Testbank

to accompany

nd
Financial Planning 2
edition
By
Warren Mckeown, Mike Kerry, Marc Olynyk

Prepared by

Peter Lennox
University of South Australia
Testbank to accompany Financial Planning 2nd edition

© John Wiley & Sons Australia, Ltd 2014

Chapter 5
Direct Investment – fixed interest and shares
Multiple-choice questions

1. In terms of the asset classes of cash and fixed interest, nominate the incorrect
statement:

a. Cash may be invested on the short term money market at the cash rate and is
more liquid than fixed interest.
b. The essential feature of most fixed interest investments is that the interest rate
is set at the start of the period and the principal is fixed.
*c. Cash is always regarded as a riskier investment than fixed interest.
d. None of the above.

Correct answer: c
Feedback: Cash is typically regarded as a less risky investment than fixed interest given its
liquidity and lower risk exposure to changing values. Learning objective 5.1 ~ distinguish
between cash and fixed-interest securities..

2. The relationship between nominal rates and real rates of return in times of rising
inflationary levels results in:

a. real rates exceeding nominal rates of return.

*b. nominal rates exceeding real rates of return.
c. both nominal and real rates of return being equal.
d. real rates being positively related to inflationary levels.

Correct answer: b
Feedback: In times of rising inflationary levels nominal rates will exceed real rates of return as
real rates are reduced by the level of inflation. Learning objective 5.2 ~ understand the nature of
and participants in the fixed-interest investment market.

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 Chapter 5: Direct Investment – fixed interest and shares

3. Money market securities generally have a term:

*a. less than that of the capital market.

b. greater than that of the capital market.
c. equal to that of the capital market.
d. of at least 5 years.

Correct answer: a
Feedback: Money market securities are short-term investments generally having a term of not
more than 1-year whereas longer dated securities are traded in capital markets. Learning
objective 5.3 ~ understand the different forms of direct fixed-interest investments.

4. The yield curve:

a. typically has a normal shape which slopes downward to the right.

b. is a graph of interest rates relative to their risk.
*c. may be flat when short-term and long-term rates are virtually the same, and a
humped yield curve may occur when medium-term rates are higher.
d. all of the above.

Correct answer: c
Feedback: The yield curve is a graph of interest rates relative to their time-to-maturity and may
be flat when short-term and long-term rates are virtually the same, and a humped yield curve
may occur when medium-term rates are higher. Learning objective 5.3 ~ understand the different
forms of direct fixed-interest investments.

5. In terms of discount securities nominate the incorrect statement:

a. Instruments such as BABs are discount securities in that their selling prices are less
than (at a discount to) their face values.
b. The face value of the security is sold at a discount so that the amount paid on
maturity is equal to the face value of the security.
*c. Pays a coupon or interest payment monthly until maturity.
d. All of the above.

Correct answer: c
Feedback: Discount securities do not make coupon payments as all interest is compounded and
paid to the investor at maturity. Learning objective 5.3 ~ understand the different forms of direct
fixed-interest investments.

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Testbank to accompany Financial Planning 2nd edition

6. The effect of a change in the general level of interest rates on the capital values of traded
fixed-interest securities is such that:

a. a fall in the general level of interest rates will normally promote decreases in the
capital values of traded fixed-interest securities.
*b. holders of these securities will enjoy an appreciation in capital values when the
general level of interest rates falls.
c. there is a positive relationship between the general level of interest rates and the
capital values of traded fixed-interest securities.
d. both a and c.

Correct answer: b
Feedback: Holders of traded fixed-interest securities will enjoy an appreciation in capital values
when the general level of interest rates fall. This is consistent with the inverse relationship
between prices and interest rate movements. Learning objective 5.4 ~ appreciate the difference
between discount and coupon securities and the effect of a change in interest rates.

7. Contributing ordinary shares:

a. may be cumulative, participating or redeemable.

b. are shares issued on the understanding that dividends will not be payable until a
future specified date when a particular project becomes profitable.
c. are completely paid up when initially issued.
*d. are not completely paid up when initially issued.

Correct answer: d
Feedback: Contributing shares are not completely paid up when initially issued. Learning
objective 5.5 ~ understand the nature of and participants in the share market.

8. Characteristics of preference shares include:

a. cumulative shareholders retaining priority over profits until all outstanding dividends
have been paid.
b. participating shareholders having priority for dividends and have potential access to
additional dividends after ordinary shareholders have been paid.
c. redeemable shareholders having their shares bought back or redeemed at their face
value at the discretion of the company at a certain date.
*d. all the above.

