Tutorial & Computer Lab – Week 3

Parrino et al. Chapters 2 & 5

Instructions

• Spend first 60 min on these tutorial questions

• Spend the remaining 30 min on replicating all Excel exercises from Parrino et al.
Chapter 5, i.e. create a new Excel file and redo all Excel examples from that
chapter (students may work in groups of up to 3 people)

Note: Tutors may not be able to cover all tutorial questions/excel exercises during the
tutorial time. Students are expected to complete all remaining exercises as part of their own
self-study.

1. Discuss the primary role of the financial system in the economy, and how fund transfers take
place.

The primary role of the financial system is to gather money from people and businesses with
surplus funds (lender-savers) and channel money to businesses and consumers who need to
borrow money (borrower-spenders). If the financial system works properly, only creditworthy
investment projects with high rates of return (higher than the cost of capital) are financed and
all other projects are rejected. Money flows through the financial system in two basic ways: (1)
directly, through financial markets or (2) indirectly, through financial institutions.

2. Discuss direct financing and the role investment banks play in this process.

Direct markets are typically wholesale markets where large public companies transact. These
companies sell securities, such as shares and bonds, directly to investors in exchange for
money, which they use to invest in their businesses. Investment banks are important in the
direct markets because they help companies sell their new security issues. The services
provided by investment bankers include origination, underwriting, and distribution.

3. Describe the primary, secondary and money markets, and explain these markets are so
important to businesses.
 Primary markets are markets in which new securities are sold for the first time. Secondary
markets provide the aftermarket for securities previously issued. Not all securities have
secondary markets. Secondary markets are important because they enable investors to convert
securities easily to cash. Business companies whose securities are traded in secondary markets
are able to issue securities at a lower cost than they otherwise could because investors are
willing to pay a premium price for securities that have secondary markets.

Large companies use money markets to adjust their liquidity because cash inflows and outflows
are rarely perfectly synchronised. Thus, on the one hand, if cash expenditures exceed cash
receipts, the company can borrow short term in the money market, or, if the company holds a
portfolio of money market instruments, some of the securities can be sold for cash. On the
other hand, if cash receipts exceed expenditures, the company can temporarily invest the funds
in short-term money market instruments. Businesses are willing to invest large amounts of idle
cash in money market instruments because of their high degree of marketability and their low
default risk.

4. Capital markets: How do capital market instruments differ from money market instruments?

Capital market instruments are less liquid or marketable, they have longer maturities, usually
between 1 and 30 years, and they carry more financial risk.

5. Capital markets: What are the major differences between public and private markets?

Public markets are organised financial markets where the public buys and sells securities
through their share brokers. In contrast, private markets involve direct transactions between
two parties. ASIC regulates both public and private securities markets in Australia.

6. Interest rates: What is the Fisher equation, and how is it used?

The Fisher equation is the equation relating the expected, not the reported or actual,
annualised change in prices (∆Pe) and the real rate of interest to the nominal rate of interest. It
is used to protect buying power from changes in inflation, and it is incorporated into a loan
contract by adding it to the real interest rate that would exist in the absence of inflation.

7. What is financial intermediation, and why is it important?

Financial intermediation is the process of converting financial securities with one set of
characteristics into securities with another set of characteristics. For example, commercial
banks use consumer term deposits to make loans to small businesses.
8. What are some services that commercial banks provide to businesses?

Commercial banks are the largest financial intermediaries in the economy and offer the widest
range of financial services to businesses. Nearly every business has a significant relationship
with a commercial bank – usually a cheque or transaction account and some type of credit or
loan arrangement. In addition, banks do a significant amount of equipment lease financing.

9. What is an IPO, and what role does an investment banker play in the process?

Investment bankers specialise in helping companies to sell their new debt or equity issues in
financial markets. In an initial public offering (IPO), the investment banker prepares the new
issue for sale and then underwrites the deal. Other functions of the investment banker in an
IPO process include preparing the prospectus, registering the documentation with ASIC and
providing general financial advice to the issuer.

10. Your parents have given you $1,000 a year before your graduation so that you can take a trip
when you graduate. You wisely decide to invest the money in a bank term deposit that pays
6.75 per cent interest. You know that the trip costs $1,025 right now and that the inflation for
the year is predicted to be 4 per cent. Will you have enough money in a year to purchase the
trip?

Yes. The term deposit will be worth $1,067.50 at the end of the year ($1,000 x 6.75% + $1000),
and the price of the trip will be $1,066 ($1,025 x 4% + $1,025). The term deposit will be able to
cover the trip.

11. Differentiate between compounding and discounting

The process of converting an amount given at the present time into a future value is called
compounding . It is the process of earning interest over time. Discounting is the process of
converting future cash flows to what its present value is. In other words, present value is the
current value of the future cash flows that are discounted at an appropriate interest rate.

12. Explain how compound interest differs from simple interest

Suppose you invest $100 for three years at a rate of 10 percent. Simple interest would imply
that you will earn $10 for each of the three years for a total of $30 interest. At the end of three
years you would have $130. Compound interest recognises that the interest earned in years 1
and 2 will also earn interest over the remaining period. Thus, the $10 earned in the first year
would earn interest at 10 percent for the next two years, and the $10 earned in the second
year would earn interest for the third year. Thus the total amount that you would have at the
end of three years would be: $100(1.10) 3 = $133.10 . By compounding, you have earned an
 additional interest of $3.10. The total interest or compound interest is the $33.10 earned on
the $100 invested, while the simple interest earned is equal to $30.

