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FIN222Tutorial1
1
st
HourMaterial

**CQ1.5 In determining the price of a companys shares, what are some of the external and
internalfactorsthataffectprice?Whatisthedifferencebetweenthesetwotypesofvariables?

Externalfactorsthataffectthecompanyssharepriceare:
(1)economicshocks,suchasnaturaldisastersorwars,
(2)thestateoftheeconomy,suchasthelevelofinterestrates,and
(3)thebusinessenvironment,suchastaxesorregulations.

Ononehand,externalfactorsarevariablesoverwhichthemanagementhasnocontrol.

On the other hand, internal factors that affect the share price can be controlled by management to
somedegree,becausetheyarecompanyspecific,suchas
(1) financial management decisions (including capital budgeting decision, financing decision
andworkingcapitalmanagementdecision)
(2) productqualityandcost,and
(3) thelineofbusinessmanagementhasselectedtoenter.

Overall,thethreemostimportantvariableswhichdeterminesthesharepriceare
(1) the expected cash flow stream and its magnitude (which will be affected by both external
andinternalfactorsmentionedabove)
(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
missedinvestmentopportunities.
- Acompanycancontrolthesecosts
o bytyingmanagementcompensationtocompanysperformanceor
o by the threat of corporate raiders that can take over a company not performing up to
expectations
o bythecompetitivenatureofthemanagementlabormarket(topperformingmanagershave
betteralternativesthantoworkforpoorlyruncompanies.)

QP1.13 What is the business organisation form preferred by companies that require a large
capitalbase,andwhy?

- PublicCorporation.Thereasonis

- A company can list on securities exchange, such as the Singapore Exchange (SGX) as a public
companytogainaccesstothepublicmarkets.

2

**QP1.16Whataresomeofthedrawbackstosettingprofitmaximisationasthemaingoalofa
company?

- Itisdifficulttodeterminewhatismeantbyprofits.
Accountingprofitsaresubjecttomanipulation.
- It does not address the size and timing of cash flowsit does not account for the time
valueofmoney.
- Itignorestheuncertaintyofriskofcashflows.

**QP2.1Whatistheroleofthefinancialsystem,andwhatarethetwomajorcomponentsofthe
financialsystem?

- 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).
(RememberthatFinancingdecision(abouthowtofinance)requiresaccesstofunds.)
- Thefinancialsystemconsistsoffinancialmarketsandfinancialinstitutions.

QP2.4 List the two ways in which a transfer of funds takes place in an economy. What is the
maindifferencebetweenthesetwo?

- Direct financing: Funds can flow directly through financial markets (eg. primary market vs
secondarymarketormoneymarketvscapitalmarket)
- Indirect financing: Funds can flow indirectly through intermediation markets where funds flow
throughfinancialinstitutionsfirst
**QP2.8Whatisaprimarymarket?WhatdoesIPOstandfor?

- Aprimarymarketiswherenewsecuritiesaresoldforthefirsttime.
o Itcouldbenewsecuritiessoldfromanewlylistedfirm(IPO)ornewsecuritiessoldfroman
existingcompany.
- IPOstandsforinitialpublicoffering.

**QP2.16Whatisasharemarketindex?Listthreesharemarketindexes.

- Asharemarketindexisatoolusedtomeasuretheperformanceofthesharemarketwhether
themarketvalueisonaveragegoingupordown.SomeofthebetterknownSingaporeindexes
are
- FTSEStraitsTimesIndex(STI)trackstheperformance of thetop30 companies listed onthe
SingaporeExchange.
- FTSEStraitsTimesAllshareIndexcomprisesallcompanieswithinthetop98%byfullmarket
capitalizationintheSingaporeExchange.
- theDowJonesIndustrialAverageisthemostwellknownindexcovering30largestcompanies
inUSsharemarket.




3

QP2.20BesidesTreasurynotes,whatareothermoneymarketinstruments?

- Inadditiontogovernment,largebanksandcorporationscanalsoborrowforshorttermbyissuing
moneymarketinstrument(eg.commercialpaperunsecuredpromissorynote)
- Commercial paper is only backed by an issuing bank or corporation's promise to pay the face
amountonthematuritydatespecifiedonthenote.
- Since it is not backed by collateral (specific property pledged as security) , only firms with
excellentcreditratingsfromarecognizedratingagencywillbeabletoselltheircommercialpaper
atareasonableprice.