Correct answer: d
Feedback: Characteristics of the various types of preference shares differ. Ordinary preference
shareholders have a claim only on profits for a particular year. Cumulative shareholders retain
priority over profits until all outstanding dividends have been paid. Participating shareholders

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 Chapter 5: Direct Investment – fixed interest and shares

have priority for dividends and have potential access to additional dividends after ordinary
shareholders have been paid. Redeemable shareholders can have their shares bought back or
redeemed at their face value at the discretion of the company at a certain date. Learning objective
5.5 ~ understand the nature of and participants in the share market.

9. An example of an issue of a financial security in the primary market would be:

a. the acquisition of shares in a company from an existing investor purchased on the

ASX.
b. shares arising as a result of a dividend reinvestment plan.
c. shares arising from participating in a rights issue.
*d. both b and c.

Correct answer: d
Feedback: Both shares arising as a result of a dividend reinvestment plan and from participating
in a rights issue are examples of financial security issues in the primary market as they represent
new share issues. Learning objective 5.5 ~ understand the nature of and participants in the share
market.

10. Market forces are the primary determinant of share prices in the secondary market with
prices increasing arising from:

*a. excess levels of buying pressure over selling pressure.

b. excess levels of selling pressure over buying pressure.
c. equilibrium levels of buying and selling pressure.
d. either b or c.

Correct answer: a
Feedback: Share prices will increase arising from excess levels of buying pressure (demand)
over selling pressure (supply). Learning objective 5.6 ~ consider the influences on share prices.

11. Technical analysts:

a. use forecasts of future data based on company fundamentals to make financial

decisions.
b. examine the past price history of a company in order to identify patterns of price
movements.
c. prepare graphs of past price movements in order to isolate buy and sell points which
are used to make financial decisions.
*d. both b and c.

Correct answer: d

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Testbank to accompany Financial Planning 2nd edition

Feedback: Technical analysts examine the past price history of a company in order to identify
patterns of price movements and prepare graphs of past price movements in order to isolate buy
and sell points which are used to make financial decisions. Learning objective 5.6 ~ consider the
influences on share prices.

12. The ASX Trade platform facilitates share trading in Australia based on:

a. time-price priority.
b. price-volume priority.
*c. price-time priority.
d. none of the above.

Correct answer: c
Feedback: The ASX Trade platform facilitates share trading based on price-time priority with the
‘price’ being the highest price if someone is looking to buy shares and the lowest price if
someone is looking to sell their shares. ‘Time’ priority is on a ‘first-come-first-serve’ basis and is
secondary to the price offered / sought when applying the ASX Trade platform. Learning
objective 5.6 ~ consider the influences on share prices.

13. Examples of market risk factors include:

a. an oil spill by an exploration company resulting in a large fine.

b. the death of a key director of a company.
c. safety concerns leading to union activities undertaken in a particular industry.
*d. none of the above.

Correct answer: d
Feedback: Each of the factors listed are unsystematic risk factors not market risk factors.
Learning objective 5.6 ~ consider the influences on share prices.

14. The electronic transfer and settlement system for representing share ownership in
Australia is referred to as:

a. CHECKERS.
b. CARDS.
*c. CHESS.
d. SFE.

Correct answer: c
Feedback: In Australia, CHESS is the relevant electronic transfer and settlement system
representing share ownership. Learning objective 5.6 ~ consider the influences on share prices.

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 Chapter 5: Direct Investment – fixed interest and shares

15. The capital asset pricing model (CAPM):

a. recognises a positive relationship between risk and return.

b. uses beta as the relevant measure of market risk.
c. requires a value for the risk-free rate.
*d. all of the above.

Correct answer: d
Feedback: All of the above issues are relevant for the capital asset pricing model (CAPM).
Learning objective 5.7 ~ understand the capital asset pricing model (CAPM).

16. CAPM says: (nominate the incorrect statement):

a. the expected return on a share is equal to the risk-free rate plus the amount of beta
multiplied by the risk premium.
b. if investors wish to buy a particular share, the expected return must, at least, be equal
to the return they would earn if they invested in a risk-free asset.
*c. investors need to be compensated for taking risk, they will not be compensated for
total risk, just the unsystematic risk.
d. beta and the risk premium multiplied together, plus the risk-free rate, provide the
expected return of the share.

Correct answer: c
Feedback: The expected return on a share is equal to the risk-free rate (the rate offered by a
government security) plus the amount of risk (beta) multiplied by the price of risk (the risk
premium). If investors wish to buy a particular share, the expected return must, at least, be equal
to the return they would earn if they invested in a risk-free asset (such as a government bond or
bank deposit). In addition, we know that owning shares is risky, so investors need to be
compensated for that risk. They will not be compensated for total risk, just the systematic risk.
Beta measures the systematic risk of the share and the risk premium measures the price of risk.
These two variables multiplied together, plus the risk-free rate, provide the expected return of the
share. Learning objective 5.7 ~ understand the capital asset pricing model (CAPM).

