Fundamentals of Finance - ABC Friendly Finance Company - Assignment Example

Fundamentals of Finance Customer’s Name Grade Course Tutor’s Name (May 10, 2012) Outline I. Question 1 (a)- (c) II. Question 2 (a)- (c) III. Question 3 (a)- (d) IV. Question 4 (a)- (d) V. Question 5 Question 1 The aim of this question is to weigh through three options and decide the best form of investment. The three borrowing options offer different rates. The interest rates are nominal meaning that they have not been adjusted to inflation. The effective rate is used in this case since it is more realistic. The interest rates have been compounded. Compounding means that they change with time. This can be daily, monthly, quarterly or annually. The funding that is needed is $1,000,000 and is required for 5 years. The best option is that which gives rise to the least amount payable at the end of the loan. Option 1: ABC Friendly Finance Company The nominal rate is 10.50% per annum which is compounded daily. ABC Friendly Finance Company effective annual rate of interest: = (1+0.1050/365)^365-1=1.000287671^365-1 =1.110693838-1= 0.110693837 =11.07% Amount payable after 5 years= P (1+r/n) nt =$1,000,000 (1+ 0.1107/365) 365*5 =$1,000,000*(1.0003032881825) =$1,739,184.07 Option 2: DEF Commercial Bank Ltd The nominal rate is 10.55% per annum which is compounding quarterly. DEF Commercial Bank Ltd effective annual rate of interest: =(1+0.1055/4)^4-1=1.026375^4-1 =1.109747718-1=0.109747717 =10.97% Amount payable after 5 years: =$1,000,000 (1+ 0.1097/4) 4*5 =$1,000,000*(1.02742520) =$1,717,918.60 Option 3: SHARKIES Cheap Loans Ltd The rate used in this option is 9.50% per year (simple interest). This has been converted to 4.75% per every half year. Therefore, the installments are made in equal ‘six monthly installments’ over the term of the loan. SHARKIES Cheap Loans Ltd effective annual rate of interest: =2*Annual no. of payments*Interest/ (Total no. of payments+1)*Principal =2*2*(95,000*5)/ (2*5+1)*1,000,000= 1,900,000/ (11*1,000,000) =0.1727=17.27% Amount payable after 1 year=$1,000,000 + (1,000,000*0.1727/2*1) = 1,000,000+86,350 =$1,086,350 Amount payable after 2 years=$1,086,350+86,350=$1,172,700 Amount payable after 3 years=$1,172,700+86,350=$1,259,050 Amount payable after 4 years=$1,259,050+86,350=$1,345,400 Amount payable after 5 years=$1,345,400+86,350=$1,431,750 The best source of finance would be from SHARKIES Cheap Loans Ltd. This is because the amount of loan payable after 5 years would be $1,431,750 which is much less as compared to other sources. For instance, the amount of loan payable when using ABC Friendly Finance Company would be $1,739,184.07 while the amount payable when using DEF Commercial Bank Ltd would be $1,717,918.60. This leaves SHARKIES Cheap Loans Ltd as the cheapest and the best source of financing. b) The effective rate of interest per annum would definitely change if Sharkies Cheap Loan Ltd charged an application fee of $1000 payable on day zero of the loan. This is because fees such as application fees reduce the amount of loan borrowed. Consequently, the rate of interest is expected to increase as the denominator (amount borrowed) reduces. Loan principal=$1,000,000 Interest rate=9.50% Application Fee=$1,000 Effective amount borrowed= $1,000,000-$1,000=$999,000 Interest paid= 0.095*1,000,000=$95,000 Effective Interest rate= Interest paid/ Effective amount borrowed =$95,000/$999,000=0.09509 =9.51% The effective rate of interest when the client is charged the application fee is slightly higher than when there are no application fees. The change is only slight because the application fee was a mere $1,000 which had little effect on the total amount borrowed. (c) As discussed earlier, nominal interest rate does not take in to account economic factors like the inflation rates. If inflation rate is accounted in calculation of interest rate, then real interest rate is realized. Real interest rate= Nominal interest rate-Inflation rate ABC Friendly Finance Company nominal interest rate=10.50% Current inflation rate=3.00% Real interest rate=10.50%-3.00%=7.50% Next year’s nominal rate of interest: Nominal interest rate is expected to increase if inflation is factored in. Both the real interest rate and the expected interest rate are used in this case to know the future changes in the nominal interest rate. =Nominal interest rate= (1+real interest rate) (1+expected inflation rate)-1 = (1+0.075) (1+0.035)-1 = (1.075*1.035)-1=0.1126 = 11.26% Question 2 After obtaining a loan, it becomes necessary to know the effects that the loan will have on the cash flows of a business. In this case, the loan is repaid monthly and the interest rate is also