THE AUSTRALIAN NATIONAL UNIVERSITY

SCHOOL OF FINANCE AND APPLIED STATISTICS

Mid-Semester Examination

FOUNDATIONS OF FINANCE
Study period: 15 minutes
Writing period: 90 minutes

Permitted materials:
Calculator - non-programmable

INSTRUCTIONS:
1. This exam paper comprises a total of 3 pages. Please ensure your paper has the
correct number of pages.
2. The exam includes a total of 4 questions. The questions are of unequal value, with
marks indicated for each question. You must attempt to answer all questions.
3. Do not round calculations until providing your final answer to each question.
Final answers should be rounded to 2 decimal places.
4. Include all workings for each question, as marks will not be awarded for answers
that do not include workings.
5. Ensure you include your student number on your answer book.

Total Marks = 23

Question 1 (5 marks)
Your friend Steve has just received a phone call from his local credit union informing
him that his loan application has been approved. In his excitement at receiving the
good news, Steve has forgotten how much the bank has let him borrow. By the time
Steve realized he needed to find out this information, the bank had closed for the day.
To make things worse, Steve cant remember his financial mathematics formulas and
is therefore unable to calculate how much he has borrowed. So, knowing you are
currently enrolled in Foundations of Finance and would therefore be able to help him,
he has called you and asked you to calculate this value for him. Calculate how much
Steve has borrowed given he makes fortnightly loan repayments (ie repayments every
2 weeks) of $1,500 given the following information and assuming there are exactly 26
fortnights in a year:

The loan will be repaid over 25 years;

Interest is payable at a fixed rate of 12% p.a. compounded annually;
Repayments are to be made fortnightly; and,
The first repayment will be made exactly 2 weeks from today (ie the loan
period starts from today).

Question 2 (5 marks)
Question 2 comprises two parts. Students must answer both parts of the question:
In the process of completing Foundations of Finance, you have discovered your love
of the financial markets and, in particular, share markets. In light of this, you are
seriously considering purchasing shares in a company called VC Limited. However,
before making your final decision, you have calculated the theoretical price of one
share in the company and plan to compare this value with the quoted share price as
part of deciding whether it represents a good investment. Employing a Dividend
Discount Model with a constant growth rate and using a required rate of return on
equity of 10% p.a., you have calculated the theoretical price of a share in VC limited
as $9.50. Given that the company pays annual dividends, and the last dividend paid by
the company has just been paid and was $0.50 per share:
a) Solve for the per annum constant growth rate you assumed in calculating the
theoretical price of one share in VC Limited. (4 marks)
b) If shares in VC Limited are currently trading at $10.00, do they represent a
good investment from your perspective? Why? (1 mark)

Page 2 of 9

Question 3 (6 marks)
Question 3 comprises two parts. Students must answer both parts of the question:
a) Find the price of an 8%, $100 Commonwealth Government bond with exactly
4.25 years to maturity given a required rate of return of 9% p.a. (4 Marks)
b) What will happen to the price of the bond in a) immediately after a coupon is
paid? Why? (2 Marks)

Question 4 (7 marks)
You have been observing the increased health awareness of Australians for some time
and, in view of this, have decided to establish and run a fitness centre. You estimate
that initial cash outflows will include: $50,000 to renovate the gym premises; $45,000
for new equipment; and, $5,000 to install the equipment. You have done a market
survey which leads you to believe that you will get 500 members each paying $1,000
in membership fees per year. You have also found 5 gym instructors you can hire at a
cost of $30,000 each per year. You also estimate additional costs of running the gym
to be $200,000 per year. For tax reasons, you have decided to expense the renovation
costs and depreciate the equipment over five years using the straight line method (NB:
Given the nature of gym equipment, you dont think it will be worth anything at the
end of this time so have decided to calculate depreciation using a salvage value of
zero). However, you expect the equipment will be fully functional for 10 years and
are therefore assessing the viability of setting up the gym for a 10 year period.
Assuming that the initial investment is made today, all cash flows are received or paid
at the end of the year, the tax rate is 40% and your six-month required rate of return is
6%, should you invest in the project? Why?

(End of Examination)

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MID-SEMESTER EXAM SOLUTIONS

Question 1 (5 marks)
Your friend Steve has just received a phone call from his local credit union informing
him that his loan application has been approved. In his excitement at receiving the
good news, Steve has forgotten how much the bank has let him borrow. By the time
Steve realized he needed to find out this information, the bank had closed for the day.
To make things worse, Steve cant remember his financial mathematics formulas and
is therefore unable to calculate how much he has borrowed. So, knowing you are
currently enrolled in Foundations of Finance and would therefore be able to help him,
he has called you and asked you to calculate this value for him. Calculate how much
Steve has borrowed given he makes fortnightly loan repayments (ie repayments every
2 weeks) of $1,500 given the following information and assuming there are exactly 26
fortnights in a year:

The loan will be repaid over 25 years;

Interest is payable at a fixed rate of 12% p.a. compounded annually;
Repayments are to be made fortnightly; and,
The first repayment will be made exactly 2 weeks from today (ie the loan
period starts from today).

