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Suggested Solutions for Tutorial 8

Please note that following suggested solutions are only very basic points and you need
to read the textbook and other reference materials for better understanding.


2. The finance manager of a company has arranged a term loan for the company with the
following conditions attached. The loan will have a variable rate of interest of LIBOR plus
75 basis points. The loan interest will be reset every three months for the duration of the
loan. Explain the operation of these specific loan conditions. How would the finance
manager obtain the new interest rate every three months?
- a term loan is a loan provided by a bank, or other financial institution, for a specific purpose,
over a defined period of time
- the amount and period of the loan is specified in the loan contract
- a loan with a variable interest rate means that the interest rate charged on the principal amount
outstanding will be reset periodically under the terms of the loan contract
- a variable rate loan contract will specify a reference interest rate
- various published reference rates are available including BBSW, LIBOR, USCP or an
institutions own prime rate
- the above loan is using LIBOR, the London Interbank Offered Rate, which is the adjusted rate at
which banks in the London market will lend overnight funds
- the loan is set at LIBOR plus 75 basis points, therefore if LIBOR is currently 5.60% per annum
then the loan interest rate will be 6.35% per annum
- both the borrower and the lender are able to find LIBOR published electronically daily by
Reuters
- At the reset date each three months they will look up the relevant Reuters LIBOR 3-month
money screen to ascertain the new rate

6. As the finance manager of a garden tools manufacturing company you approach your
bank to obtain a term loan so that the company can buy a new metal pressing machine. The
bank offers your company a loan of $65 000 over a five-year period at a rate of interest of
7.40 per cent per annum, payable at the end of each month. Calculate the monthly loan
instalment.

) 1 ( 1

(

+
=

i
i
A
R
n

where:
R is the instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods

A = $65 000
i = 0.074 / 12 = 0.006 167
2

n= 5 years 12 months = 60

167 006 . 0
) 167 006 . 0 1 ( 1
000 65

60
(

+
=

R
R = $1299.39 per month

13. A highly rated corporation has issued $1 million of debentures, with a fixed-interest
coupon equal to current interest rates of 13 per cent per annum, coupons paid half-yearly
and a maturity of seven years.
(a) What amount would the corporation have raised on the initial issue of the debentures?
- the amount raised by the corporation on the initial issue of the debentures into the market will be
equal to the face value of the debentures; that is, $1 000 000
- this is because current yields on this type of security, at the issue date, are equal to the fixed
interest rate paid on the debenture

(b) After one year, yields on identical types of securities have fallen to 12 per cent per annum.
The existing debenture now has exactly six years to maturity. What is the value, or price, of
the existing debenture in the secondary market?
In order to calculate the value, or price, of the existing debentures in the market, it is
necessary to determine the present value of the face value, plus the present value of the
coupon stream (note: the price is being calculated at a coupon date exactly one year after
initial issue)

( )
( )
(
(

+ +
(

+
=

n
n
i A
i
i
C P 1
1 1


Present value of the face value:
= A(1 + i)
n


= $1 000 000 (1 + 0.06)
12

= $496 969.36
plus:
Present value of coupon stream:

) 1 ( 1
(

+
=

i
i
C
n

= $65 000 [1 (1 + 0.06)
12
] / 0.06
= $544 949.86

Price of the debenture:
= $496 969.36 + $544 949.86
= $1 041 919.22

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(c) Explain why the value of the debenture has changed.
- the price of the existing fixed interest security (debenture) has risen because yields in the market
have fallen
- that is, there is an inverse relationship between interest rate movements and price

15. At a finance company you are the manager of lease finance. You have begun to talk to local
companies to try and sell the concept of lease finance for their businesses.
(a) Explain the nature of lease finance, and distinguish between operating leases and finance
leases.
- a lease is a contract whereby the owner of an asset, the lessor, grants to another party, the lessee,
the exclusive right to use the asset, usually for an agreed period of time, in return for the
payment of rent
- lessorthe owner of an asset that is subject to a lease agreement; receives lease rental payments
- lesseethe user of an asset subject to a lease agreement; makes lease rental payments
- leasing is the borrowing (renting) of an asset instead of the borrowing of funds to purchase the
asset
Operating lease:
- a short-term arrangement where the lessor may lease the same asset to successive lessees over
time in order to earn a return on the asset
- the lease arrangements normally contain only minor penalties for cancellation of the lease. This
feature leaves the risk of obsolescence of the asset with the lessor
- an operating lease is usually a full service lease; that is, the maintenance and insurance of the
leased asset is the responsibility of the lessor
Finance lease:
- generally a longer-term arrangement between the lessor and the lessee
- the lessor earns a return on the asset from the one lease contract
- the lessor's role is essentially one of financing
- the lessee contracts to make regular lease rental payments, usually monthly, over the period of
the lease, which may be for more than two years
- a distinguishing characteristic of the finance lease is that the lessee contracts to make a lump sum
payment, representing the residual value of the asset, at the end of the lease period
- when the residual payment is made, the ownership of the asset normally passes to the lessee and
appears on its balance sheet
- a finance lease is usually a net lease; the costs of ownership and operation of the asset are borne
by the lessee. These costs include maintenance and repairs, insurance, taxes and stamp duties
associated with the lease

17. Up until mid-2007, the growth in the securitisation of assets in the international capital
markets had been enormous.
(a) Identify and discuss at least six reasons why this form of funding had become so attractive.
- increased return on equity: business growth is increased without the need to dilute shareholders
funds
- a source of finance when other traditional sources of intermediated and debt finance may not be
available
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- improved return on assets, particularly where, through the securitisation process, assets with
lower credit ratings are upgraded with credit enhancement
- diversify funding sources: asset-backed securities are often attractive to a new range of investors
- reduced credit exposure: the sale of assets may transfer the credit risk associated with the pooled
assets to the SPV and ultimate investors
- regulatory advantage: banks in particular are required to maintain minimum capital requirements
based, in part, on their balance-sheet assets. Securitisation, where there is no recourse back to the
bank, removes assets from the balance sheet and removes the capital cost imposition
- increased balance-sheet liquidity: assets which previously were non-liquid and remained on the
balance sheet are converted to cash
- reduced asset concentration: for example, banks tend to provide a large proportion of their asset
portfolio in mortgage finance. Securitisation allows the bank to divest itself of some of these
assets and to give new mortgage finance without increasing its overall mortgage asset
concentration
- accelerated income: by divesting assets through securitisation, an institution effectively brings
forward returns that would otherwise have progressively occurred over time
- improved financial ratios: return on investment and return on equity may be improved through
the process of securitisation





















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