Part 2

1. State the reason(s) why value of an annuity due is always greater than an otherwise
identical ordinary annuity.

Answer: An annuity due is an annuity where cash flow occurs at the beginning of the
period and an ordinary annuity is an annuity where the cash flow occurs at the end of the
period. The value of an annuity due is always greater than an otherwise identical ordinary
annuity is because interest is added for an extra amount of time. As annuity due is
collected sooner it will always have a greater value due to the time value of money

2. What makes the effective rate of interest differ from the nominal rate of interest except
annual compounding?

Effective Rate of interest is the annual rate of interest that is actually paid or earned.
On the other hand, the nominal rate of interest is the annual rate of interest charged by a
lender or promised by a borrower, it is contractual. A deal is made between two parties.
Apart from the annual compounding another difference between effective and nominal
interest rate is that the effective annual rate increases with increasing compounding
frequency. Sometimes effective rate is significantly higher than the nominal rate.

3. What is the goal of a financial manager while creating a portfolio? How an investor can
theoretically form a successful portfolio?

The main goal of a financial manager while creating a portfolio is to create an efficient
portfolio, an efficient portfolio is a portfolio that will provide the maximum return for a
given amount of risk. An investor can theoretically form a successful portfolio by
attempting to reduce overall risk. This can be done through diversifying portfolios by
adding and combining assets that have the lowest correlation. Combining negatively
correlated assets can reduce the risk of portfolio without reducing the average return.
4. Briefly explain the distinguishing features of debt and equity.

Debt includes all borrowing, including bonds, incurred by a company and is repaid
according to a fixed payment schedule. It is obtained from creditors.
Equity consists of funds provided by the owners (investors or shareholders) of the
company that is repaid subject to the performance of the company. It is obtained from
investors who then become part owners of the firm.
Other major differences between debt and equity are. In equity the maturity is not stated
however in debt it is clearly stated. There is no interest deduction in equity but there is
interest deduction in debt.

5. Which discount rate firm uses for capital budgeting decision?

The weighted average cost of capital (WACC) is the discount rate firm uses for capital
budgeting decision. It is also called a firm’s cost of capital and it calculates the net
present value of a business. It is also used to assess investment opportunities, since it is
considered to represent the opportunity cost of the firm