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)
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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.
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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)
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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)
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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)
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