Chapter 3:

More Advanced Financial Analysis

Dr Nurin Haniah Asmuni
Centre of Actuarial Studies
Faculty of Computer and Mathematical Sciences
26 April 2016
 Inflation

Risk &
uncertainty
Factors Expenses
affecting
calculation of
interest rates
Currency
&
Taxes
exchange
rates
1. Inflation
 What is inflation?
- Represent the loss of purchasing power over time
 Measure of inflation?
 Let:
o i’ = real rate of interest (adjusted for inflation)
o i = nominal rate of interest (actual rate of interest)
o r = rate of inflation (1  i )  (1  i ' )(1  r )
1 i
1  i' 
1 r
ir
i' 
1 r
 1. Inflation (cont.)
 PV of a series of payments at the end of each period for n periods
with base payment at time 0 is R:
 Each payment reflects inflation
 1 r  
n

1  r 1    
1 r  
2 n
1 r   1  i  
PV : R     ...      R (1  r ) 
 1  i  1  i   1 i    ir 
   

 

 Rate of interest is adjusted for inflation
 1 1 1 
PV : R    ...  n 
 Ran i

1  i ' 1  i ' 2
1  i '  

 Example 1
 An insurance company has just made a payment of RM30,000
under the settlement provisions of a personal injury lawsuit. The
company is making annual payments and five more payments are
due. Future payments are indexed to the CPI (Consumer Price
Index) which is assumed to increase at 5% per year. If the rate of
interest is assumed at 8%, what is the PV of the remaining
obligation? (Answer: 137,953.42)
 i =?
 r =?
 i’ =?
Question 1
 The nominal rate of interest is 8% and the rate of inflation is
5%. A single deposit is invested for 10 years. Let:
A = value of the investment at the end of 10 years measured in
“constant dollars,” i.e. in dollars valued at time 0.
B = value of the investment at the end of 10 years computed at
the real rate of interest.

Find the ratio A/B.

(Answer: 1)
Question 2
 Rework Question 1 assuming equal level deposits at the
beginning of each year during the 10-year period instead of a
single deposit. (Answer: 0.82)
2. Expenses
 Examples of types of expenses:
 Commissions
 Brokerage fees
 Underwriting expenses – charged by the investment bankers,
usually applied during the process of bonds issuance by
corporations or government
Example 2
 An investor age 40 deposits RM10,000 in a mutual fund
which is expected to earn 7.5% effective and has an expense
ratio of 1.5%. At age 65, determine the percentage reduction
in the expected retirement accumulation attributable to the
expense ratio. Refer to Example 9.4.
(Answer: 29.62%)
 3. Effect of taxes
 Let:
b
 i = before-tax interest rate
a
 i = after-tax interest rate
 t = tax rate

 i a  (1  t )i b Interest is taxed

 If tax rate is the same for n years, and interest is taxed as it is

earned each year, then the after-tax AV is
 
a ( n)  1  i a
n

 1  (1  t )i 
b n
Example 3
 RM1,000 is being invested at the beginning of the year. All
investment income is fully taxed as it is earned. Given the
interest rate is 8% and tax rate is 25%, compute the after-tax
accumulated value at the end of 1 year.
Answer: RM1,060
Effect on Price of Tax
 Bonds issued in some countries are often taxed on
any interest and/or capital gain received
 We can find the price of bond allowing for the
effect of tax, by calculating the present value (PV)
of the net cash flows after deducting the
tax payable
Consider a bond paying semi-annual coupons:
 If the tax is payable immediately, given a tax rate of t, the
after tax net cashflows are:
 Interest/coupon = Fr – t (Fr)
 Maturity value = C – t (C - P)
Where the t (Fr) is tax on interest
And t (C – P) is tax on capital gain payable only if C-P > 0.

 If the tax payments are deferred for 6 months, given a tax

rate of t, the after tax net cashflows are:
 Interest/coupon = Fr – t (Fr)v
 Maturity value = C – t (C - P)v
Where the t (Fr) is tax on interest
And t (C – P) is tax on capital gain payable only if C-P > 0.
Example 4
 Find the price of a RM100 10-year bond with 8% coupons
payable semi-annually, to yield 6% convertible semi-annually
allowing for 30% tax on:
i. Interest earned only
ii. Interest earned and capital gain
Assume that the bond is to be redeemed at par value and tax on
interest and capital gain are deferred for 12 months.
 (i) tax on interest earned only
For this case, we allow for tax on interest earned only and
assume that tax is payable one year (12 months) after each
taxable income:
P 4 4 4 … … 4 + 100

0 1 2 3 4 5 … 20 21 22

0.3(4)= 1.2 1.2 1.2 … … 1.2

𝑃 = 4𝑎20|3% + 100𝑣 20 − 1.2𝑎20|3% 𝑣 2

= 4 − 1.20𝑣 2 𝑎20|3% + 100𝑣 20
= 98.049
(ii) tax on interest earned and capital gain
 Let the price denoted as P. For this case, tax on capital gain will be paid only if
100 > P.
 Since we have calculated the price in (i) allowing for tax on interest earned only
to be less than 100.
 Therefore, there will be a capital gain and capital gain tax (T) will be payable.

P 4 4 4 … … 4 + 100

0 1 2 3 4 5 … 20 21 22

0.3(4)= 1.2 1.2 1.2 … …1.2+T

𝑃 = 4𝑎20|3% − 1.2𝑎20|3% 𝑣 2 + 100𝑣 20 − 𝑇𝑣 22

= 4 − 1.20𝑣 2 𝑎20|3% + 100𝑣 20 − 0.3(100 − 𝑃)𝑣 22
4−1.20𝑣 2 𝑎20|3% +100𝑣 20 −30𝑣 22
= = 97.687
1−0.3𝑣 22
Homework
 Rework example 4 assuming that the payments of tax on
interest and capital gain are payable immediately.
 Rework example 4 assuming that the payments of tax on
interest and capital gain are deferred for six months.
 Comment on your results.