compounded monthly. The interest rate is variable meaning that it is changing after some time i.e. monthly. Of importance is that the loan will be repaid using both interest and principal. Life of loan: 10 years Repayments: Monthly Amount of loan: $10 million Type of interest rate agreement: Variable interest rate Interest rate charged: 12% per annum compounding monthly The loan is to be refunded wholly by the maturity date through month by month installments consisting of both interest and principal. (a) Calculation of the monthly repayment amount. Monthly repayment amount= P (1+r/12) n Loan amount (P) = 10,000,000 R=12% r=12/1200=0.01% Monthly repayment amount= 10,000,000 (1+0.01)12 =$11,268,250.30 (b) Calculation of the amount outstanding in the loan at the time of just having made the 40th repayment. After making 40 installment payments, around three and a third years will have elapsed. This is because every year, 12 installment payments are made. The total number of installments is supposed to be 120. 40th repayment= 10,000,000 (1+0.01)40 =10,000,000*1.488863734 =$14,888,637.34 Total payment=10,000,000 (1+0.01)12*10 =10,000,000*3.300386895 =$33,003,868.95 Amount outstanding after the 40th repayment=$33,003,868.95-$14,888,637.34 =18,115,231.61 The amount outstanding is the difference between the amount paid after 120 installments and the amount paid after 40 installments. (c) Calculation of the new monthly repayment amount. This is given the fact that the interest charged by the bank increased (after the 40th repayment) to 15% per annum compounding monthly. After increased interest rate, the amount payable is expected to rise. New monthly repayment amount= P (1+r/12) n Loan amount (P) = 10,000,000 R=15% r=15/1200=0.0125% New monthly repayment amount= 10,000,000 (1+0.0125)12 =$11,607,545.18 Question 3 This question aims at assessing both the present value and future value of retirement amount. The method used is excel’s PV and FV formulae. (a) Calculation of the present value of the $600,000 at two different times in life: At the time of your 19th birthday: The present value is expected to be negative given that there are many years back from the time of retirement. Additionally, there are no monthly or annual contributions that can make the present value to be a positive figure. Investment rate=5% Future value=$600,000 Period (n)= 60-19=41 years Present value: -81,168.96 Investment rate 5% Future value $600,000 Period(n) 41 Present value ($81,168.96) At the time of your 23rd birthday: Investment rate=5% Future value=$600,000 Period (n)= 60-23=37 years Present value: -98,661.38 Investment rate 5% Future value $600,000 Period(n) 37 Present value ($98,661.38) b) Calculation of the yearly amount of the annuity (i.e. the amount that you will need to save from your employment salary per annum) to achieve the target of $600,000. Target amount=$600,000 Interest=5% N= 37 years Regular payment= Target amount [i/(1+i)n-1] =600,000 [0.05/5.0814] Regular yearly payments= $5,903.88 (c) How the answer in (b) above would change if the ‘real’ investment rate declines to 4.5% per annum. With decrease in interest rate, the annual contribution amount would increase. Target amount=$600,000 Interest=4.5% N= 37 years New regular payment= Target amount [i/(1+i)n-1] =600,000 [0.045/4.0969] New regular yearly payments= $6,590.35 (d) The amount of money you would have by the time you retire if you were able to save an extra 10% per annum to contribute. After saving an additional 10% of the regular $5,903.88, the future value of retirement amount will increase. Previous regular yearly payment $5,903.88 Current regular yearly payment $ -6,494.27 Investment rate 5% Period(n) 37 Future value $660,000 The money available after the 10% increase in monthly payments would be $660,000. This would exceed the previous target by $60,000. Question 4 The aim of this question is to assess the merits and demerits of international stock trading. This has been done by comparing the Australian stocks and two other international stock traders in the year 2008. After comparing the stock performances, the next step is to advise the Australian investors if it was worth investing their funds internationally. This is considering the fact that DIP used DIP#2 Fund to trade internationally with investors’ money. The investors are interested in knowing the viability of this venture. As a graduate trainee, I formulated a short memo that can be used to respond to clients who are upset. The memo has addressed the needs of the investors using 2008 data obtained from Australia’s ALL ORDINARIES, Dow Jones’s and Walt Disney’s stocks. The comparisons have been used to come up with