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MCD2170: Foundations of Finance

Revision Tutorial Handout

Trimester 2, 2023

Exam structure

The final examination consists of five short answer questions and ten multiple-choice questions. The exam paper carries a total of 80 marks. The exam duration is TWO hours and Ten minutes. Students must attempt all questions.

The table below shows the final exam paper structure.

	Question number in the e-Assessment platform	Marks allocated	Related Weekly topic	How to submit the answers
Section A: Short answer questions	Question 1	15 marks	3 & 4	Answers to be uploaded as images
	Question 2	15 marks	5	Answers to be uploaded as images
	Question 3	15 marks	7	Answers to be uploaded as images
	Question 4	15 marks	8	Answers to be uploaded as images
	Question 5	10 marks	9	Answers to be typed into the space provided in the e-assessment platform
Section B: Multiple-choice questions	Question 6 to Question 15	1mark×10=10 marks	1, 2, 10 and 11	Choose the correct answer from the choices provided in the e-assessment platform

This revision document is organised based on weekly topics. The questions in the exam will be of similar complexity. Solutions to these questions will be made available at the end of week 12.

Please note that for the final examination, all material covered in Moodle

and textbook chapter readings are considered potentially examinable. Hence the following materials are also recommended for students who aim to achieve an excellent result.

• Weekly in-class group activities

• Financial Calculation Practice 1(under week 6) & 2 (in the Additional Resources folder) on Moodle

• Weekly LC or Lesson questions

• Weekly homework

Please also note a practice exam on the e-Assessment platform will be provided to help students understand the format of the final exam questions and how each question is supposed to be answered.

· Practice exam Link:

https://eassessment.monashcollege.edu.au/mod/quiz/view.php?id=3038

· Enrolment Key: MCD2170@2022

· Attempts allowed: Unlimited

WEEK 1 &2

1. What are the three main components of a financial system, Provide an example of each component.

2. Describe two different ways that savings are ultimately transferred to deficit units in need of funds. Identify 3 advantages of each type of way of transferring funds

3. Briefly explain how the nominal interest rate (NIR) of a financial asset is determined, i.e. the determinants of NIR

4. Identify the following securities with the highest yield and lowest yield (at issuance) and briefly explain why.

· 10-year treasury bonds

· 10-year corporate bonds with an AAA rating

· 10-year corporate bonds with a BB rating

· 2-month treasury notes

5. Distinguish and differentiate the following types of financial markets

· Primary market vs. secondary market

· Money market vs. capital market

· Wholesale market vs. retail market

· Public market vs. Private market

WEEK 3 and 4

1. You would like to save annually to be able to buy a car 6 years from today. You plan to make the first deposit today and the last deposit 5 years from now. Assume the car will cost you $30,000 and your deposits will earn you interest at 6% p.a, compounded annually

(a) What is your annual deposit amount?

(b) Instead of making annual deposits, assume you would like to make a deposit of the same dollar amount every two years. The first deposit will still be made today, and the last deposit will be 4 years from today. If the bank still pays you 6% p.a. compounded annually, to accumulate $30,000 6 years later, how much will you need to deposit every two years?

(c) Now assume you would like to make your deposit monthly and the bank is happy to pay your interest on a monthly basis. What is the APR that would make the bank indifferent to these two ways of paying interest?

(d) Assuming you make the deposit of $300 at the end of each month and the first deposit will be made one month from today, use the answer to part b) to calculate how much your deposits would accumulate 6 years later.

(e) Assume that 6 years later, the car price has gone up to $35,000. You decide to use the accumulated deposit in your answer to part (c) as the down payment and take up a 2-year car loan. What would your monthly payment be if the interest rate is 7.5% and compounded monthly?

2. Suppose you are exactly 25 years old and you are planning to save for your retirement, which will happen in 40 years. You plan to deposit an equal amount at the beginning of each month in your retirement account with the first saving made today. Assume the retirement account pays you 6% p.a. compounded monthly.

a) If you would like to have $1,000,000 in your retirement account 40 years later when you are retired, how much will you have to deposit monthly?

b) If you could only afford to deposit $400 per month, but you still want to retire with $1,000,000 in 40 years, what is the effective annual rate of return that you need to earn on your retirement account?

c) If you are expected to live for 30 years in retirement and you need to withdraw $4000 per month (with the first withdrawal one month after retiring) for living expense. Assume your saving will continue to earn you 6% p.a. compounded monthly. Calculate how much remaining account balance will you be able to leave to your children 30 years later.

