STRATHMORE INSTITUTE OF MATHEMATICAL SCIENCES

BBS ACTUARIAL SCIENCE

CAT 1 MARKING SCHEME
BSA 2204 FINANCIAL MATHEMATICS 2
DATE: Friday 16th September 2022 Time: 1 hour
Instructions
1. Answer all questions in this paper in the answer booklet provided
2. Total marks for this CAT is 30 but scaled to 15% of your coursework marks for this semester.
3. Marks for each question are written in square brackets alongside the question itself.

1. What is meant by the following terms:

a. Risk discount rate
The risk discount rate is the difference between an investment's return and the risk-free rate of return.

b. Internal rate of return.

The internal rate of return for an investment project is the effective rate of interest that equates the present
value of income and outgo, ie it makes the net present value of the cashflows equal to zero.

c. Discounted payback period [6]

The discounted payback period for a project is the smallest time t for which the present (or accumulated)
value of the income up to time t exceeds the present (or accumulated)
value of the outgo up to time t .

2. Explain how the internal rate of return is used as an investment appraisal tool. [2]
IRR greater than cost of financing then the project is viable.

3. State one disadvantage of using payback period as a criteria for making an investment decision. [1]
Does not consider the time value of money (as opposed to discounted payback period.)

4. The Naibori expressway is a major road project that has been carried out in the capital of Kinay. On
the project a major highway has been constructed under a Build-Operate-Transfer model on which a
private contractor builds the road and operates it for a period (in this case 27years) and collects toll
payments from road users using the expressway. At the end of the BOT period (27years), the road is
handed over to the government of Kinay. Cashflows are expected to be as follows on the project.

All figures are in Millions USD

All income is received continuously through the year

Outflows Income
Year 1 $225 one off at the beginning of the year 0
Year 2 $225 continuously through the year 0
Year 3 $225 continuously through the year 0
Year 4 0 $20
Year 5 0 $35
Year 6 0 $50 (remains at this level for 10yrs and
increases to $75 thereafter for the
remainder of the project)

For each year on which income is received, there is an expressway maintenance fee of 12.5% (of
Income) that is incurred. In other words for each year of income, there is an outflow of 12.5% of
income.

Calculate the following net present value of the project assuming a rate of return 8% per annum. [8]

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Net present value
 225   225  a2 v  1  12.5%  20a1v 3  35a1v 4  50a10 v 5  75a12 v15 
i
but an  an and therefore we can substitute as follows

i
 225   225  a2 v

 i i i i 
 1  12.5%  20 a1v 3  35 a1v 4  50 a10 v 5  75 a12 v15 
     

i
 225   225  a2 v

i
 1  12.5%    20a1v 3  35a1v 4  50a10 v 5  75a12 v15 
 

we can read off the values for i  8%

 225   225   1.039487  1.7833  0.925926
20  0.9259  0.79383  35  0.9259  0.73503 
87.50% 1.039487   
50  6.7101 0.68058  75  7.5361 0.31524 

 225   386.19   87.50%  1.039487  14.70  23.82  228.34  178.18

 206.41

Net present value is -$206.41Mn

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5. You have recently inherited a small island, which may be used for sheep rearing, goat breeding, or
forestry, and have calculated that the cash flows associated with these three projects will be as follows:

a. Calculate the internal rates of return of each of these projects (to the nearest 0.1%).

b. You do not have the capital for any of these ventures, but you have been offered a bank loan
of £20,000 at 5% per annum interest payable annually in arrears. This loan is repayable in
20 years’ time, there being no early repayment option. Should you require further loans, they
will be granted by the bank on the same interest basis and will be repayable at the same date
as the original loan. If you have any money to invest after paying bank interest, you may
invest it to secure interest at 4% per annum effective. Which of the three projects will give
the largest profit in 20 years’ time?
[13]

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