BUS704 Case Study For Financial Management
Questions:
b)How much interest will be paid in the 104th repayment?
c)How much would Rex and Rhonda owe the bank immediately before making the 200th repayment?
Answer:
The given information and data is summarized below:
Hose costs
Accumulated deposit (down payment for the house)
Expected loan amount
Annual nominal interest rate (yearly)
Annual nominal interest rate (monthly) = (6.5/12) % =0.5417 per month
Repayment period for loan (years)
Repayment period for loan (months)
Monthly repayment
Interest that would be paid in 104th repayment
In order to determine the interest amount that would be paid in 104th repayment, the amortisation table for the loan needs to be produced which has been represented in the following excel spread sheet.
The interest that would be paid in 104th repayment is $2,676 as shown above.
The total amount that Rhonda and Rex will owe the bank by before making 200th repayment is calculated through amortisation table of the loan.
The total amount that Rhonda and Rex will owe the bank by before making 200th repayment is
Question 2
The FV (future value) of annuity (at t = 15) = $123,750
Interest rate = 5.35 % p.a.
Assume that the annual annuity amount would be $X.
The equation can be drawn based on the above shown table.
Therefore, it can be said that annual annuity payment would be $6,485.36.
Total number of days to maturity = 90 days
Current price (bond) = $98,980
Face value (bond) = $100,000
Annual nominal yield =?
Effective annual yield =?
Let’s assume that the annual nominal yield is x%.
Hence, the annual nominal yield would be 4.24%.
Further,
Effective annual yield can be calculated as highlighted below.
Effective annual yield
It can be seen from the above that effective annual yield and annual nominal yield is not same and hence, it can be said that effect of compounding is not taken into consideration by nominal yield calculation.
Annual rate of return
For Accumulation Index
For Ordinaries Price Index
The table represents the information regarding the three bonds.
Face value of bond = $100
Current yield (market interest rate) = 7.0% p.a.
Calculation of current price of each bond
The PV of bonds will be discounted value of the respective future cash inflows which are expected during the bond’s maturity period.
For Bond A
Period of maturity and annual coupon
Hence, current price of bond is $102.62.
For Bond B
Period of maturity and annual coupon
Current price of bond
Hence, current price of bond is $110.16.
For Bond C
Period of maturity and annual coupon
Current price of bond
Hence, current price of bond is $120.50.
Calculation of duration for each of the bond
For Bond A
Hence, the duration of bond A is 2.86 years.
For Bond B
Hence, the duration of bond A is 3.87 years.
For Bond C
Hence, the duration of bond A is 4.97 years.
Calculation of current price of each bond
The PV of bonds will be discounted value of the respective future cash inflows which are expected during the bond’s maturity period.
The market interest rate is taken as 8%.
For Bond A
Period of maturity and annual coupon
Hence, current price of bond is $100.
For Bond B
Period of maturity and annual coupon
Current price of bond
Hence, current price of bond is $106.62
For Bond C
Period of maturity and annual coupon
Current price of bond
Hence, current price of bond is $115.97
Internal Rate of Return (also known as IRR) may be highlighted as the discount rate resulting in project or investment NPV to become zero. With regards to allocation of capital resources, this is a critical tool for highlighting the commercial viability of possible projects. Some of these projects are long term and tend to incur significant capital expenditure at the start for future cash inflows and thereby reliable evaluation is crucial (Arnold, 2015).
There are a host of capital budgeting techniques present for capital project evaluation with IRR being one of the reliable methods. A noteworthy feature of IRR contributing to the reliable evaluation is that it considers the time value associated with money. When projects with long useful life are being evaluated, consideration of time value of money becomes imperative since cash inflow/(outflow) occurring at a later date would not amount to the same value in present terms. Thus, any incremental revenue or related cost occurring more than a decade from today cannot be taken to mean the same in absolute terms and the underlying opportunity cost ought to be considered. Clearly, IRR is thus superior when compared with methods like payback period which fail to consider the time value associated with money and hence would not provide correct assessment of project’s commercial viability (Petty et. al., 2015).
Yet another advantage associated with use of IRR is on account of consideration of the total incremental cash flows that take place over the project’s useful life. Thus, a comprehensive projection of the project is obtained. In contract, there are certain capital budgeting techniques (example, discounted payback period & undiscounted payback period) that only take the incremental cash flows into cognizance till the recovery of the original investment. Therefore, the IRR technique would be considered more reliable than the payback period based technique irrespective of payback period being discounted or not (Damodaran, 2015).
Another advantage associated with use of IRR is that there is no requirement of discount rate or cost of capital for its computation. This provides an edge to IRR over other established capital budgeting techniques like NPV which tend to quite sensitive to the discount rate used. The estimation of this cost of capital or discount rate in a reliable manner is not easy since a host of factors tend to impact this and also project/investment risk is not necessarily comparable with the firm level risk. In case of IRR estimation this does not pose any issue since it can be estimated without using cost of capital as a input. However, it is noteworthy that IRR interpretation and decision regarding project feasibility would require the cost of capital or discount rate applicable for the underlying project/investment (Brealey, Myers and Allen, 2014).
Despite the above features associated with IRR and the underlying reliability, there are a few issues with IRR which deserve mention. A case in point is the unrealistic assumption relating to reinvestment rate being equal to IRR which is not always true. Usually, the reinvestment rate tends to either err on the higher or lower side depending on whether the underlying IRR value is low or high respectively. IRR also is not reliable when during the years (besides the initial year), there are negative cash flows provided by the underlying project. In these projects, there are more than one IRR value obtained that can possibly lead to issues in interpretation on the part of user. Further, another circumstance where IRR is not considerable as a reliable measure is when comparison of multiple projects with difference in useful lives is carried out. Owing to the useful life difference, a measure carrying out annualised computation is more reliable as it is independent of the actual useful life of the projects (Parrino and Kidwell, 2014).
Further, in wake of growing impact of external parameters in the feasibility of various projects, it has become a common practice to have real options provided for long term projects or investment. An example to illustrate the importance and use of real options would be a mining project related to crude oil. After commencement of exploration activity, it might happen that an economic slowdown may occur and thereby the demand of oil is reduced which has an adverse impact on the project viability. These situations can be dealt with the presence of real options which at a small cost tend to extend an option to the management or project team to abandon the project or shift the same in the future when more viable conditions exist. This limits the losses which the companies would have to otherwise bear in these high capital expenditure projects (Damodaran, 2015).
In relation to real options valuation, it is imperative to note that the techniques deployed are comparable to those deployed for valuation of financial options. Thus, the common techniques for capital budgeting including IRR do not fit into valuation of these volatile options as the underlying value depends on a plethora of issues such as price of commodity volatility, duration and underlying strike price at which option can be exercised. The presence of these dynamic factors and the lack of certainty make IRR unsuitable for highlighting the potential cash flows with reliability. Thus, it is advisable for valuation of real options, it is preferable to deploy tools like binomial lattice, Black Scholes Model along with other simulation techniques (Petty et. al., 2015).
In line with the discussion carried out above, it may be fair to conclude that indeed IRR is a reliable capital budgeting technique especially in regards to feasibility analysis of capital projects with long duration. The various aspects which contribute to the same are consideration of cash flow over useful life, time value of money and not needing the cost of capital for computation. Despite the reliability, there do arise some scenarios where the reliability of IRR falters and alternate methods are considered more useful. Besides, real options valuation cannot be carried out using IRR and require specialised tools and mathematical models.
References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times Management.
Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia
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