ABMF4024 BUSINESS FINANCE
Tutorial 2 Answer
October 16, 2010
QUESTION 1 In a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand it. This transfer of capital can take place in three different ways: 1. Direct transfers of money and securities occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its securities to savers, who in turn give the firm the money it needs. 2. Transfers may also go through an investment banking house which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses securities and the savers money merely pass through the investment banking house. 3. Transfers can also be made through a financial intermediary. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold businesses securities. Intermediaries literally create create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets.
QUESTION 2 The three forms, or levels, of market efficiency are: weak-form efficiency, semistrong-form efficiency, and strong-form efficiency. The weak form of the EMH states that all information contained in past stock price movements is fully reflected in current market prices. The semi strong form of the EMH states that current market prices reflect all publicly available information. The strong form of the EMH states that current market prices reflect all pertinent information, whether publicly available or privately held.
QUESTION 3 Liquidity
is the term used to describe how easy it is to convert assets to cash. The most liquid asset, and what everything else is compared to, is cash. This is because it can always be used easily and immediately.
QUESTION 4 The price that a borrower must pay for debt capital calls Interest Rate. The price of equity capital calls Required Return. There are4 factors that affect the cost of money, which are the production opportunities, time preference for consumption, risk, and inflation. Production opportunities are the investment opportunities in productive (cash-generation) assets. For example, if the return if high, thus the interest will be high also. Time preferences for Consumption are the preferences of consumers for current consumption as opposed to saving for future consumption. Risk refers to the chance that an investment will provide a low or negative return in a financial market context. Inflation
is the amount by which process increase over time.
ABMF4024 BUSINESS FINANCE
Tutorial 2 Answer
October 16, 2010
QUESTION 5 Financial intermediary is an organization that raises money from investors and provides financing for individuals, corporations, or others organizations. Mutual fund are corporations accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issues by businesses or government units. These organizations pool funds and thus reduce risks by diversification. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling types of savers. Hence, there are bond funds for those who desire safety stock funds for savers who are willing to accept significant risks in the hope of higher returns, and still other funds that are used as interestbearing checking accounts.
QUESTION 6 The real risk-free rate of interest (r*), is the interest rate that would exist on a riskless security if no inflation were expected, and it may be thought of as the rate of interest on short-term treasury securities in an inflation-free world. The nominal risk-free rate is the rate of interest on a security that is free of all risk. Its measured: real risk-free rate plus a premium for expected inflation: rRF = r* + IP.
QUESTION 7 T-bill rate 5.5% r*
= r* + IP = r* + 3.25% = 2.25%.
QUESTION 8 r* = 3%; I1 = 2%; I2 = 4%; I3 = 4%; MRP = 0; rT2 = ?; rT3 = ? r = r* + IP + DRP + LP + MRP. Since these are Treasury securities, DRP = LP = 0. rT2 IP2 rT2
= r* + IP2. = (2% + 4%)/2 = 3%. = 3% + 3% = 6%.
rT3 IP3 rT3
= r* + IP3. = (2% + 4% + 4%)/3 = 3.33%. = 3% + 3.33% = 6.33%.
ABMF4024 BUSINESS FINANCE
Tutorial 2 Answer
October 16, 2010
QUESTION 9 rT10 = 6%; rC10 = 8%; LP = 0.5%; DRP = ? r = r* + IP + DRP + LP + MRP. rT10 = 6% = r* + IP10 + MRP10; DRP = LP = 0. rC10 = 8% = r* + IP10 + DRP + 0.5% + MRP10. Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both bonds are equal. The only difference between them is the liquidity and default risk premiums. rC10 = 8% = r* + IP + MRP + 0.5% + DRP. But we know from above that r* + IP10 + MRP10 = 6%; therefore, rC10 = 8% = 6% + 0.5% + DRP DRP = 1.5%
QUESTION 10 r* = 3%; IP2 = 3%; rT2 = 6.2%; MRP = ? rT2 = r* + IP + MRP. 6.2% = 3% + 3% +MRP MRP = 0.2%
QUESTION 11 r* = 5%; I1-4 = 16%; MRP = DRP = LP = 0; r4 = ? rRF = (1 + r*)(1 + I) 1 = (1.05)(1.16) 1 = 0.218 = 21.8%.
QUESTION 12 r = r* + IP + MRP + DRP + LP. r* = 0.03. IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035. MRP = 0.0005(6) = 0.003. DRP = 0 LP = 0 rT7 = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.
QUESTION 13 Were given all the components to determine the yield on the bonds except the default risk premium (DRP) and MRP. Calculate the MRP as 0.1%(5 1) = 0.4%. Now, we can solve for the DRP as follows: 7.75% = 2.3% + 2.5% + 0.4% + 1.0% + DRP, or DRP = 1.55%.