the necessary conclusions. DIP funds manager Memo To: Esteemed Clients From: DIP funds management department CC: Management Board Date: 5/7/2018 Re: Impact of DIP#2 Fund’s International Diversification Following the comparison between Australian, Dow Jones and Walt Disney’s stock players, in 2008 it was found out that: The stock prices were internationally declining. Even though Dow Jones’ stocks prices were above Australia’s stocks prices in 2008, the former’s prices were also declining tremendously. Walt Disney’s stocks were actually performing worse than Australia’s. This is evidence that it was not economically viable or beneficial to invest in international stock markets. Therefore, the investors would have benefitted from solely investing in the Australian stock market in 2008 instead of investing in the DIP#2 Fund. This information can be supported by the three tables below. Additionally, it is worth noting that there are various major risk factors that affect global investments. For example, the rates of inflation can be different as compared to local inflation rates. This can affect the performance of stocks. Especially, during 2008, businesses were experiencing recession and therefore this could affect foreign investments. Additionally, there is the issue of varying interest rates. The interest rates offered by financial institutions in difference stock markets can be differing. If for instance the monetary systems do not regulate these interest rates, then the return on investments is likely to reduce. This could have affected the DIP#2 Fund performance. Take in to consideration that Reserve Bank of Australia already controls Australia’s interest and inflation rates. It is therefore necessary to take in to consideration these risk factors when opting for international stock trading. Regards Graduate Trainee DIP#2 Fund Management Department. Australian ALL ORDINARIES (^AORD) from 1/01/2008 to 31/12/2012 (“Yahoo Finance: Home” p. 1) Date Open High Low Close Volume Adj Close 12/1/2008 3669.8 3670.3 3418.7 3659.3 894190400 3659.3 11/3/2008 4003 4291.9 3201.5 3672.7 1087322500 3672.7 10/1/2008 4662.4 4843.5 3693.9 3982.7 1069965500 3982.7 9/1/2008 5209.2 5250.4 4569.1 4631.3 1145805600 4631.3 8/1/2008 5047.4 5235.8 4829.2 5215.5 969534100 5215.5 7/1/2008 5345.8 5351.4 4880 5052.6 976375200 5052.6 6/2/2008 5774 5800.5 5266.3 5332.9 1240949600 5332.9 5/1/2008 5654.2 6059.5 5605.1 5773.9 1037963300 5773.9 4/1/2008 5416.1 5735.8 5359.3 5657 858413300 5657 3/3/2008 5639.3 5640 5130.1 5409.7 1173195900 5409.7 2/1/2008 5717.2 6057.8 5577.3 5674.7 967358000 5674.7 1/2/2008 6418.6 6462.8 5222 5697 1031051200 5697 Dow Jones Industrial Average (^DJI) from 1/01/2008 to 31/12/2012 (“Yahoo Finance: Home” p. 2) Prices             Date Open High Low Close Avg Vol Adj Close* 1-Dec-08 8,826.89 9,151.61 8,072.47 8,629.68 6,609,161,000 8,629.68 3-Nov-08 9,326.04 9,711.46 7,392.27 8,829.04 6,231,635,200 8,829.04 1-Oct-08 10,847.40 11,022.06 7,773.71 9,325.01 7,290,610,800 9,325.01 2-Sep-08 11,545.63 11,831.29 10,266.76 10,850.66 7,009,506,600 10,850.66 1-Aug-08 11,379.89 11,933.55 11,144.59 11,543.55 4,264,482,300 11,543.55 1-Jul-08 11,344.64 11,820.21 10,731.96 11,378.02 5,923,937,200 11,378.02 2-Jun-08 12,637.67 12,652.81 11,226.34 11,350.01 4,840,303,300 11,350.01 1-May-08 12,818.34 13,191.49 12,397.56 12,638.32 4,039,814,700 12,638.32 1-Apr-08 12,266.64 13,052.91 12,208.42 12,820.13 4,113,069,000 12,820.13 3-Mar-08 12,264.36 12,687.61 11,650.44 12,262.89 4,868,908,000 12,262.89 1-Feb-08 12,638.17 12,841.88 12,006.79 12,266.39 4,148,143,000 12,266.39 2-Jan-08 13,261.82 13,338.23 11,508.74 12,650.36 4,925,982,300 12,650.36 Walt Disney Co. (DIS) from 1/01/2008 to 31/12/2012 (“Yahoo Finance: Home” p. 3) Prices             Date Open High Low Close Avg Vol Adj Close* 1-Dec-08 22.04 26.1 20.27 22.69 15,933,400 21.82 3-Nov-08 25.85 26.24 18.6 22.52 20,977,500 21.34 1-Oct-08 30.3 31.06 21.25 25.91 20,856,800 24.55 2-Sep-08 32.74 34.85 29.25 30.69 16,750,600 29.08 1-Aug-08 30.5 33.42 29.83 32.35 11,775,900 30.65 1-Jul-08 30.91 31.77 28.55 30.35 16,934,600 28.76 2-Jun-08 33.5 34.71 31.14 31.2 15,235,300 29.56 1-May-08 32.45 35.02 32.42 33.6 13,253,500 31.84 1-Apr-08 31.52 33.03 29.57 32.43 12,125,400 30.73 3-Mar-08 32.61 32.71 30.05 31.38 11,974,000 29.73 1-Feb-08 30.75 33.23 30.05 32.41 14,379,500 30.71 2-Jan-08 32.32 32.63 26.3 29.84 15,555,100 28.27 (b) The data provided below is to be used to assess if it is viable to invest in two assets that are positively correlated. It is worth noting that such a correlation is risky given that such assets will be rising and falling in value at the same time Asset A Asset B Return 15% 24% Standard Deviation 