17. The Gordon dividend discount model has a number of problems which include:

a. the required rate of return must be greater than the expected growth rate. If this is
not the case, then the model will estimate a negative value for the share price
(which is impossible).
b. if the expected growth rate is really greater than the required rate of return, then the
Gordon growth model is not appropriate for valuation.
c. this model assumes that the fundamentals of the firm will remain constant over
time.

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Testbank to accompany Financial Planning 2nd edition

*d. all of the above.

Correct answer: d
Feedback: This model has some special features. First, the required rate of return must be greater
than the expected growth rate. If this is not the case, then the model will estimate a negative
value (which is impossible — share prices on the market are always positive). If the expected
growth rate is really greater than the required rate of return, then the Gordon growth model is not
appropriate for valuation. Second, this model assumes that the fundamentals of the firm will
remain constant. If the firm changes its payout ratio, for example, the firm’s growth rate will
change and so the value of the firm will also change. Learning objective 5.8 ~ apply two basic
valuation models — the Gordon dividend discount model and the price–earnings ratio — to
value shares.

18. Using sustainable growth rates:

a. seeks to overcome the limitations of using past growth rates as a reliable indicator
of future growth rates.
b. requires companies to have a retention ratio of less than 100%.
*c. both a and b.
d. none of the above.

Correct answer: c
Feedback: The use of sustainable growth rates is a method that seeks to overcome the limitations
of using past growth rates as a reliable indicator of future growth rates and requires companies to
have a retention ratio of less than 100% (that is, for the firm to pay some level of dividends).
Learning objective 5.8 ~ apply two basic valuation models — the Gordon dividend discount
model and the price–earnings ratio — to value shares.

19. Investing in precious metals:

a. is often undertaken as a hedge against inflation.

b. provides both income and capital returns to investors.
c. is subject to significant supply and demand pressures.
*d. both a and c.

Correct answer: d
Feedback: Investing in precious metals is often undertaken as a hedge against inflation and is
subject to significant supply and demand pressures. Learning objective 5.9 ~ appreciate the
existence of other forms of direct investment.

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 Chapter 5: Direct Investment – fixed interest and shares

20. Focusing an investment portfolio with ethical investments:

a. allow investors to integrate personal values and social concerns with their
investment objectives.
b. potentially creates adverse diversification issues for the investor increasing their
investment risk exposure
*c. both a and b.
d. is not likely to be constrained by a lack of information available from many
companies regarding this issue.

Correct answer: c
Feedback: Selecting ethical investments allow investors to integrate personal values and social
concerns with their investment objectives however this potentially creates adverse diversification
issues for the investor increasing their investment risk exposure. There is still often a lack of
available information regarding ethical investments which constrains investment in this area.
Learning objective 5.9 ~ appreciate the existence of other forms of direct investment.

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Testbank to accompany Financial Planning 2nd edition

Short Answer Questions

21. Who are the primary regulators of the Australian financial system?

Answer: The Reserve Bank of Australia (RBA), the Australian Securities and Investments
Commission (ASIC) and the Australian Prudential Regulatory Authority (APRA) are the primary
regulators of the Australian financial system. In broad terms, such bodies seek to ensure that the
public maintains confidence in the financial system and its institutions and can readily participate
in the financial system without being financially taken advantage of. These bodies are also
generally concerned with the stability of the financial system and to assist the government in the
pursuit of its economic objectives.

Learning objective 5.1 ~ distinguish between cash and fixed-interest securities.

22. Briefly explain how lenders use the cash rate when setting interest rates.

Answer: The cash rate provides lenders with a benchmark figure for setting interest rates due to
its risk-free nature. The actual interest rate charged by lenders will include a premium over the
cash rate arising from the perceived riskiness of the borrower and to compensate the lender for
the time factor of future repayments.

Learning objective 5.2 ~ understand the nature of and participants in the fixed-interest
investment market.

23. Explain the relationship between the cash rate and the real cash rate. Illustrate your
discussion by calculating the real rate of return for a 1-year term deposit that
provides for the following 3-monthly interest rates over its term: 1 to 3 months – 5%
p.a., 4 to 6 months - 7% p.a., 7 to 9 months – 6% p.a. and 10 to 12 months - 7% p.a.
Inflation rates over this period are as follows: 1 to 3 months – 2% p.a., 4 to 6 months -
3% p.a., 7 to 9 months – 4% p.a. and 10 to 12 months - 5% p.a.

