Question 1 (2.5 marks)

(a) You plan to save $40,000 in two years to purchase a new car you’ve always wanted. The bank is currently offering 6% interest rate on deposit per annum compounded quarterly. How much would you have to invest today to achieve $40,000 in two years? (1.5 marks)

(b) If you borrowed a sum of $30,000 repayable in twenty-four equal monthly installments (loan repayments) at an interest rate of 12% per annum. What is the required loan repayment at the end of each month? (1.0 marks)

Question 2 (2.5 marks)

(a) Explain with examples where possible the inverse relation between price and yield in the bond market? (1.0 marks)

(b) ABC Ltd is a small business owned by Donald and Harry Sang. The Sang brothers are considering the replacement of the ducted heating system in their office. They were presented with two heating models, the Braemar and the Brivis. The current heating system has been fully depreciated and would have no resale value. The Braemar model will cost $15,000 and last for eight years, while the Brivis costs $21,000 and has a useful life of 10 years. The Brivis is also more energy efficient and is expected to produce a cost saving in gas bills of $4,000 per year while the cost saving associated with the Braemar model is $2,500 a year. Both models would require annual maintenance cost of $500 a year. ABC Ltd adopts the straight line depreciation method whereby assets are fully depreciated by the end of their useful life. The company’s applicable tax rate is 30% and its discount rate on capital budgeting projects is 12%.

(i)Calculate the cash flow associated with the two heating models. (0.5mark)

(ii) What are the Net Present Values of the two models? (0.5 mark)

(iii) Which system should be chosen? Calculate Equivalent Annual Annuity. (0.5 mark)

Question 3 (5 marks)

Assume that the risk-free rate of return is 5% and the market risk premium is 11%. Security A has a beta of 0.75 and Security B has a beta of 1.2.

(i) What are the required rate of return for Security A and Security B? (1 mark)

(ii) Draw the security market line. What does it represent? (1 mark)

(iii) Suppose that Security C has a risk-return characteristic such that it lies above the security market line. Is Security C a desirable investment? Why or why not? (2 marks)

(iv) What conclusions can you make with regard to securities that lie above the security market line and those that lie below it? (1 mark)

Question 4 (5 marks)

(i) What are the limitations of the payback period as a capital-budgeting technique? (1 mark)

(ii) What are the advantages of payback period? Why is it so frequently used? (1 mark)

(iii) Does the discounted payback method overcome the problems associated with the traditional payback method? Why or why not? (1 mark)

(iv) Under what conditions would the payback and discounted payback methods produce identical results? (1 mark)

(v) If a project’s payback period is less than the maximum acceptable payback period that the firm will accept, does this mean that the project’s Net Present Value will also be positive? Explain. (1 mark)

(a) You plan to save $40,000 in two years to purchase a new car you’ve always wanted. The bank is currently offering 6% interest rate on deposit per annum compounded quarterly. How much would you have to invest today to achieve $40,000 in two years? (1.5 marks)

(b) If you borrowed a sum of $30,000 repayable in twenty-four equal monthly installments (loan repayments) at an interest rate of 12% per annum. What is the required loan repayment at the end of each month? (1.0 marks)

Question 2 (2.5 marks)

(a) Explain with examples where possible the inverse relation between price and yield in the bond market? (1.0 marks)

(b) ABC Ltd is a small business owned by Donald and Harry Sang. The Sang brothers are considering the replacement of the ducted heating system in their office. They were presented with two heating models, the Braemar and the Brivis. The current heating system has been fully depreciated and would have no resale value. The Braemar model will cost $15,000 and last for eight years, while the Brivis costs $21,000 and has a useful life of 10 years. The Brivis is also more energy efficient and is expected to produce a cost saving in gas bills of $4,000 per year while the cost saving associated with the Braemar model is $2,500 a year. Both models would require annual maintenance cost of $500 a year. ABC Ltd adopts the straight line depreciation method whereby assets are fully depreciated by the end of their useful life. The company’s applicable tax rate is 30% and its discount rate on capital budgeting projects is 12%.

(i)Calculate the cash flow associated with the two heating models. (0.5mark)

(ii) What are the Net Present Values of the two models? (0.5 mark)

(iii) Which system should be chosen? Calculate Equivalent Annual Annuity. (0.5 mark)

Question 3 (5 marks)

Assume that the risk-free rate of return is 5% and the market risk premium is 11%. Security A has a beta of 0.75 and Security B has a beta of 1.2.

(i) What are the required rate of return for Security A and Security B? (1 mark)

(ii) Draw the security market line. What does it represent? (1 mark)

(iii) Suppose that Security C has a risk-return characteristic such that it lies above the security market line. Is Security C a desirable investment? Why or why not? (2 marks)

(iv) What conclusions can you make with regard to securities that lie above the security market line and those that lie below it? (1 mark)

Question 4 (5 marks)

(i) What are the limitations of the payback period as a capital-budgeting technique? (1 mark)

(ii) What are the advantages of payback period? Why is it so frequently used? (1 mark)

(iii) Does the discounted payback method overcome the problems associated with the traditional payback method? Why or why not? (1 mark)

(iv) Under what conditions would the payback and discounted payback methods produce identical results? (1 mark)

(v) If a project’s payback period is less than the maximum acceptable payback period that the firm will accept, does this mean that the project’s Net Present Value will also be positive? Explain. (1 mark)

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