12% 19% The assumption in this question is that: The correlation coefficient between Asset A and Asset B is 0.8 and investors will split their monies equally between the two assets. According to Portfolio theory combining assets with negative correlation is less risky. This can be seen in the standard deviation figure of 6.10% shown below. However, the assets at hand are highly positively correlated meaning that the return on them rises and falls together. This way, it is not likely to completely eradicate risk. The only benefit is when there are positive returns. The investor will be in a position to reap double benefits from increased returns because positive coefficient means the two assets perform the same. Variance= WA2 σA2 + WB2 σB2 + 2 WA WB r A,B σA σB = (0.152x 122) + (0.242x 192) + (2* 0.15*0.24*0.8*12*19) =3.24+ 20.7936+ 13.1328=37.1664 Variance =37.17 Standard deviation=√37.17=6.10% c) In order to reduce risk assets with negative correlation should be combined. Therefore, when one asset falls in value the other one is expected to rise. The aim of this question is to obtain a combination of the two assets that would give rise to a -1 correlation coefficient. The best weight of Asset A and Asset B are to be obtained such that investors would incur no risk i.e. a zero standard deviation. Correlation coefficient= -1 Zero Standard Deviation can be obtained if: (1- WB) σA - WB σB=0 σA -WB (σA+ σB)=0 WB= σA/(σA+ σB) σA =0.12 σB=0.19 WB=0.12/ (0.12+0.19) =0.12/0.31 WB=0.39=39% WA=61% For there to be no risk, the best weight combination of the two asset returns would be 39% for asset B and 61% for asset A. (d) The major risk exposures of a global investment fund: As required in the instructions, the answer to this question is in the last paragraph of the attached memo. The factors discussed are inflation and interest rates. Question 5 Systemic stability: This question explains some of the main activities undertaken by the Reserve Bank of Australia (RBA) to ensure systemic stability in Australia. It explains this by use of two major policy techniques. These are the monetary policy and the payments system. The stability of a system is the responsiveness of the system to inputs and or instabilities. A system can be financial, economic and political among others. A system with the ability to be constant despite external factors and which returns to its original state when the external factors are removed can be said to be stable. A system is stable if every input used produces an output. As a financial institution, Reserve Bank of Australia (RBA) can ensure that cases of systematic instability do not occur. According to Wallis Inquiry, some of the roles that Reserve Bank of Australia is supposed to play in ensuring systematic stability are: controlling the fiscal policy and the payments system (“Reserve Bank of Australia: Monetary Policy” par. 1). Monetary stability entails establishment of interest rates upon overnight loans which are issued in the money market. This is also known as cash rate. Due to this cash rate, the other rates of interests in the economy are affected therefore influencing borrower and lender habits. The other economic areas that are affected are the economic activities and inflation rates (“Reserve Bank of Australia: Monetary Policy” par. 1). The other method that RBA uses to maintain monetary policy is through price stability, employment and ensuring of economic prosperity and wellbeing of Australian citizens. In order to attain these goals, the bank has an inflation target which aims at maintain the inflation rate of consumer prices at an average of 2 to 3 per cent. This way, long term strength of the currency and prolonged growth of the economy can be realized (“Reserve Bank of Australia: Monetary Policy” par. 2). An efficient payments system is also necessary in supporting daily economic operations of the Australian economy. RBA has a Payments System Board which ensures efficiency in the payments system and strength of the financial scheme. RBA is responsible for controlling the operations in of the payments system such as cheques and payment cards (“Reserve Bank of Australia: Monetary Policy” par. 3). Additionally, it oversees the smooth movement of money from a given financial institution’s accounts to another. RBA regulates clearing and settlement of operations in the financial sector. The operational roles of the bank in the payments system are to own and manage the bank’s information and Transfer System (RITS) (“Reserve Bank of Australia: Monetary Policy” par. 4). Works Cited Reserve Bank of Australia: Monetary Policy 2012. Web. 20 May. . Yahoo Finance: Home 2012. Web. 20 May. . Read More