Answer: The real cash rate adjusts for the effects of inflation and provides information on the
purchasing power of funds using the Consumer Price Index (CPI) as the relevant measure of
inflation.
In our example the real rate of return can be calculated using the following formula:
1 + rreal = (1 + rnominal / 1 + Inflation rate)
The nominal rate of return for the 1-year term deposit will be:
= ((1 + [5%/4]) (1 + [7%/4]) (1 + [6%/4]) (1 + [7%/4])) - 1
= ((1.0125) (1.0175) (1.015) (1.0175)) - 1
= (1.064) -1
= 6.4%
The rate of inflation for the 1-year period will be:

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 Chapter 5: Direct Investment – fixed interest and shares

= ((1 + [2%/4]) (1 + [3%/4]) (1 + [4%/4]) (1 + [5%/4])) - 1

= ((1.005) (1.0075) (1.01) (1.0125)) - 1
= (1.0354) -1
= 3.54%
Hence the real rate of return for the 1-year term deposit will be:
1 + rreal = (1 + 6.4% / 1 + 3.54%)
rreal = ([1.064] / [1.0354]) - 1
= 1.0276 -1
= 2.76%
From the above it can be seen that although the nominal rate of return on the 1-year term deposit
was 6.4%, after removing the effects of inflation on this return the real rate of return was reduced
to 2.76%.

Learning objective 5.2 ~ understand the nature of and participants in the fixed-interest
investment market.

24. Mickey Ronaldo purchased a 180 day Commonwealth Treasury Note (T-note) having
a face value of $100,000 on 15 April 2014. The purchase price of the T-note was
$96,730.
a) Calculate Mickey’s annualised nominal rate of return based on the face value of the
T-note.
b) Calculate Mickey’s annualised nominal rate of return based on the purchase price of
the T-note.
c) Which of the above annualised nominal rates of return is more representative of
Mickey’s actual rate of investment return?

Answer:

Details Amount ($)

Face value 100,000
Purchase price 96,730
Interest amount (Face value - Purchase price) 3,270
Number of days in a year - 365 days
Term of investment - 180 days
Annualised factor - 2.0278 (365 / 180)

a) Annualised return based on the face value of the T-note:

= $3,270 x 2.0278
$100,000
= 6.63% p.a.

b) Annualised return based on the purchase price of the T-note:

= $3,270 x 2.0278
$96,730
= 6.85% p.a.

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Testbank to accompany Financial Planning 2nd edition

c) The annualised nominal rate of return which is more representative of Mickey’s actual rate of
investment return would be that calculated on the purchase price of T-note. This is because the
purchase price is the amount actually outlaid at the commencement of the investment (and thus is
relevant for the full term of the investment) whereas the maturity value is simply the final
amount realised on redemption.

Learning objective 5.4 ~ appreciate the difference between discount and coupon securities and
the effect of a change in interest rates.

25. At the commencement of the current financial year Rene Silverwater invested
$70,000 in a 2-year ‘snowball’ fixed deposit providing an interest rate of 5% p.a. with
interest paid half-yearly. The interest paid is reinvested back into the fixed deposit
which is the basis for the ‘snowball’ description. On maturity, the investment
provides a bonus interest amount of $500 for all investments that have a balance at
maturity that exceeds their initial investment by more than 10%. Rene is subject to a
40% marginal tax rate for interest income derived in the first year and 30% for the
second year.
Rene has sought your assistance in determining whether he would be eligible for the
interest bonus and also to calculate his total after-tax net income from the investment.

Answer: Rene’s interest returns for the 2-year fixed deposit where the accumulated balance is
based on the future value formula; FV = PV(1 + i)n with a half yearly interest rate is 2.5%
(5%/2) will be:

Period Accumulated Opening Net

balance ($) principal ($) Interest ($)
After 6 months FV = 70,000(1 + 2.5%)1 70,000 1,750
= 75,000(1.025)1
= 71,750
After 12 months FV = 71,750 (1 + 2.5%)1 71,750 1,794
= 71,750 (1.025)1
= 73,544
After 18 months FV = 73,544 (1 + 2.5%)1 73,544 1,839
= 73,544 (1.025)1
= 75,383
After 24 months FV = 75,383 (1 + 2.5%)1 75,383 1,885
= 75,383 (1.025)1
= 77,268
Given that the balance of the investment at maturity is $77,268 and this exceeds the initial
investment of $70,000 by more than $7,000 (10% of the initial investment), Rene will be entitled
to the $500 interest bonus. This will increase the interest paid for the last 6 months from $1,885
to $2,385.