3. Assume that you take a 30-year mortgage for 800,000 at 9 % p.a. It is to be repaid monthly.

(a) What is the monthly repayment amount? Assume the interest is compounded monthly

(b) What is the balance outstanding after four years?

(c) Four years after the mortgage starts, you are able to pay $400 more into your mortgage, what impact would this have on the remaining terms of your mortgage?

(d) If the interest rate increases to 9.6% after 4 years, what will be your new monthly repayment?

(e) Assume your parents would like to help you with the extra monthly payment due to the increase in the interest rate from 9% to 9.6%. What is the lump sum amount of money they need to give to you so that your monthly payment will remain the same as in part a)?

(f) If at the end of year 4, the bank wishes to change your repayment from monthly to per fortnight, what is the APR the banks should offer so that you are indifferent between this new offer and the initial arrangement (i.e. 9% p.a. interest rate and monthly repayment)?

4. Your rich aunt offers you the choice of 3 pay-outs today

Choice 1: $1000 paid every year for 5 years, with the first payment to be received at the end of year 3

Choice 2: $3000 paid today.

Choice 3: $80 paid at the end of each month for 5 years, with the first payment to be received in a month

(a) What is the effective annual interest rate that would make you indifferent between choice 2 and choice 3

(b) If you were to receive the monthly payment at the beginning of each month for 5 years in Choice 3, what monthly payment would make you indifferent to receiving $3000 today? Use a 10% p.a. interest rate.

5. You are thinking of buying a house. The house costs $400,000. You have $50,000 in cash that you can use as a down payment on the house, but you need to borrow the rest of the purchase price, i.e. $350,000. The bank is offering you a 30-year mortgage that requires annual payments and has an interest rate of 7% per year

a) What will your annual payment be if you sign up for this mortgage?

b) Assume you can only afford to pay $25,000 per year. The bank still agrees to allow you to pay this amount each year and borrow $350,000. At the end of the mortgage, you must take a balloon payment (i.e. a lump sum payment) that is, you must repay the remaining balance on the mortgage. How much will this balloon payment be?

6. Jason just graduated from university and he is planning to buy an apartment in the city. He plans to take a 30-year mortgage with an interest rate of 4% p.a. and compounded monthly.

a) If the apartment that Jason is interested in buying costs $750,000 and he can only afford to make monthly repayments of $3000, will Jason be able to buy this apartment? Assume that Jason has no savings that he can use as a deposit towards buying this apartment.

b) 20 years ago, Jason’s parents started depositing $5000 at the beginning of each year for Jason’s future expenses in an investment account. If the account paid 8% return per year, what is the account balance today? Would Jason be able to afford the apartment with the help of the investment account balance?

c) Assume that instead of making annual deposits as in part b), his parents had instead deposited at the start of each month, and interests were calculated and paid monthly, what is the ARP that would make his parents indifferent to these two ways of payment? What is the monthly deposit amount that would accumulate the same account balance as in part b)

WEEK 5

1. What is capital budgeting, and what does capital budgeting involve?

2. What is the difference between Independent projects and mutually exclusive projects?

(a) Define the three capital budgeting techniques: the Payback Period, the Net Present Value (NPV) and the Internal Rate of Return (IRR).

(b) Briefly discuss the advantages, disadvantages and decision rules of each approach.

i. Its payback period is less than or equal to the cut-off point

ii. Its payback period is more than the cut-off point

iii. Its internal rate of return is less than the cost of capital

iv. Its internal rate of return is more than the required rate of return

4. The following cash flows have been given for mutually exclusive Projects Alpha and Beta:

Year	Project Alpha	Project Beta
0	-175000	-82500
1	40000	30000
2	60000	-10500
3	85000	40000
4	92000	75000
5	92000	92000

(a) Use the payback period method to identify which project is more attractive. The requirement is that projects have a payback period of 3 years or less.

(b) At 10% cost of capital, use the NPV approach to identify which project should be accepted and why?

(d) If the cost of capital is 10%, given the results of the 3 approaches, which method should apply to make a final decision and why?

