MODEL ANSWERS FOR PRINCIPLES OF INVESTMENT SECTION A QUESTION 1 (a) (b) (c) The fundamental principles of investment are as follows; Time value of money: this is the influence that interest rates have on the value of money over a period of time. (2 marks) Risk versus return: Risk refers to uncertainty about the occurrence of a future outcome. Risk can be divided into financial and non financial risk. Financial risk is the possibility that a future event will diminish the value of an investment. Financial risk is measured by the standard deviation and the coefficient of variation. Non financial risk is exposure to uncertainty which is non monetary in nature, e.g. health and safety risk. Return refers to the capital appreciation or loss in the form of cash dividends or interest resulting from investment. Historical returns are measured by the holding period return (HPR) and holding period yield (HPY), whereas future returns are measured by the expected return and required rate of return. (4 marks) A market would be informationally efficient if the following apply (any two); A large number of competing, profits – maximising, independent participant’s analysis and value securities. (2 marks) New information arrives rapidly. (2 marks) The competing investors attempt to adjust prices rapidly to reflect new information. (2 marks) Students must choose any five from the following asset classes (5 marks) Equity Fixed income securities (which would include bonds, shares and bank deposits) Debt instruments Real estate Art objects Rare stamps Currencies (Total 15 marks) 1 QUESTION 2 (a) (b) An investment manager would take the following steps: Establish investment objectives and constraints. (2 marks) Establish the investment policy. (2 marks) Select a portfolio strategy. (2 marks) Select assets. (2 marks) Measure and evaluate performance. (2 marks) The expected rate of return is the rate expected to be realised from an investment and is calculated by multiplying the probabilities of occurrence by their associated outcomes. The required rate of return is the minimum return an investor would require from an investment, given the riskiness of the instrument. If the expected return is less than the required return, the investment is not worth pursuing. (5 marks) (Total 15 marks) QUESTION 3 (a) Calculation using an FV factor: FV = PV x [FV factor for n = 6, i = 5%] (2 marks) FV = K200 x [1.340] ← FV factor from ( 2 marks) FV = K268 ( 1 mark) (b) Using the formula to determine the present value, we have: PV = FV x [1 ÷ (1 + i)n ] PV = K5,000 x [ 1 ÷ (1 + 0.02)12 ] ( 1 mark) PV = K5,000 x [ 1 ÷ (1.02)12 ] ( 1 mark) PV = K5,000 x [ 1 ÷ 1.2682418 ] ( 1 mark) PV = K5,000 x [ 0.78849 ] ← PV factor ( 1 mark) PV = K3,942.45 ( 1 mark) (c) Annuities are essentially series of fixed payments required from you or paid to you at a specified frequency over the course of a fixed period of time. The most common payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly (four times a year) and monthly (once a month). There are two basic types of annuities: ordinary annuities and annuities due: (1 mark) 2 Ordinary Annuity: Payments are required at the end of each period. For example, straight bonds usually pay coupon payments at the end of every six months until the bond's maturity date. (2 marks) Annuity Due: Payments are required at the beginning of each period. Rent is an example of annuity due. You are usually required to pay rent when you first move in at the beginning of the month, and then on the first of each month thereafter. (2 marks) (Total 15 marks) QUESTION 4 (a) (b) The participants in the money market consist largely of: (5 marks) individuals Small to medium sized companies Corporate companies Banks Government, through the central bank Parastatals Interest – bearing instruments These are instruments that pay interest on the initial investment amount to the holder. They include: (3 marks) Overnight/time/term deposits Negotiable certificate of deposit Reserve bank debentures Repurchase agreements Roads board bridging bonds Discount instruments These are instruments that do not pay interest to the holder, but are purchased at a discount on the nominal value. They include: (2 marks) 3 (c) Treasury bills Bankers Acceptances Commercial paper Promissory notes Land bank bills Capital project bills The money market can be classified into two categories: The retail market. The wholesale market The retail market involves smaller amounts of funds, usually not more than K20 million. Most individuals, small and medium enterprises are active participants in the retail market because of the smaller amounts involved. Typical instruments that are used in this market include call accounts, notice deposits, motor vehicle finance and overdrafts. (2.5 marks) The wholesale market involves larger amounts of more than K20 million. Most participants in this market are banks, corporate and government. (2.5 marks) (Total 15 marks) SECTION B QUESTION 5 Setting the Investment Objective The first step for the investor is to set the investment objective. This would vary for individuals, pension and mutual funds, banks, financial institutions, insurance companies, etc. For instance the objective for a pension or mutual fund or insurance company may be to have a cash flow specification to satisfy liabilities at different dates in the future. These liabilities would include redemption, dividends or claim settlement payouts. For a bank it may be to lock in a minimum interest spread over their cost of funds. For the individual investor the objective may be to maximize return on investment. A more appropriate word would be ‘optimize’. As the individual would achieve optimum return at optimum risk. To maximize return would imply the maximization of risk, which would not be practical or sustainable. (5 marks) 4 Establishing Investment Policy Setting policy begins with asset allocation amongst the major asset classes available in the capital market. Which range from equities, debt, fixed income securities, real estate, and foreign securities to currencies. While setting the investment policy the constraints of the environment and that of the investor have to be kept in perspective. The environment would include: government rules and regulations (or restrictions); another would be the operating system of the market place. Individual constraints would include financial capability, availability of time to undertake the exercise, risk profile and the level of understanding the investor has of the investment environment. (5 marks) Selecting the Portfolio Strategy The portfolio strategy selected would have to be in conformity with both the objectives and policy guidelines. Any contradiction here would result in a systems break down and losses. Let’s consider a person with a job that keeps him busy for 10-12 hours a day, five days of the week. On Saturday he helps the family with household chores. On Sunday he