FINANCIAL CONCEPTS A
A SOLUTIONS AND MODEL ANSWERS FOR DRAFT
EXAMINATION
NOVEMBER 2013
Prepared By: Jayi Mlaliki
SECTION A
Question 1
(15 marks)
The Correct answer is:
c) 4 years at the interest rate of 9% per year.
(3 marks)
The calculations are respectively (Remember to subtract the 'one'):
a)
b)
c)
d)
1.055 = 1.276282;
1.037 = 1.229874;
1.094 = 1.411582;
1.062 = 1.1236
(3 marks)
(3 marks)
(3 marks)
(3 marks)
3 marks for each correct calculation and another 3 marks for the correct choosing of investment with highest
investment
Question 2
a)
(20 marks)
Using Computer (Excel)
Select a Cell in Excel, then input:
PV (0.19, 4, 600000, 0) Solution:? £1,583,151.31
b) Financial Calculator
Inputs:
5
N
10
I
Display
FV
?
NPV
HP12C
f FIN CLX
10 i
0
10.00
10,000 g CHS CF0,
600,000 g
CFj
600,000 g
CFj
600,000 g
CFj
600,000 g
CFj
-10,000
600,000
600,000
600,000
600,000
Clear all financial registers
Interest rate(cost of capital or required return)
expressed in years
initial cash flow out (cost of project)
Cash flow year 1
Cash flow year 2
Cash flow year 3
Cash flow year 4
1
Press NPV
c)
1,583,151.31
Net Present Value
Present Value Tables
Year
Cash flow
0
1
2
3
4
NPV
0
19% discount factors
1.000
600,000
600,000
600,000
600,000
1
2
3
4
Present Values K
0
0.8403
0.7062
0.5934
0.4987
1,583,160.00
Question 3
(15 marks)
Rather than use accounting profits, the evaluation of a project must use cash flows, why? There are several
advantages of using cash flow accounting:

Survival of a company depends on its ability to generate cash.

Cash is comprehensive or concrete whereas profit can be manipulated.

As bankers (Creditors) we are interested in a company’s ability to repay and Cash is direct.

Cash flow provides a better means of comparing between companies.

Cash flow satisfies the needs of all users better.
o For management. It provides the sort of information on which decisions should be taken.

Cash flow forecasts are easier to prepare & more useful than profit forecasts.

Auditing is easier with cash flow accounts than accrual basis accounts.

Accruals concept is confusing while cash flows are easily understood and there are many ambiguities e.g.
various methods of inventory valuation, depreciation and individual judgements when making provisions for
bad debts.
Question 4
(15 marks)
a) Contrasting the following;
(i) Compound Interest versus Simple Interest
(3 mark)
Simple interest is interest that accrues linearly. In other words, it grows by a certain fraction of the principal
per time period. Compound interest is interest which is regularly added to the debt (compounded). Interest is
then calculated not only over the principal, but also over the interest that has been added to the debt before,
in other words, it is calculated over the total amount owed. With compound interest, the frequency of
compounding influences the total amount of interest paid over the life of the loan.
(ii) Effective annual rate versus Nominal Interest rate
(5 mark)
A nominal interest rate is the interest rate that does not compensate for inflation and this is the rate that
many banks advertise also known as annual percentage yield (APY). It is the return on the principal amount
over an entire year. For example, a 5% rate compounded monthly would have an approximate APY of 5.12%.
Effective Annual Rate (EAR) This is the actual rate paid (or received) after accounting for compounding that
occurs during the year. If you want to compare two alternative investments with different compounding periods
you need to compute the EAR and use that for comparison.
There is need to distinguish between nominal interest rates and effective interest rates when comparing
interest rates. An interest rate is called nominal if the period of time after that the interest is credited (e.g. a
month) is not identical to the basic time unit (normally a year).
b)
Value of investment converting from nominal interest rate to effective interest rate;
Display
HP12C
f FIN
0
Clear all financial registers
2
12 ENTER
4n
÷i
1000000
CHS
FV
12.00
4.00
4.00
-100000.00
Nominal rate
Compounding period (4 quarters in a year)
% quarterly interest rate
Investment amount
($1,125,508.81)
The FV value of K1,000,000 investment @ 12% compounded
quarterly
c)
Solution

