Question 1:

A company has 2 bonds in issue, both with a nominal value of £100 and redeemable at
par value:
Bond A 5% maturing in 3 years
Bond B 10% maturing in 3 years
The required yield is 4%.

Required:
Calculate the duration of Bond A and Bond B.

Answer

BOND A
DISCOUNT FACTOR
TIME CASHFLOW PV
4%

1 5 0.962 4.8

2 5 0.925 4.6

3 105 0.889 93.3

Total 102.8

BOND B
DISCOUNT FACTOR
TIME CASHFLOW PV
4%

1 10 0.962 9.6

2 10 0.925 9.3

3 110 0.889 97.8

Total 116.7
Question 2:
What is the difference between total risk, systematic risk and unsystematic risk? What is
the impact of portfolio diversification on these respective risk elements?

ANSWER
Total Risk
Total risk is combination all risk factors associated with making some type of investment
decision. Identifying all the factors that could come into play means looking closely at
both the Systematic and Unsystematic Risk involved with either buying or selling a given
investment, such as shares of stock, bonds, mutual funds or commodities.

Systematic Risk
This risk is associated with market factors that affect all entities in the market. This type
of risk cannot be eliminated or mitigated through diversification. For example, inflation,
war, global economic issues, revolution, political events etc. this is the risk that affects
entire market. Like COVID 19, it is global pandemic that has affected the entire market.

Unsystematic Risk
It is the portion of an asset’s risk associated with random causes that can be eliminated
through diversification. This risk is firm/industry specific. This risk is caused by factors
which affect all industries and businesses to some extent or other such as: interest rates,
tax legislation, exchange rates and economic boom or recession.

Question 3:
Required:
Calculate the present value of the following cash flows assuming a discount rate of 10%.
(a) A cash inflow of £5,000 in one year's time
(b) A constant annual cash inflow (an annuity) of £5,000 received for the next five years
(c) A constant cash inflow of £5,000 received in three years' time and for the next four
years (time 3–7)
(d) A constant annual cash inflow (an annuity) of £5,000 received for the foreseeable
future

ANSWER

PART A

TIME CASH INFLOW DISCOUNT RATE 10% PV

1 5000 0.909 4545

PART B

TIME CASH INFLOW DISCOUNT RATE 10% PV

1-5 5000 3.791 18955

PART C

TIME CASH INFLOW

3-7 5000

Discount rate = 3.791

PV at time 2 = 18955

PART D

Time 1-Infinity
Cash inflow = 5000

Discount factor = 10

PV = 50000
Question 4:
Entraq plc is considering two proposals to invest in the manufacture of solar panels:
Proposal A – to build a customised plant with specialist staff in Cornwall, which can only
be used to construct solar panels. This proposal would build Entraq's profile in the solar
panel industry.
Proposal B – to use more expensive machinery in Entraq's existing premises in
Basingstoke that could be adapted to produce components for the wind power industry.
A general election is expected next year that will affect the likely growth of the solar panel
industry.
Required:
Identify the real options present in these investments.

ANSWER

According to given data, there are some options:

Proposal A
• Option to Expand NO
• Option to Delay YES

Proposal B
• Option to Delay NO
• Option to Expand NO
• Option to Abandon/Withdraw YES
• Option to Redeploy NO

Question 5:
McTavish Inc and Sporran Inc are two companies identical in every respect apart from
their capital structures. McTavish has a D/E ratio of 1:4 and its equity beta is 1:3. Sporran
has a D/E ratio of 1:3. Corporation tax is 30%. Assume debt is risk-free.

Required：
Calculate Sporran Inc’s equity beta and interpret the result.

ANSWER

Ungeared Beta βa =1/8

Sporran Inc’s Equity Beta βs = 0.25

Equity Beta measures the volatility of the investment. Higher the beta, means higher the
risk. Geared Betas are more riskier than ungeared betas. Equity beta demonstrates that
Sporran is less riskier than McTavish, but mostly high risk means high chances of return.
Question 6:
A professional accountancy institute in the United Kingdom is evaluating an investment
project overseas – in Eastasia, a politically stable country. The project will cost an initial
2.5 million Eastasian dollars (EA$) and it is expected to earn nominal post-tax cash flows
as follows.
Year 1 2 3 4
Cash flow (EA$'000) 750 950 1,250 1,350
(a) The expected inflation rate in Eastasia is 3% a year, and 5% in the UK.
(b) The current spot rate is EA$ 2 per £1 Sterling.
(c) The company requires a sterling return from this project of 16%.

Required:
Calculate the £ Sterling net present value of the project by discounting nominal annual
cash flows in £ Sterling.

ANSWER

First of all , we have to calculate exchange rate between Pound and Eastasian dollars
(EA$). For this purpose, we can use Purchasing Power Parity.
The expected spot rate can be found by:

Year EA$/₤
1 1.9619
2 1.9245

3 1.8878

4 1.8518

After calculating ₤ sterling, NPV of the project by discounting nominal annual cash flows
can be found out by:

Discounting Nominal Annual Cashflows in ₤ sterling at 16%

YEAR CASHFLOW (EA$'000) $/₤ CASHFLOW ₤’

0 -2500 2 -1250

1 750 1.9619 382

2 950 1.9245 494

3 1250 1.8878 662

4 1350 1.8518 729