takes the day off and enjoys himself. Now with such a busy life, we cannot expect him to obtain optimal returns from investments in the equity market. Where is the time for thought, analysis and action? He would at best be playing a game of Blantyre sports. For a person with such a busy life schedule it would be best to invest in fixed income securities. These would include RBM bonds, Bank deposits, insurance, etc. Where there is a lower but assured return. However, if this average, hard working and successful person still wants to invest in the equity market for a relatively higher rate of return. Then he would have to create the time for the thought, analysis and action required for success in this endeavor. Portfolio strategies are mainly of two types: Active strategies and Passive strategies. Active strategies have a higher expectation about the factors that are expected to influence the performance of the asset class. While Passive strategies involve a minimum expectation input. The latter would include indexing which would require the investor to replicate the performance of a particular index. Between these two extremes we have a range of other strategies which have elements of both active and passive strategies. In the fixed income segment, structured portfolio strategies have become popular. Here the aim would be to achieve a predetermined performance in relation to a benchmark. These are frequently used to fund liabilities. (5 marks) Selecting the Assets It is of importance for the investor to select specific assets to be included in the portfolio. It is here that the investor or manager attempts to construct an optimal or efficient portfolio. This would give the expected return for a given level of risk, or the lowest risk for a given expected return. 5 The asset classes can be chosen from: Equity Fixed income securities (which would include bonds, shares and bank deposits) Debt instruments Real estate Art objects Rare stamps Currencies The investor would ideally have all the above in his investment portfolio. This would then require the investor to rebalance the various components of his overall portfolio from time to time, depending on his objectives with respect to this portfolio. These objectives may be time based or asset price based or a combination of both. (5 marks) Measuring and Evaluating Performance This step would involve the measuring and evaluating of portfolio performance relative to a realistic benchmark. We would measure portfolio performance in both absolute and relative terms, against a predetermined, realistic and achievable benchmark. Further, we would evaluate the portfolio performance relative to the objective and other predetermined performance parameters. The investor or manager would consider two main aspects; namely risk and return. He would measure and evaluate, whether the returns were worth the risk, or whether the risk was worth the return. The issue here is, whether the portfolio has achieved commensurate returns, given the risk exposure of the portfolio. Measuring and evaluating portfolio performance, would be used to give the investor or manager feedback. And would help the investor or manager in improving the quality and performance of both the portfolio and its management process in the future. (5 marks) (Total 20 marks) QUESTION 6 6.1 HPR = Ending value of investment + Cash flows (1 mark) Beginning value of investment = 39+1.50 / 34 (1 mark) = 1.1912 (1 mark) 6 Annual HPY = (HPR – 1) X 100 (1 mark) (1.1912 – 1) x 100 = 19.12% 6.2 Possible outcomes Probability Return (1 mark) Weighted value (1) (2) (1) x (2) Pessimistic 0.25 13 3.25% Most likely 0.50 15 7.50% Optimistic 0.25 17 4.25% Total 1.00 Expected return (k) = 15% (5 marks) (b) (1) (i-k) x (i-k) Pi (2) i (k) 1 13% 15% -5% 4% 25 1% 2 15% 15% 0% 0% 50 0% 3 17% 15% 2% 4% 25 1% Variance i-k (2) (1) x (2) 2% Standard deviation = square root of 2% = 1.4142% (5 marks) (c) CV = Standard deviation Expected return (k) CV = 1.4142 15 = 0.094 (5 marks) 7 QUESTION 7 (a) The top down approach involves an analysis of microeconomic influences and industry analysis before the company can be analysed. The bottom up approach uses valuation techniques to value assets without considering the influences of macroeconomic and industry forces on the prospects of the company. (5 marks) (b) A restrictive monetary policy has the effect of raising the market interest rates, which, in turn, increases companies’ borrowing costs and thus affects the profitability of companies. Individuals would also be affected because it would be expensive for them to borrow money from the bank to finance their homes, motor vehicles and other durable goods. (5 marks) (c) The idea behind the three step valuation process is to identify the macroeconomic influences that may impact on the company’s ability to generate earnings. Once you have identified these factors, it is easier to analyse the earning capabilities of industries and companies. (5 marks) (d) Students must list the following; (5 marks) The threat of substitute products The threat of the entry of new competitors The intensity of competitive rivalry The bargaining power of customers The bargaining power of suppliers (Total 20 marks) QUESTION 8 NET PRESENT VALUE (NPV) The net present value (NPV) is found by subtracting a project’s initial investment (Cfo) from the present value of its cash flows (CFt) discounted at a rate equal to the firm’s cost of capital (r) NPV = Present value of cash inflows – Initial investment When NPV is used, both inflows and outflows are measured in terms of present Kwachas. Because we are dealing only with investments that have conventional cash flow patterns, the initial investment is automatically stated in terms of today’s kwachas. If it were not, the present value of a project would be found by subtracting the present value of outflows from the present value of inflows. (5 marks) 8 Decision Criteria When NPV is used to make accept – reject decisions, the decision criteria are as follows: If the NPV is greater than 0, accept the project. If the NPV is less than 0, reject the project. If the NPV is greater than 0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV. (5 marks) INTERNAL RATE OF RETURN (IRR) The internal rate of return (IRR) is probably the most widely used sophisticated capital budgeting technique. However, it is considered more difficult than NPV to calculate by hand. The IRR is the discount rate that equates the NPV of an investment opportunity with 0 (because the present value of cash inflows equals the initial investment). It is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows. (5 marks) Decision Criteria When IRR is used to make accept – reject decisions, the decision criteria are as follows: If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project. These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and therefore the wealth of its owners. (5 marks) (Total 20 marks) 9