**QP2.22Howdocapitalmarketinstrumentsdifferfrommoneymarketinstruments?

- Money markets are markets in which shortterm debt instruments with maturities of less than
oneyearareboughtandsold.
- Financialinstrumentssoldinmoneymarketshaveveryshortmaturities,usuallyovernightto180
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,arefinancedwithequitiesordebtinstrumentswithmaturitiesofmorethanoneyear
(eg.bond).
- Capitalmarketinstrumentsarelessliquidormarketablethereforecarrymorerisk.
**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
expectedtobe4.25percent.Whatisthetotalamountyouwillhavetopayherbackinayear?
Howmuchoftheinterestpaymentistheresultoftherealrateofinterest?

- Real=NominalInflation=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
realinterestrate($500x0.0275).

4

3
rd
HourMaterial

DoCQ5.7afterQP6.30.

**QP5.5Yourbankpays5percentinterestsemiannuallyonyoursavingsaccount.Youdontexpect
thecurrentbalanceof$2700tochangeoverthenext4years.Howmuchmoneycanyouexpect
tohaveattheendofthisperiod?

0 4years

PV=$2700 FV=?
Amountinvestedtoday=PV =$2700
Returnexpectedfrominvestment=i =5%
Durationofinvestment=n=4years
Frequencyofcompounding=m=2
Valueofinvestmentafter4years=FV
4

2 4
4
8
0.05
1 2700 1
2
2700 (1.025)
=$3289.69
mn
i
FV PV
m

| | | |
= + = +
| |
\ . \ .
=

QP5.12TracyChapmanissavingtobuyahousein5yearstime.Sheplansto putdown20percent
depositatthattime,andshebelievesthatshewillneed$70000forthedownpayment.IfTracy
caninvestinafundthatpays9.25percentannually,howmuchwillsheneedtoinvesttoday?

0 5years

PV=? FV=$70000

Amountneededfordownpaymentafter5years=FV
5
=$70000
Returnexpectedfrominvestment=i =9.25%
Durationofinvestment=n=5years
Amounttobeinvestedtoday=PV

( )
5
70000
(1.0925)
1
$44977.03
n
n
FV
PV
i
= =
+
=




5

**QP5.15:Youareindesperateneedofcashandturntoyourunclewhohasofferedtolendyousome
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 2years

PV=$1300 FV=$1500

Amounttobeborrowed=PV=$1300
Amounttobepaidbackafter2years=FV
2
=$1500
Interestrateoninvestment=i=?
Durationofinvestment=n=2years.
Presentvalueofinvestment=PV
( )
2
2
1
1500
1300
1
1500
1 1 1538
1300
1 1538 1
n
n
FV
PV
( )
( i) .
.
i=7.42%
=
+
=
+
+ = =
=
i
i
i

Youshouldgowiththebankborrowing,asthebankisofferingalowerlendingrate.

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
investmenthavetoyieldinorderforJasonsbrothertodeliveronhispromise?

Solution:
0 4years

PV=$2400 FV=$4800

Amountinvestedinproject=PV=$2400
Expectedreturnthreeyearsfromnow=FV=$4800
Investmentperiod=n=4years
Tocalculatetheexpectedrateofreturn,wesetupthefuturevalueequation.
4
4
4
4
1
4
1
4800 2400 1
4800
1
2400
2 000 1 0 1892
FV PV ( )
( )
( )
( . ) .
= +
= +
+ =
= =
= 18.92%
i
i
i
i

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**QP6.6 Present value with multiple cash flows: Biomedical Pty Ltd expects the following
cashflowstreamoverthenext5years.Thecompanydiscountsallcashflowsata23percent
discountrate.Whatisthepresentvalueofthiscashflowstream?

0 23% 1 2 3 4 5

$1133676 $978452 $275455 $878326 $1835444

2 $384,711.7 =
+ + + =
+ + +

=
94 . 651951 . 43 . 383738 09 . 148025 37 . 646739 80 . 921687
) 23 . 1 (
1835444
) 23 . 1 (
878326
) 23 . 1 (
275455
) 23 . 1 (
978452
) 23 . 1 (
676 , 1133
5 4 3 2
PV

**QP6.7 Presentvalueofanordinaryannuity:Aninvestmentopportunityrequiresapayment
of$750for12years,startingayearfromtoday.Ifyourrequiredrateofreturnis8percent,
whatisthevalueoftheinvestmenttoday?

Solution:

0 8%1 2 3 11 12

$750 $750 $750 $750 $750

Annualpayment=CF=$750
No.ofpayments=n=12
Requiredrateofreturn=8%
Presentvalueofinvestment=PVA
12

12
1
1
(1 )
750 1
1
0.08 (1.08)
n n
CF
PVA
i i
(
=
(
+

(
= =
(

= $5, 652.06

1 2 3 4 5
$1133676 $978452 $275455 $878326 $1835444




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QP6.13 Calculatingannuitypayment:TheBridgeBar&Grillhasa7yearloanof$23500with
Bankwest. It plans to repay the loan in 7 equal instalments starting today. If the rate of
interestis8.4percent,howmuchwilleachpaymentbeworth?

