MASTER OF BUSINESS ADMINISTRATION PROGRAM

SET 9 SEMESTER 2 SESSION 2022/2023

(1) Course Code : ZCMA6032

(2) Course Title : Managerial Finance

(3) Credit Hours : 2

(4) Course Status : Core

CASE 1

Time Value of Money

Assume that you are nearing graduation and that you have applied for a job with a local
bank. As part of the bank's evaluation process, you have been asked to take an
examination which covers several financial analysis techniques. The first section of the
test addresses discounted cash flow analysis.

Note: When solving these questions, the use of financial calculator is not allowed; you
must show the full steps involved.

a. What is the future value of an initial $200 after 5 years if it is invested in an account
paying 12 percent annual interest?
b. What is the present value of $200 to be received in 5 years if the appropriate interest
rate is 12 percent?
c. We sometimes need to find how long it will take a sum of money (or anything else)
to grow to some specified amount. For example, if a company's sales are growing at a rate of
15 percent per year, how long will it take sales to triple?
d. If you want an investment to double in 5 years, what interest rate must it earn?
e. What is the difference between an ordinary annuity and an annuity due?
f. 1. What is the future value of a 3-year ordinary annuity of $200 if the appropriate
interest rate is 12 percent?
f. 2. What is the present value of the annuity?
f. 3. What would the future and present values be if the annuity were an annuity due?
g. What is the future value of $200 after 4 years under 10 percent annual
compounding? Semiannual compounding? Quarterly compounding? Monthly
compounding? Daily compounding?
h. What is the effective annual rate (EAR)? What is the EAR for a nominal rate of 10
percent, compounded semiannually? Compounded quarterly? Compounded monthly?
Compounded daily?
i. Will the effective annual rate ever be equal to the nominal (quoted) rate?
j. Construct an amortization schedule for a $40,000, 12 percent annual rate loan with 5
equal installments.
 CASE 1

Answers:

a. The future value (FV) of an investment is calculated using the formula:

FV = PV * (1 + i)^n

Where:
PV = present value = $200
i = interest rate = 12% = 0.12
n = number of periods = 5 years
0 1 2 3 4 5

PV - $200 FV = ?

FV = 200 * (1 + 0.12)^5 = 200 * 1.7623 = $352.46

b. The present value (PV) is calculated using the formula:

PV = FV / (1 + i)^n

Where:
FV = future value = $200
i = interest rate = 12% = 0.12
n = number of periods = 5 years
0 1 2 3 4 5

PV - ? FV = $200

PV = 200 / (1 + 0.12)^5 = 200 / 1.7623 = $113.45

c. The formula to calculate the time it takes for an amount to grow to a specific value is:

n = ln(FV / PV) / ln(1 + r)

Where:
FV = future value = 3 times the current sales
PV = present value = current sales
i = growth rate = 15% = 0.15

g = 15%
0 n=?

PV = -1 FV = 3

Assuming current sales as 1 (for simplicity),

n = ln(3 / 1) / ln(1 + 0.15) = ln(3) / ln(1.15) ≈ 7.27 years

d. The formula to calculate the interest rate required for a present value to grow to a future
value in a certain time period is:

i = (FV / PV)^(1/n) - 1

Where:
FV = future value = 2 times the present value
PV = present value = current investment
n = number of periods = 5 years

i = ?%
0 1 2 3 4 5

PV = -1 FV = 2

Assuming the current investment as 1 (for simplicity),

i = (2 / 1)^(1/5) - 1 = 0.1487 or 14.87%

e. An ordinary annuity is a series of equal payments at the end of each period over the length
of the annuity, while an annuity due is a series of equal payments at the beginning of each
period.

f. 1. The future value of an ordinary annuity is calculated using the formula:

FV = Pmt * [(1 + i)^n - 1] / i

Where:
Pmt = payment per period = $200
i = interest rate per period = 12% = 0.12
n = number of periods = 3 years

i = 12%
0 1 2 3

200 200 200

FV = ?

FV = 200 * [(1 + 0.12)^3 - 1] / 0.12 = 200 * 0.40493 = $674.88

f. 2. The present value of an ordinary annuity is calculated using the formula:

i = 12%
0 1 2 3

200 200 200

PV = ? FV = $674.88

PV = Pmt * [1 - (1 + i)^-n] / i

PV = 200 * [1 - (1 + 0.12)^-3] / 0.12 = 200 * 2.40183 = $480.37

f. 3. For an annuity due, both the future and present values will be higher because each
payment is invested for a longer period of time.
 i = 12%
0 1 2 3

200 200 200

PV = ? FV = ?

