Download MODEL ANSWERS TO FINANCIAL ECONOMICS (IOBM

MODEL ANSWERS TO FINANCIAL ECONOMICS (IOBM-AD301)
SECTION A
Question 1
(i)
Sinking fund
This is an annuity invested in order to meet a known
commitment at some future date.
Common uses f sinking fund include repayment of debt
or provision of funds to purchase a new asset when the
existing one is fully depreciated
(ii) Hedge
This is a financial strategy that offsets the risks from
one security (or other investment) by buying or selling
others .
A common example is the use of options and futures to
reduce the risks of holding a portfolio of investments
(iii) Yield curve/Term structure of interest rate
This is a graph that plots the yield of similar quality
bonds against their maturities, ranging from the
shortest to the longest
Is the relationship between the yield to maturity on the
one hand and on the other hand, the time to maturity
for pure discounted bonds
NORMAL YIELD CURVE
YIELD
5%
4%
3%
2%
1%
5
10
15
20
25
Time to maturity (in years),
(iv) Annuity
This is a series/stream of fixed, normally equal
payments equally spaced over a specific period of time/
Examples include regular deposits to a savings account
(standing order), monthly rentals, pension income,
mortgage payments etc
(v) Amortization
Is the process of decreasing or accounting for an
amount over a period of time.
It is the distribution of a single lump sum cash flow into
many smaller cash flows
Eg Assuming Nengezi negotiates a loan of K200,000
over 15 years at 10.5% per annum, the annual payment
necessary to amortize a debt is
P (i)
{1-[1/(1+i)n]}
200,000 (0.105)
{1-[1/(1+0.105)15]}
=27061
Question 2
a)
(i)
(ii)
an ordinary annuity and an annuity due.
An ordinary annuity is an annuity where payments
are required at the end of each period e.g. a
straight bond pays coupon payments at the end of
every 6 months until the bond’s maturity date. An
annuity due on the other hand, payments are
required at the beginning of each period. E.g
monthly rentals
systematic risk and unsystematic risk
systematic risk is the portion of risk of individual
security’s returns caused by factors affecting the
market as a whole (i.e. macro variables such as
interest rate, inflation etc) and cannot be avoided
by diversification. Unsystematic risk on the other
hand are diversifiable risks that are unique to a
particular firm (such as a firm going bankrupt or
staff going on strike) and can be reduced through
diversification
b)
Let N= 3,
I/Y=5%
PV=K1,000
FV
=
FV =
PV
(1 +I/Y)N
1000(1+5%)3=K1,157.60
Question 3
a)
To enhance strategic focus: a firm may divest/sell business
that are not part of its core business so that it can focus on
what it does best
To raise funding: by selling one of its businesses in
exchange for cash, divestitures help generate funds for a
firm.
Creation of stability: divesting a part of a firm can help
create stability especially where one division’s market is
becoming volatile
Compliance: a firm may divest as a result of want to
comply with an order/directive by the regulatory
authorities eg if the merge or existing set up goes against
competition and fair trading practices
Another motive for divesture is that a firm’s “break up”
value is sometimes believed to be greater than the value
of the firm as a whole. In other words, the sum of a firm’s
individual asset liquidation values exceeds the market
value of the firm’s combined firms to sell off what would
be worth more when liquidated than when retained.
(b)
PV
P
=
=
(c)
=
A/i
7000/0.2
K35,000
i
=
100 X
A/PV
i
=
100 X
3000/30000
I
=
0.10 i.e 10%
Question 4
(i)
capital structure policy
a firm has control over its capital structure. As more
debt is issued, the cost of debt increases and as more
equity is issued, the cost of equity increases. Both
these have the effect on dampening the profitability of
the organization
(ii) dividend policy
increasing a company’s dividend pay out ratio tends to
increase the break point between lower cost internally
generated equity and newly issued equity is lowered.