0 1 23 4 5 6(=thebeginningofYear7)
|
CF CF CF CF CFCFCF
PVA
n
=$23,500 n=7; i=8.4%

Presentvalueofannuitydue=$23,500
Returnoninvestment=i=8.4%
Paymentrequiredtomeettarget=CF
Typeofannuity=Annuitydue
UsingthePVAequation:

7
7
1
23, 500 1 (1 )
(1 )
1
23, 500 1 (1 0.084)
0.084 (1 0.084)
23, 500*0.084
1
1 (1.084)
(1.084)
n
CF
PVofAnnuityDue i
i i
CF
CF
CF
(
= = +
(
+

(
= +
(
+

=
(

(

= $4, 221.07

EachpaymentmadebyBridgeBar&Grillwillbe$4221.07,startingtoday.

**QP6.14 Perpetuity:Yourgrandfatherisretiringattheendofnextyear.Hewouldliketoensure
thathe,andafterhedies,hisheirsreceiveapaymentof$10,000ayearforever,startingwhen
heretires.Ifhecaninvestat6.5percent,howmuchdoesneedtoinvesttoreceivethedesired
cashflow?

Solution:

Annualpaymentneeded=CF=$10,000
Investmentrateofreturn=i=6.5%
Termofpayment=Perpetuity
Presentvalueofinvestmentneeded=PV
10000
PV of Perpetuity
0.065
CF
i
= =
= $153, 846.15

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**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
thisyearandsubsequentpaymentsthatwillthereaftergrowatarateof3.4percentannually.
Ifyouusea9percentdiscountrateforinvestmentproducts,whatisthepresentvalueofthis
growingperpetuity?

Solution:

Cashflowatt=1=CF
1
=$20000
Annualgrowthrate=g=3.4%
Discountrate=i=9%
Presentvalueofgrowingperpetuity=PVA

6 $357,142.8 =

=

) 034 . 0 09 . 0 (
20000
) (
1
g i
CF
PVA

**QP6.26 Presentvalueofanannuitydue:SharonKabanahaswonalotteryandwillreceivea
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,whatisthepresentvalueofthecashflowsthatshewillreceive?

Solution:

0 7.25%1 2 3 19 20

CF=$89729.45 atthebeginningofeachyear

Annualpayment=CF=$89729.45
Typeofannuity=Annuitydue
No.ofpayments=n=20
Requiredrateofreturn=7.25%
Presentvalueofinvestment=PVA
20

20
1
1 (1 )
(1 )
89729.45 1
1 (1.0725)
0.0725 (1.0725)
n
CF
PVofAnnuityDue i
i i
(
= +
(
+

(
=
(

= ~ $999, 999.95 $1, 000, 000

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**QP6.30 Effective annual rate: You are considering three alternative investments: (1)a 3year
banktermdepositpaying7.5percentinterestcompoundedquarterly;(2)a3yearbankterm
depositpaying7.3percentinterestcompoundedmonthly;and(3)a3yearbanktermdeposit
paying7.75percentinterestcompoundedannually.Whichinvestmenthasthehighesteffective
annualrate?

Solution:

(1) Interestrateontermdeposit=i=7.5%
Frequencyofcompounding=m=4
Effectiveannualrate=EAR
% 71 . 7 1 0771 . 1
1
4
075 . 0
1 1
m
1
4
= =

+ =
(

+ =
m
i
EAR

(2) Interestrateontermdeposit=i=7.3%
Frequencyofcompounding=m=12
Effectiveannualrate=EAR
% 55 . 7 1 0755 . 1
1
12
073 . 0
1 1
m
1
12
= =

+ =
(

+ =
m
i
EAR

(3) Interestrateontermdeposit=i=7.75%
Frequencyofcompounding=m=1
Effectiveannualrate=EAR
% 75 . 7 1 0775 . 1
1
1
0775 . 0
1 1
m
1
1
= =

+ =
(

+ =
m
i
EAR

Thethreeyearbanktermdepositpaying7.75percentinterestcompoundedannuallyhasthe
highesteffectiveyield.

CQ5.7Ifyouweregivenachoiceofinvestinginanaccountthatpaidquarterlyinterestandonethatpaid
monthlyinterest,whichoneshouldyouchooseandwhy?

Because this is an investment decision, NOT borrowing decision, one should pick the account
thatpaysinterestmorefrequently(aslongastheinterestratesarethesame).Thisallowsfor
theinterestearnedintheearlierperiodstoearninterestandtheinvestmenttogrowmore.