Mathematically
 100
 365
 1
 0.02736  2.736 %

99
.
27076

 98

Financial calculator
HP-10b Input 100; Press ENTER; Press ÷; Input 99.27078;
Press -; Input 1; Press x; Input 365; Press ÷; Input 98; Display 0.02736
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SECTION B
Question 5
(20 marks)
Advantages of the payback method
1.
2.
3.
4.
5.
It is simple and easy to apply
As a concept it straightforward to understand.
The payback period is not open to manipulation since it is calculated using cash flows as opposed to
accounting profits which are open to manipulation by managerial preferences for particular accounting
policies.
If we accept that more distant cash flows are more uncertain and that increasing uncertainty is synonymous
with increasing risk, it is possible that another advantage of the payback method is that it takes account of
risk, in that implicitly assumes that a shorter payback period is superior to a longer one.
If a company is restricted in the amount of finance that it has available for investment, the payback can be
argued to be a useful appraisal method, since the sooner cash is returned by a project, the sooner it can be
reinvested into other projects. While there is some truth in this argument, it ignores the fact there are better
investment appraisal methods available to deal with capital rationing, as will be explained later in this
module.
Disadvantages of the payback method
There are a number of difficulties in using the payback method to assess capital investment projects and these are
sufficiently serious for it to be generally rejected by corporate finance theory as a credible method of investment
appraisal.
1. Importantly, it ignores the time value of money, so that it gives equal weight to cash flows whenever they
occur.
2. The payback method also ignores the size and timing of cash flows within the payback period. From our
example, we can see the payback period remains 3.5 years even if the project generates no cash inflows in
the first and second years of operation, but then a cash inflow of K400 in the third year. In fact, any
combination of cash flows in the first three years which total K400 would have given the same payback
period. The problem of ignoring the time value of money is partly remedied by using the discounted payback
method discussed in later in this chapter (see next page).
3. Another serious disadvantage of the payback method is that it ignores all cash flows outside of the payback
period and so does not consider the project as a whole. If a company rejected all projects with payback
periods greater than three years, it would reject the project given in our earlier example. Suppose that this
project, in year 4, had been expected to generate a cash inflow of K1,000. This expected cash inflow would
have been ignored if the sole investment appraisal method being applied was the payback method, and
would have been rejected.
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Question 6
a)
(20 marks)
For Deferred Annuities due, payments are commenced at some time in future with the last payment being
made at a specific point in time (when payments commence they are made at the beginning of period).
b)
c)
Question 7
i.
Mutually Exclusive Investments
In most cases companies must choose between two or more alternatives that can do the same job or using the same
facility. Thus, the organisation can only undertake one project in favour of the other project (s). Using the IRR method
can result in a wrong choice of project:
ii.
Non conventional cash flows
If an investment has cash flows of different signs in successive periods (e.g. a cash inflow followed by a cash outflow,
followed by a further cash inflow), it may have more than one IRR. Such cash flows are called non-conventional
cash flows, and presence of multiple IRRs may result in incorrect decisions being taken if the IRR decision rule is
applied.
iii.
Changes in the discount rate
If there are changes in the cost of capital over the life of an investment project the NPV method can easily
accommodate. However, the IRR, however, cannot take into account the change in discount rate in different years.
iv.
Reinvestment assumptions
Instead of assuming, as basic IRR calculation does, that every surplus Kwacha earns a positive return at the same
rate as has to be paid for every Kwacha invested (i.e. the same IRR of return for positive and negative cash flows). In
other words, IRR implicitly assumes that the cash inflows that are received say half-way through a project, can be
reinvested elsewhere at a rate equal to the IRR until the end of the project’s life. This is intuitively unacceptable. In
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the real world, if a firm invested in a very high yielding project and some cash was returned after a short period, this
firm would be unlikely to be able to deposit this cash elsewhere until the end of the project and reach the same
extraordinary high yield, and yet this is what the IRR implicitly assumes. The more likely eventuality is that the intraproject cash inflows will be invested at the ‘going rate’ or the opportunity cost of capital. In other words, the firm’s
normal discount rate is the better investment rate. The effect of this erroneous reinvestment assumption is to inflate
the IRR of the project under examination. Not so with NPV, which assumes that, cash inflows arising during the life of
the project are reinvested at the opportunity cost of capital.
Question 8

First find Net present values of the different projects:
NPVA = -1000 + (3000 x 0.467) = K401
NPVB = -800 + (200 x 0.909) + (300 x 0.826) +.... = K451
NPVC = -750 + (300 x 3.791) = K387
NPVD = -500 + (150 x 4.868) = K230
NPVE= -800 + (350 x (4.868-0.909) ) = K586

Find profitability index formula is:
Initial investm ent PV of Future Cash in  flows
:
PV of initial investm entoutflows
PROJECT
A
Profitability Index
1.401
B
1.564
C
D
E
1.516
1.462
1.732
a)
The company is not in a capital rationing position;
Accept all projects (Full marks only applicable after above calculations)
b)
The company is in a capital rationing position, the projects are divisible and only K2, 500 is
available.
Investment schedule:
K800 in Project E
K800 in Project B
K750 in Project C
K150 in Project D
TOTAL NPV = K1, 493
The company is in a capital rationing position, the projects are not divisible and only K2, 500 is
available.
c)
Investment schedule:
K800 in Project E
K800 in Project B
K750 in Project C
TOTAL NPV = K1, 424
SURPLUS FUNDS = K150
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