Solution
From the question, we have the following information:
i) Borrowings = ?
ii) n = 25 x 26 = 650
1
26

iii) r = (1.12 ) 1
= 0.0043683
iv) F=$1,500
Now, use the present value of an ordinary annuity formula to calculate the value of
Steves borrowings:
1 (1.0043683) 650
Borrowings = $1,500

0.0043683

= $323,183.42

Page 4 of 9

Question 2 (5 marks)
In the process of completing Foundations of Finance, you have discovered your love
of the financial markets and, in particular, share markets. In light of this, you are
seriously considering purchasing shares in a company called VC Limited. However,
before making your final decision, you have calculated the theoretical price of one
share in the company and plan to compare this value with the quoted share price as
part of deciding whether it represents a good investment. Employing a Dividend
Discount Model with a constant growth rate and using a required rate of return on
equity of 10% p.a., you have calculated the theoretical price of a share in VC limited
as $9.50. Given that the company pays annual dividends, and the last dividend paid
by the company has just been paid and was $0.50 per share:
a) Solve for the per annum constant growth rate you assumed in calculating the
theoretical price of one share in VC Limited. (4 marks)
Solution
P=

D0 (1 + g )
re g

P(re g ) = D0 + D0 g
Pre Pg = D0 + D0 g
Pre D0 = D0 g + Pg
Pre D0 = g ( D0 + P)
g=

Pre D0
D0 + P

Substituting :
g=

($9.50* 0.10) $0.50

$0.50 + $9.50
$0.45
$10.00

= 0.045
= 4.5%
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b) If shares in VC Limited are currently trading at $10.00, do they represent a

good investment from your perspective? Why? (1 mark)
Solution
No, they dont as the value to you of a share in VC Limited is $9.50 (ie this is
what you would be willing to pay for a share in the company), but they are
trading at a price higher than this, namely $10.00.

Page 6 of 9

Question 3 (6 marks)
a) Find the price of an 8%, $100 Commonwealth Government bond with exactly
4.25 years to maturity given a required rate of return of 9% p.a. (4 Marks)
Solution
The instrument matures in 4.25 years, but we know that coupons are paid
semi-annually. Therefore, there is 3 months until the next coupon is paid.
Given this, it is easiest to calculate the present value of all cash flows in 3
months time and subsequently discount this figure back another 3 months to
obtain todays price. Again, in doing this, it is important to recall the
quotation conventions for coupon-paying bonds. The price of the bond is
calculated as follows:

C = $100 x

0.08
2

= $4.00
1 (1.045) 8
$100
Bt + 0.25 = $4.00 + $4.00
+

8
0.045 (1.045)
= $100.70
$100.70
(1.045)0.5
= $98.51

B=

Given the coupon rate of the instrument is less than its yield, it is unsurprising
its price is less than its face value.

b) What will happen to the price of the bond in a) immediately after a coupon is
paid? Why? (2 Marks)

Solution
The price of the bond will fall by exactly $4.00. This is because the price of
the instrument is the present value of the future cash flows given by the
instrument. Immediately before the coupon payment, the price would reflect
the imminent coupon payment of $4.00 (as it is about to be paid, the present
value of this cash flow is $4.00). Following the coupon payment, it would no
longer form part of the future cash flows of the instrument and this would be
reflected by the price decreasing by $4.00.

Page 7 of 9

Question 4 (7 marks)
You have been observing the increased health awareness of Australians for some time
and, in view of this, have decided to establish and run a fitness centre. You estimate
that initial cash outflows will include: $50,000 to renovate the gym premises; $45,000
for new equipment; and, $5,000 to install the equipment. You have done a market
survey which leads you to believe that you will get 500 members each paying $1,000
in membership fees per year. You have also found 5 gym instructors you can hire at a
cost of $30,000 each per year. You also estimate additional costs of running the gym
to be $200,000 per year. For tax reasons, you have decided to expense the renovation
costs and depreciate the equipment over five years using the straight line method (NB:
Given the nature of gym equipment, you dont think it will be worth anything at the
end of this time so have decided to calculate depreciation using a salvage value of
zero). However, you expect the equipment will be fully functional for 10 years and
are therefore assessing the viability of setting up the gym for a 10 year period.
Assuming that the initial investment is made today, all cash flows are received or paid
at the end of the year, the tax rate is 40% and your six-month required rate of return is
6%, should you invest in the project? Why?
Solution
First, lets identify the cash flows that would form part of the project (outflows
denoted with negative sign):
Year 0:
Renovation costs (expense and therefore deduction)
Net outflow for renovation equal to $50,000(1-0.40)
Machinery and installation

-$30,000
-$50,000

Years 1-5:
Annual depreciation charge:
($45, 000 + $5, 000) $0
= $10, 000
5
So, the depreciation tax shield for Yrs 1 5 is:

$4,000

0.40*$10,000

Years 1 10:
Post-tax CFs (excluding depreciation):
(1-0.40)((500*$1,000)-(5*$30,000)-$200,000)

$90,000

NPV Calculation:
First, the discount rate in the question needs to be converted to an AER:
(1.06)2 1 = 0.1236
= 12.36%
Page 8 of 9

Now, the NPV of cash flows is:

1 (1.1236) 5
1 (1.1236)10
NPV = $80, 000 + $4, 000
+
$90,
000

0.1236
0.1236

= $80, 000 + $14, 291.43 + $501,113.06

= $435, 404.49

As the NPV is positive, you will accept the project as it provided you with a rate of
return above that which you require.

(End of Examination)

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