Major Assignment

FIN205 Business Finance

Semester 2, 2017
Maximum Marks: 40

The assignment may be completed using excel functions where

appropriate. You should make reference to the formula that is
applied to your calculations.

Please show your calculations clearly

Instructions:

1. Your assignment should be written in MSWord format.

2. If you use excel spreadsheets, please copy and paste them into MSWord.

3. Once you have completed the assignment, it needs to be lodged in the Assessments
section of Learnline. Your assessments must be lodged using MSWord.

PDF, Excel or paper copies will not be accepted.

Required:
1) Make sure that your assignment can be readily printed on A-4 paper preferably in
portrait format with appropriate page breaks. Do not have a portion of a wide
worksheet expand beyond 1 page.

2) Make sure your name and student number are on every page of your submission.

Ethics:

This is an individual assignment (not a group assignment). If portions of your assignment are
copied or very close to copying, all parties will be penalised for copying. Copying would be
considered plagiarism and CDU has strict policies. It is up to you to keep your assessment
confidential.

1
Question 1 (Total Marks: 10)
Use the information below for parts a & b.

Currently the risk-free rate equals 3% and the expected return on the market portfolio
is 8%. A financial analyst provides you with the following information:

Share Beta Expected Return

A 1.50 14%
B 0.60 8%
C 1.20 9%
D 1.80 10%

a. Indicate whether each share is overpriced, underpriced, or correctly priced.

(Marks: 2)
b. Show how a smart investor could construct a portfolio of shares A and B that would
outperform share D.
(Marks: 3)
Use the information below for parts c e.

Assume the cost of capital is 12%. Sharpe Manufacturing is considering the following
projects:
Year Project A Project B Project C
0 -20,000 -40,000 -70,000
1 18,000 5,000 30,000
2 18,000 10,000 30,000
3 18,000 30,000 40,000
4 80,000 50,000
5 100,000 180,000

c. Rank the projects based on NPV.

(Marks: 1)
d. Which of the projects would Sharpe Manufacturing accept using the payback method if
its policy is to accept all projects with a payback period of 2.75 years or less?
(Marks: 2)
e. What are the internal rate of return and profitability index of Projects A, B and C?
(Marks: 2)

2
Question 2 (Total Marks: 10)

Interest rates in Australia are currently at an all-time low. A few days earlier (in August
2017) Sam found her dream home. Its priced at $700,000. Sam plans to pay 10% of the
house price from her savings. For the remaining 90% of the house price she has been offered
a home loan at a very attractive annual interest rate of 3.5% by Star Bank. Sam can choose
between a 20 or 25-year loan. She has to repay the loan through equal annual installments
over the term of the loan. Her first installment of repayment will be in August 2018.

a. Assuming the interest rate remains constant over the entire loan term calculate Sams
annual repayments for a 20-year loan and compare it with the repayments for a 25-year
loan.
(Marks: 2)

b. Calculate and compare the total interest paid for a 20-year and 25-year loan.
(Marks: 2)

c. Everything else remaining the same what is the relationship between the loan term and
(i) annual repayments (ii) total interest paid? Provide a brief explanation for your answer.
(Marks: 2)

Interest rates seldom remain constant over the entire loan term. Suppose Sams home loan
interest rate is fixed for the first 3 years. After 3 years, i.e., from August 2020, Sam will have
to pay an annual interest rate of 6% for the remaining term of her home loan.

d. Calculate the annual loan repayments for Sam from August 2021 onwards if she had
taken a 20-year loan originally. How does this compare with her repayments for a 25-year
loan?
(Marks: 4)

3
Question 3 (Total Marks: 20)

Download and save the file FIN205A1.xlsx to answer this question. This file contains monthly
data on yields of Australian Government Bonds and New South Wales (NSW) Treasury Bonds
from January 2007 December 2008.

For questions a e, consider Australian Government Bonds only.

a. Pick the month you were born. Draw the yield curve for that month in 2007 and 2008.
Also, draw the yield curve for the month falling exactly in the middle. (For instance, if you
were born in April, draw the yield curves for April 2007, October 2007 and April 2008.)
(Marks: 3)

b. What should be the shape of the yield curve under normal circumstances? Why?
(Marks: 2)

c. Compare the shapes of the three yield curves that you have drawn. From the yield curves,
can you infer anything about the markets expectation about the future of Australian
economy?
(Marks: 3)

d. What is the yield on 2-year bond in January 2007? Under the expectations theory, what
interest rate do investors expect on a 1-year bond next year (i.e., January 2008)? Using the
same method calculate the expected interest rates on 1-year bonds for all the months of
2008.
(Marks: 3)

e. How do the expected interest rates compare with the actual interest rates in 2008? Do
your calculations validate/not validate the expectations theory? List some possible reasons
why the expectations hypothesis may not hold.
(Marks: 3)

For questions f g, consider both Australian Government Bonds and NSW Treasury Bonds
for the period January 2007 December 2008.

f. For 3, 5 and 10 year bonds what was the average spread between Australian Government
Bonds and NSW Treasury bonds? Can you provide a reason for this?
(Marks: 3)

g. Draw a graph plotting the spread between Australian Government Bonds and NSW
Treasury Bonds. Comment on the pattern of the spread. Can you provide an explanation for
this pattern?
(Marks: 3)