The future value of an annuity due is calculated as FV of ordinary annuity * (1 + i) = 674.88 *

(1 + 0.12) = $755.86

The present value of an annuity due is calculated as PV of ordinary annuity * (1 + i) = 480.37

* (1 + 0.12) = $537.21

g. Under different compounding frequencies, the future value is calculated as:

FV = PV * (1 + i/m)^(n*m)

Where:
m = number of compounding periods per year
For annual, m=1; semiannual, m=2; quarterly, m=4; monthly, m=12; daily, m=365

Using PV=$200, i=10%=0.10, n=4 years,

FV_annual = 200 * (1 + 0.10/1)^(4*1) = $292.82

FV_semiannual = 200 * (1 + 0.10/2)^(4*2) = $295.49
FV_quarterly = 200 * (1 + 0.10/4)^(4*4) = $296.90
FV_monthly = 200 * (1 + 0.10/12)^(4*12) = $297.87
FV_daily = 200 * (1 + 0.10/365)^(4*365) = $298.35

h. The effective annual rate (EAR) is the actual annual rate of return taking into consideration
the effect of compounding. It's calculated as:

EAR = (1 + i/m)^(m*n) - 1

For a nominal rate of 10 percent, the EAR for different compounding frequencies is:

EAR_semiannual = (1 + 0.10/2)^(21) - 1 = 10.25%

EAR_quarterly = (1 + 0.10/4)^(41) - 1 = 10.38%
EAR_monthly = (1 + 0.10/12)^(121) - 1 = 10.47%
EAR_daily = (1 + 0.10/365)^(3651) - 1 = 10.52%

i. The effective annual rate (EAR) will be equal to the nominal rate only if the interest is
compounded annually. If the interest is compounded more than once a year, the EAR will be
greater than the nominal rate.

j. In creating the amortization schedule, we need to calculate the annual payment more
accurately so that the ending balance in the 5th year is exactly zero.

The annual payment can be calculated using the following annuity payment formula:

PMT = [PV * i] / [1 – ((1 + i)^n)]

Where:
PMT = annuity payment
PV = present value (loan amount) = $40,000
i = interest rate = 12% = 0.12
n = number of periods = 5 years

PMT = [40,000 * 0.12] / [1 – ((1 + 0.12)^5)] = $11,096.39

Now, let's build a more accurate amortization schedule:

Beginning Principal Ending

Year Payment Interest
Balance Payment Balance
1 $40,000.00 $11,096.39 $4,800.00 $6,296.39 $33,703.61
2 $33,703.61 $11,096.39 $4,044.43 $7,051.96 $26,651.65
3 $26,651.65 $11,096.39 $3,198.20 $7,898.19 $18,753.46
4 $18,753.46 $11,096.39 $2,250.42 $8,845.97 $9,907.49
5 $9,907.49 $11,096.39 $1,188.90 $9,907.49 $0.00

In the amortization schedule:

1. The Beginning Balance is the amount of principal that is still owed at the beginning of each
year.
2. The Payment is the 5 equal instalment amount calculated above.
3. The Interest for the year is the beginning balance times the interest rate.
4. The Principal Payment for the year is the payment amount minus the interest.
5. The Ending Balance is the beginning balance minus the Principal payment.

The ending balance in year 5 is $0, which indicates that the loan has been fully repaid.
 CASE 2
Bonds and Bond Valuation
Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance
Company and co-directors of the company's pension fund management division. A
major new client, the Northwestern Municipal Alliance, has requested that Mutual of
Seattle present an investment seminar to the mayors of the represented cities, and
Strother and Tibbs, who will make the actual presentation, have asked you to help them
by answering the following questions. Because the Boeing Company operates in one of
the league's cities, you are to work Boeing into the presentation.