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 Chapter 5: Direct Investment – fixed interest and shares

After-tax net income for each year of the investment will be:

Year Total Interest ($) Tax payable at tax Net

rate ($) Interest ($)
1 After 6 months – 1,750 3,544 x 40% 3,544 – 1,418
After 12 months – 1,794 = 1,418 = 2,126
Total 3,544
2 After 18 months – 1,839 4,224 x 30% 4,224 – 1,267
After 24 months – 2,385 = 1,267 = 2,957
4,224
Total 7,768 2,685 5,083

Rene’s after-tax net income from the 2-year ‘snowball’ fixed deposit investment will thus be
$5,083.
Learning objective 5.4 ~ appreciate the difference between discount and coupon securities and
the effect of a change in interest rates.

26. Outline the primary differences between ordinary and preference shares.

Answer: The term ‘preference’ for preference shares refers to the relationship between ordinary
and preference shares with respect to claims on the firm’s profits and assets. Preference
shareholders will be entitled to receive the first claim on company profits for current dividend
payments and where cumulative preference shares are issued, in fact will be entitled to the
payment of all outstanding dividend payments prior to any dividend distributions to ordinary
shareholders. In the event of company liquidation, preference shareholders will be entitled to a
return of capital on company assets prior to any payments made to ordinary shareholders.

Other differences between ordinary and preference shareholders typically arise in relation to the
calculation of dividend entitlements and voting rights. Preference shareholders generally are only
entitled to a fixed dividend payment (subject to the company having sufficient profits to pay such
dividends), whereas dividend payments to ordinary shareholders are likely to vary over time.
Limited voting rights are generally provided to preference shareholders unlike the full voting
rights entitlements of ordinary shareholders. The above discussion illustrates why ordinary
shareholders are often described as the residual owners of the company (as they are the last to
financially benefit from everything relating to the company).

Learning objective 5.5 ~ understand the nature of and participants in the share market.

27. Outline the general characteristics of the Securities Market Line (SML).

Answer: The Securities Market Line (SML) shows the graphical relationship between systematic
risk and return as measured by the CAPM. It is a straight line graph showing the minimum rate

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of return required where an investment is made in a risk-free asset and the progressively higher
required rates of return as the investor is exposed to higher amounts of (systematic) risk. The
SML can be used to identify undervalued and overvalued investments by plotting returns for
investments with those falling below the SML being regarded as relatively overvalued (and
unattractive for investment purposes) and with those falling above the SML being regarded as
relatively undervalued (and thus attractive for investment purposes).

Learning objective 5.7 ~ understand the capital asset pricing model (CAPM).

28. You have assessed the following information for Kid’s Apparel Ltd. based on your
expectations of the company over the next financial year:

Operating profit (before-tax) $13.8 million

Taxable income $10 million
Company tax rate 30%
Authorised share capital 10 million
Issued share capital 7.5 million
Current share price $21.60

Based on the information provided, calculate the company’s price/earnings (P/E) ratio and
comment on the company’s growth prospects given that the industry average P/E ratio is
12 times.

Answer: Calculate after-tax earnings:

Detail Amount ($)

Operating profit (before-tax) 13,800,000
Less Tax payable ($10m x 30%) 3,000,000
After-tax earnings 10,800,000

After-tax earnings = 10,800,000

Issued shares 7,500,000
Earnings per share = 1.44 per share (10,800,000 / 7,500,000)
P/E ratio = 21.60 / 1.44
= 15 times

As the industry average P/E ratio is 12 times, Kid’s Apparel Ltd.’s growth prospects are
expected to be positive given a company P/E ratio of 15 times as the company is being rated at a
higher level than the industry average.

Learning objective 5.8 ~ apply two basic valuation models — the Gordon dividend discount
model and the price–earnings ratio — to value shares.

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29. What characteristics are typically associated with ethical investments?

Answer: Ethical investments seek to integrate the personal values and social concerns of the
investor with their investment objectives. Promotion of ethical investments has also been
undertaken under the alternative headings of socially responsible investment (SRI), ‘green’ or
environmental investment.

A practical issue for investors contemplating such investment focus is whether by pursuing such
goals their investment returns are likely to be positively or negatively affected. This includes
whether such investors are restricting diversification benefits because of their particular
investment objectives. An analysis of recent research studies has not been conclusive in relation
to this question, which has at least partly been due to the difficulties in deciding what
characteristics define an ethical investment.

Learning objective 5.9 ~ appreciate the existence of other forms of direct investment.

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