5. Toyota is considering installing a new production line which is forecasted to start earning $5 million in revenue in the second year of operation. Revenue is projected to decrease at 10% p.a., operating costs are 25% of annual revenue, and the production line is kept till the end of year 4, after which it is sold for $2mil. Setting up the production line requires $2mil today and $4mil in the first year. 40% Toyota's capital is financed through equity which has a cost of 14% and the creditors are willing to charge 6% less than what the shareholders earn

(a) Draw a timeline and set out the cash flows by year.

(b) Calculate the required rate of return for this project.

(d) What is the NPV of this project? Explain if Toyota should accept this project according to the NPV rule.

(e) If Toyota’s credit rating upgrades from A to AA, holding the other factors constant, explain

· how would this change affect WACC.

· how the IRR and NPV of the project and the capital budgeting decision made by using the IRR approach and NPV approach would be affected

6. Nudie Ltd. specializes in making bottled Juice and currently buys bottles from an outside supplier at $0.25 per bottle. It requires 2,000,000 bottles per year. Nudie is considering producing the bottles themselves instead of buying them. Direct in-house production cost is estimated to be 0.15 per bottle. To produce the bottles, it would cost $600,000 to purchase and install the equipment today. The life of the equipment will be 5 years, after which it is expected to be sold for 20% of the original cost. The equipment will also need to be maintained in the second year of production for a cost of $30,000.

Nudie has 40% of its capital financed through debt costing 13% p.a. The shareholders want to earn 2% more than what the creditors earn.

a) Draw the timeline and set out annual cash inflows, outflows and net cash flow by year.

b) Calculate the Net Present Value (NPV) of this project. Explain if the project should be accepted according to NPV decision rule.

WEEK 7

1. Identify 3 differences between the money market and the bond market.

2. Briefly explain what bond ratings are.

3. Westpac offers to sell 90-day negotiable certificates of deposit (NCD) with a face value of 300,000 and a yield of 6.45% per annum.

a) What is the selling price of an NCD?

b) If Westpac would like to raise a total of $60,000,000, how many NCDs will the bank issue? Round up your final answer to a whole number.

4. A highly rated corporation has issued a bond with a face value of $1 million and semi-annual coupon payments of $65,000. The current market yield of similar corporate bonds is 13% p.a. The bond has a maturity of seven years.

a) When does a bond sell at a discount, premium and par? What amount would the corporation have raised on the initial issue of the bonds?

b) After one year, yields on identical types of securities have fallen to 12 per cent per annum. The existing bond now has exactly six years to maturity. What is the implied price of the existing bond in the secondary market?

c) Explain why the value of the bond has changed.

a) A semi-annual compounding bond with a face value of $1000. The coupon rate is 7% p.a., and it takes 10 years to mature. Its current market price is $1075.

· Calculate the annual YTM of this bond.

· If an investor purchases the bond at the market price and keeps it until maturity, what is his HPY per year?

b) If you bought this bond and held it for 2 years and then sold it at a market yield of 5%, draw a timeline to show all cashflows associated with this investment and calculate your HPY.

6. Company ABC is currently issuing 3-year corporate bonds with a face value of $1000 and quarterly coupon payments. If the bond has a yield to maturity of 8% and is selling for $1060,

a) Without calculation, use bond pricing theory to identify and explain if the bond's annual coupon rate is higher or lower than 8%.

b) Calculate the annual coupon rate of this bond.

c) Assume you bought this bond one year after its issuance for $1100 and kept it until maturity. Draw a timeline to show all cashflows associated with your investment and calculate your annual holding period yield.

WEEK 8

1. Explain the following concepts:

Capital structure:

Initial public offering (IPO)

ASX200 index

P/E ratio

2. Distinguish between shares (equity) and debt securities?

3. Distinguish the characteristics between ordinary shares and preference shares.

4. Company ABC just paid a cash dividend of $0.50 per share. Investors require a 15% return. If the dividend is expected to grow at a steady 6% per year, what is the current value of a share? What will the share be worth in four years?

5. Company XYZ is expected to pay a cash dividend of $0.50 per share at the end of this year. Investors require a 15% return. If the dividend is expected to grow at a steady 6% per year, what is the current value of a share? If the shares are selling for $6 per share, should the investors buy them?