13. Multiple compounding periods: Find the future value of an investment of $127 000 made today
for 5 years and paying 11 per cent for the following compounding periods:

a. Quarterly
b. Monthly
c. Daily
d. continuous

0 5 years

├────────────────────┤

PV = $100,000 FV = ?

Amount invested today = PV = $100 000

Return expected from investment = i = 8.75%

Duration of investment = n = 5 years

a. Frequency of compounding = m = 4

Value of investment after 5 years = FV5

mn 4×5
 i   0.11 
FV5 = PV × 1 +  = $127,000 × 1 + 
 m  4 
= $127,000 × (1.0275) 20 = $218,494.41

b. Frequency of compounding = m = 12

Value of investment after 5 years = FV5

mn 12×5
 i   0.11 
FV5 = PV × 1 +  = $127,000 × 1 + 
 m  12 
= $127,000 × (1.009166666667) 60 = $219,572.30

c. Frequency of compounding = m = 365

 Value of investment after 5 years = FV5
mn 365×5
 i   0.11 
FV5 = PV × 1 +  = $127,000 × 1 + 
 m  365 
= $127,000 × (1.000301369863)1825 = $220,104.89

d. Frequency of compounding = m = Continuous

Value of investment after 5 years = FV5

FV5 = PV × e in = $127,000 × e 0.11×5

= $127,000 × 1.7332530 = $220,123.13

14. Time to attain goal: You invest $150 in an investment fund today that pays 9 per cent interest
per annum. How long will it take to double your money?

0 n years

├────────────────────┤

PV = $150 FV = $300

Value of investment today = PV = $150

Interest on investment = n = 9%

Future value of investment = FV = $300

Number of years to double investment = n

FVn = PV × (1 + i ) n
300 = 150 × (1.09) n
(1.09) n = 300 150 = 2.00
n × ln(1.09) = ln(2.00)
ln(2.00)
n= = 8.043 years
ln(1.09)
15. Present value: Thang Nguyen needs to decide whether to accept a bonus of $1900 today or
wait 2 years and receive $2100 then. She can invest at 6 per cent per annum. What
should she do?

0 2 years

├────────────────────┤

PV = $1900 FV = ?

Amount to be received in 2 years = FV2 = $2100

Return expected from investment = i = 6%

Duration of investment = n = 2 years

Present value of amount today = PV

FV2 2100
PV = =
(1 + i ) n
(1.06) 2
= $1868.99

Since the amount to be received today ($1900) is greater than the present value of the $2100
to be received in 2 years, Thang should choose to receive the amount of $1900 today

16. You have $12 000 in cash. You can deposit it today in an investment fund earning 8.2 per cent
semiannually; or you can wait, enjoy some of it, and invest $11 000 in your brother’s business
in 2 years. Your brother is promising you a return of at least 10 per cent on your investment.
Whichever alternative you choose, you will need to cash in at the end of 10 years. Assume your
brother is trustworthy and that both investments carry the same risk. Which one will you
choose?

Option A: Invest in account paying 8.2 per cent semiannually for 10 years.

0 10 years

├────────────────────┤

PV = $12 000 FV = ?

Amount invested in project = PV = $12 000

Investment period = n = 10 years

 Interest earned on investment = i = 8.2%

Frequency of compounding = m = 2

Value of investment after 10 years = FV10

2×10
 0.082 
FV10 = PV × 1 +  = 12000 × (2.23365)
 2 
= $26803.77

17. Jimmal Bolts Ltd reported earnings of $2.1 million last year. The company’s primary business
line is manufacturing nuts and bolts. Since this is a mature industry, the analysts are certain
that the sales will grow at a steady rate of 7 per cent a year for as far as they can tell. The
company reports profit that represents 23 percent of sales. The management would like to buy
a new fleet of trucks but can only do so once the profit reaches $620 000 a year. At the end of
what year will Jimmal Bolts Ltd be able to buy the new fleet of trucks? What will the sales and
profit be that year?

Current level of sales for Jimmal = PV = $2 100 000

Profit margin = 23%

Profit for the year = 0.23 x 2100000 = $483 000

Target profit level in the future = FV = $620 000

Projected growth rate of sales = g = 7%

To calculate the time needed to reach the target FV, we set up the future value equation.

FVn = PV × (1 + g ) n
620000 = 483000 × (1.07) n
620000
(1.07) n = = 1.2836
483000
n × ln(1.07) = ln(1.2836)
ln(1.2836)
n= = 3.7 years
ln(1.12)

The company achieves its profit target during the fourth year.

Sales level at end of year 4 = FV4

 FVn = PV × (1 + g ) n
= 2100000 × (1.07) 4 = $2752671.62

Profit for the year = $2752671.62 x 0.23 = $633114.47

18. Interest rates: When are the nominal and real interest rates equal?

The only time the nominal and real interest rates are equal is when the expected rate of
inflation over the contract period is zero.