AFCP810 Finance Principles

Assignment Part 1
Term 3 2015
Steve Jun - 44754698
Question 1:
d) What criteria would you use to evaluate these scenarios? Based
on that criteria, which is the best scenario?
The criteria I would use to evaluate these scenarios would the total amount of
interest paid and the length of the loan:
a. Scenario 1 (extra $600 a month):
Saving $68,808.75 in interest, 16 years to pay off.
b. Scenario 2 (extra payment at the end of every 12 th month):
Saving $38,589.46 in interest, 17.75 years to pay off.
c. Scenario 3 (half the original payment, every fortnight):
Saving $41,550.22 in interest, 17.65 years to pay off.
As a result, the best scenario is Scenario 1 as it has the lowest amount of total
interest paid. Increasing the frequency does reduce the interest paid as well as
reduce the time of the loan when comparing against the original (from question
a) scenario however, increasing the payments by $600 takes less time and
reduces the total interest paid.
e) What other issues would you need to think about when
deciding between the above scenarios? Which one would you
choose? Why? Suggest another scenario that you would choose?
For scenario 1 you need to consider the opportunity cost of investing the $600
elsewhere. If you were to invest the $600 at 4.5% p.a. compounded monthly for
20 years, the interest saved when compared to the original scenario equates to
$68,808.75. Furthermore the loan would be paid off in 192 payments.
Alternatively, if we invested this extra $600 a month at 4.5% p.a. compounded
monthly for 191 periods (not 192, as the last payment is not required) in a bank
account we would earn a total of $53,066.96 in interest. As a result, paying the
extra $600 a month is worth more than investing it in a bank.
If assuming in this scenario that I was limited to an extra $600 per month, the
best scenario would be to pay in weekly instalments (paying of the amount in
a) above) with an increase of $150 per week totalling $1,098.97. This would
amount to a saving of $74,226.71 in interest and would take approximately
15.75 years.
Question 2:
To consider the NPV, I would first have to make a few assumptions: that I dont
fail any subjects and that they are taken consistently (therefore consistent cash
flow) and that the benefit from completing this is an increase in salary by
$10,000 increments at various years (arbitrary numbers as I do not know how
much it would increase my salary by). I would also have to assume sunk costs
involved in completing this program I am currently enrolled for the CFA Level 1

exam but given that I would not be able to handle the workload of both the
Masters program and the CFA exam, I am forgoing the expense. NPV is
calculated by determining the present value of cash inflows (benefits) minus the
present value of cash out flows (costs). The cost of this program is $4712 per
unit, where I have 10 units to complete at a rate of 4 units per year for part time
work meaning 2.5 years to complete overall. To calculate the initial investment, I
would need to discount this cash outflow at the interest rate from FEE-HELP.
The benefits from completing the Applied Finance program would vary on a case
by case basis and so I chose the arbitrary value of a permanent $10,000 increase
in salary. I also believe that given the quality and reputation of the program, the
cash flow benefit would increase over time, ultimately capping out. As a result, I
would forecast the cash flow benefit from completing the Applied Finance
program e.g. a permanent $10,000 increase in salary per year for the first 5
years (after the Masters program is finished) and then another $10,000 increase
in salary for the next 33 years (assuming I work till 65). This cash outflow would
then have to be discounted at the interest rate so that the sum can be provided
in present value terms.
The Net Present Value of the initial investment and the cash inflows would clearly
show a positive number and that undertaking this program is a profitable move.
Question 3
b) Which of the bonds A-D is most sensitive to a 1% fall in the yield
to maturity from 5% to 4% and why? Which bond is least sensitive
and why?
The most sensitive is Bond C. There is an Inverse relationship between yield of
the bond and the value of the bond (as seen in the picture below in Figure 3.2
from Finance Principles, pg50).

As the yield decreases the value of the bond increases. This reflects the
opportunity cost that could be derived from alternatively accumulating interest
at a banks interest rate. The difference between bond B and D is the maturity.
Bond C also has a longer time to maturity and therefore the compounding effect

is higher that is, long-term bonds are more sensitive to changes in interest
rates than short-term bonds.
The least sensitive is Bond B. Bond C has a shorter time to maturity when
compared to D and so the compounding effect is lower. This can be seen by the
fact that coupons on bonds can be interpreted as annuities.