(a) What is the value of a stock expected to pay a constant $3.50 dividend each year forever if the market-required rate of return is 18%?

(b) What is the estimated value of a stock, which intends to pay the dividend of $2.50 five years from now (at the end of year 5), and expects dividends to grow at 10 per cent? The Beta of this stock is 1.5. The yield on a 10-year government bond is 3%, and the long-term return of the ASX200 (i.e. the market portfolio) is 11%.

(c) If the shares are trading at $30 per share, what investment strategy would you recommend to investors with these shares in their investment portfolios, i.e. selling them or buying more?

7. Suppose Company A is expected to pay a $0.5 dividend per share in 3 years, after which the dividends are expected to grow at a constant annual rate forever. If the expected rate of return for the company is 8% and the shares are selling for $12 per share, calculate the minimum annual dividend growth rate to make the investment sound.

WEEK 9

1. Explain the following concepts:

· Direct quotation

· Indirect quotation

· Appreciation & depreciation

· Foreign exchange risk

· Commodity currency

· Term currency

2. Holding other factors constant, briefly explain how the change in the following factors would affect a country’s exchange rate

· Net export (export-import) and

· the central bank’s monetary policy

3. A FX dealer provides a quote of AUD/USD0.7550–60.

(a) What is the commodity currency and term currency in the advertised quote? Is it a direct quotation or an indirect quotation? What is the bid-offer spread for the local dealer?

(b) Australian company ABC wishes to convert AUD$10 million into USD to invest in the US stock market. If they accept the dealer’s quote, how much in USD will they receive? If the Australian dollar appreciates by 50 points in both bid and offer price, how much USD will they receive?

(c) Car manufacturer Ford requires AUD$5 million to invest in Australian facilities. If they accept the dealer’s quote, how much in USD will they pay? If the Australian dollar depreciates by 50 points in both bid and offer price, how much in USD will they pay now?

(d) BHP has US$10 million that they wish to convert to AUD. If they accept the dealer’s quote, how much in AUD will they receive?

4. An importer based in Austria that imports kangaroo meat from Australia wishes to buy Australian dollars (A$) with Austrian Schilling (ATS). The following rates are quoted:

In Melbourne AUD 1 = ATS 8.9750 – 8.9830

In Hong Kong AUD 1 = ATS 8.9686-9.0090

(a) Determine the best Australian dollar against the Austrian Schilling rate (i.e. express one unit of A$ in terms of ATS) at which one may buy Australian dollar with Austrian Schilling

(b) Evaluate at this rate the cost in Austrian Schilling of buying 5,000 kg of the premium kangaroo meat that costs $12 per kilo.

(c) If a year later, this import needs to convert its revenue of AUD $100,000 earned in Australia into Austrian Schilling (ATS)

i. What are the potential downside and upside exchange rate risk this importer may have to face?

ii. A year later AUD depreciates by 50 points in both bid-offer price in two markets, what are the new quotes in two marks?

iii. How much ATS can this importer exchange for given the quote he accept in the previous part?

WEEK10&11

1. What are the three main monetary authorities in Australia, and what are their main roles?

(a) What is monetary policy, and how does the RBA implement its monetary policy?

(b) What are the 3 objectives of monetary policy in Australia?

(c) Illustrate the potential effects of a decrease in the cash rate by RBA on consumer and business spending as well as on net exports.

3. Define interest rate margin. List 3 factors that affect the Interest Rate Margin (IRM) of a bank.

4. Monash Bank has $100 million in interest-earning assets, upon which it earns an average of 6%. Creditor obligations, on average, cost 5%. The bank has total assets of $120 million and total equity of $40 million. Calculate the interest rate margin of Monash Bank.

5. Briefly discuss the three basic types of risks that banks potentially face.

6. Briefly explain how banks are regulated in terms of capital adequacy and the rationale for this regulation.

7. Discuss and explain the potential impacts of change in Capital Adequacy Requirement on bank’s profit, risk and possibly cost of debts and the flow of funds in economy.

8. What is bank liquidity and briefly discuss liquidity management of banks.

9. What are managed investment funds? Discuss the advantages and disadvantage of MIFs

10. Briefly describe the key characteristic of superannuation.

2023-09-25

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