(iii) investment policy
it is assumed that when making investment decisions, a
company makes investments with similar degrees of
risk. If a company changes its investment policy to its
risk, both the cost of debt and cost of equity change
(iv) tax rates
tax rates affect the after tax cost of debt. As tax rates
increase, the cost of debt decreases, thereby
decreasing the cost of capital
SECTION B
Question 5
i)
an analysis of the role of savers
the loanable funds market is a hypothetical market that
brings together savers and borrowers, so that the
ii)
iii)
iv)
v)
excess funds (deposits by savers) are channeled to
productive investment by eligible borrowers
an analysis of how interest rates are determined
the level of interest rates is determined by the supply
and demand of loanable funds in the economy’s credit
market
investment and savings on the economy determine the
level of long term interest rates while short term
interest rates are determined by an economy’s financial
and monetary conditions
key components of the demand for lonable funds
net investments and net additions to liquid reserves
key components of the supply of loanable funds
net savings and increase in the money supply
how the central bank influences the level of interest rate
central bank influences the supply of loanable funds
from commercial banks and thereby changes the level
of interest rates. As central bank increases/decreases
the supply of credit available from commercial banks, it
decreases/increases the level of interest rates
Question 6
a) Which measure of central tendency (mean or median) best
represents the values of these 11 managerial salaries in the
Tanzanian banking sector? Justify your answer.
Mean = [100,000+5(175,000)+4(200000)+700,000]/11
=k225,000
Median = 100,000; 175,000;175,000;
175,000;175,000;175,000;200,000;200,000;200,000;200,000;700
,000
Median is k175,000 i.e. the middle (6th value) of the numbers
arranged in ascending order
b) The MEDIAN is the measure of central tendency that represents
the values of the salary for managers since the mean value has
only one salary higher than the mean
c) It would not be logical to conclude that the banking sector in TZ
will be able to attract the financial economist from Malawi with
her current salary of K800,000. The Malawi salary of K800,000
exceeds any of the salaries paid to TZ managers, meaning that
the mode, mean and median salary on TZ market is lower than
that of the Malawian Financial Economist is currently earning
Question 7
(a)
(b)
An Independent variable is an explanatory variable about
which knowledge is available and whose value is used
to predict or to have caused another variable. A
dependent variable on the other hand is a variable
whose value depends on and is explained by another
variable
5 scenarios where regression analysis can be applied
-To assess the interactive effects of 2 or more
independent variables with regard to a dependent
variable
-To determine the best mathematical model for
describing the relationship between a dependent and
one or more independent variables
-To determine which of the several independent
variables are important and which ones are not in
describing or predicting a dependent variable
-To obtain a quantitative formula or equation to
describe the dependent variable as a function of the
independent variable
-To characterize the relationship between dependent
and independent variables by determining the extent,
direction and strength of the relationship
c)
(i)
Y
=
a
+
bX
Y
=
10
+
5(40)
Y
=210 customers
(ii)
110
=
10
+
5(X)
5X
=
100
X
=
20 branches
Question 8
a) DESMO
economy
Probability Return
pi X ri
-
--
-
ri
ri- rJ
(ri- rJ)2
pi
ri
Slump
0.2
-5
-1
18
+23
105.8
Growth
0.6
+30
+18
18
12
86.4
boom
02
+5
+1
18
-13
33.8
18
Variance
Expected Return
226
Standard Deviation
15.03%
b) COSMO
economy
Probability Return
pi X ri
-
--
-
ri
ri- rJ
(ri- rJ)2
pi
ri
Slump
0.2
0
0
12
-12
28.8
Growth
0.6
+12
+7.2
12
0
0
boom
02
+24
+4.8
12
12
28.8
12
Variance
Expected Return
Standard Deviation
57.6
7.59%
Therefore
A) Expected return for DESMO is 18
B) Expected return for COSMO is12
C) Expected risk for DESMO is 15.03 %
D) Expected Risk for COSMO is 7.59
Note expected return can be either the VARIANCE or the
STANDARD DEVIATION, as along as the student is
consistent