 marks) Feb-25 Jun-25 Dec-25 Jun-26 … Dec-29 Jun-30 Dec-30 C C C C C C+F = # .. = 0.012 = 0.005 ( 6 ℎ) 1: (12 ) 25 = + �1−(1+)−(−1) � + (1+)(−1) = 5 + 5 �1−(1.005)−11 0.005 � + 500(1.005)11 = $531.6925669 2: ℎ ( 4 ℎ 6) 25 = 25(1+) = 531.6925669(1.005)(46) = $529.93 c) Based on your answer to part (a), explain why the bond’s price at the end of June 2022 is either higher or lower than the bond’s face value. (1 mark) B < F Interest the lender receives is less than they require to lend Therefore the additional interest will be paid by lending less at the start than the face value repaid at maturity (interest comes from (1) coupons and (2) F – B)
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