Note: In answering the following questions, full steps must but shown; no financial
calculator is allowed.

a. Discuss some of the key features of a bond.

b. Discuss the difference between the call provisions and the sinking fund provisions.
c. What is the value of a 10-year, $1,000 par value bond with a 12 percent annual
coupon if its required rate of return is 10 percent?
d. What would be the value of the bond described in part c if, just after it had been
issued, the going market rate of interest was 8 percent? Would we now have a discount or a
premium bond?
e. What is the yield to maturity on a 10-year, 8 percent annual coupon, $1,000 par value
bond that sells for $850?
f. What is interest rate (or price) risk? Which bond has more interest rate risk, an
annual payment 5-year bond or a 10-year bond? Why?
g. What is reinvestment rate risk? Which has more reinvestment rate risk, a 5-year bond
or a 10-year bond?
h. Find the value of a 10-year, semiannual payment, 12 percent coupon bond if nominal
rd = 8%.
i. Suppose a 10-year, 12 percent, semiannual coupon bond with a par value of $1,000 is
currently selling for $1,150. However, the bond can be called after 5 years for a price of
$1,050. What is the bond's nominal yield to call (YTC)?
j. Boeing's bonds were issued with a yield to maturity of 7.5 percent. Does the yield to
maturity represent the promised or expected return on the bond? Why?
 CASE 2

Answers:

a. Key Features of a Bond:

1. Par/Face Value: The amount of money that the bond issuer will pay to the bondholder
when the bond matures.
2. Coupon Rate: The interest rate that the bond issuer will pay to the bondholder
annually or semi-annually. The payment is typically a percentage of the par value.
3. Coupon Payment: The actual payment that the bondholder receives from the bond
issuer annually or semi-annually. It is calculated by multiplying the coupon rate with
the par value.
4. Maturity Date: The future date when the bond issuer repays the bondholder the bond's
par value.
5. Issuer: The organization that issues the bond and pays interest payments to the
bondholders.
6. Yield to Maturity (YTM): The total return anticipated on a bond if it is held until
maturity.

b. Call Provisions vs Sinking Fund Provisions:

 Call Provision: A feature in a bond that allows the issuer to retire or 'call' the bond
before the maturity date. This typically happens when interest rates have fallen since
the time of issue, allowing the issuer to reissue bonds at a lower interest rate.
 Sinking Fund Provision: A requirement for the issuer to periodically set aside money
specifically to repay the bondholders at maturity. It reduces the risk for investors as it
assures them that the issuer is saving money to repay them.

The main difference between the two provisions is that a call provision gives the issuer
the option to redeem the bond, whereas a sinking fund provision requires the issuer to retire a
portion of the bond issue at predetermined intervals.

c. The value of a 10-year, $1,000 par value bond with a 12 percent annual coupon and its
required rate of return is 10 percent is calculated as follows:

Present Value = Coupon Payments (PV of an ordinary annuity) + Par Value (PV of a lump
sum)

Here, Coupon Payment = 12/100 * 1000 = $120

 For a 10-year, 12% annual coupon bond, the bond's value is found as follows:
0 12% (i) 1 2 3 4 5 6 7 8 9 10 years
| | | | | | | | | | |
120 120 120 120 120 120 120 120 120 120 payment

So,
Present Value = $120 * [1 - (1 / (1 + 0.10) ^ 10)] / 0.10 + $1000 * (1 / (1 + 0.10) ^ 10)
Present Value = $120 * 6.14457 + $1000 * 0.38554
Present Value = $737.35 + $385.54
Present Value = $1122.89

d. If just after the bond had been issued, the going market rate of interest was 8 percent, the
value of the bond would be:

0 12% (i) 1 2 3 4 5 6 7 8 9 10 years

| | | | | | | | | | |
120 120 120 120 120 120 120 120 120 120 Payment

Present Value = $120 * [1 - (1 / (1 + 0.08) ^ 10)] / 0.08 + $1000 * (1 / (1 + 0.08) ^ 10)

Present Value = $120 * 6.71008 + $1000 * 0.46319
Present Value = $805.21 + $463.19
Present Value = $1268.40

Since the bond's price is above its par value ($1268.40 > $1000), it is selling at a premium.

e. The yield to maturity (YTM) on a 10-year, 8 percent annual coupon, $1,000 par value bond
that sells for $850 can be calculated using the following formula:

YTM = [Coupon + (Face Value - Price) / n] / [(Face Value + Price) / 2]

Where:
Coupon = $1,000 * 8% = $80
Face Value = $1,000
Price = $850
n = 10 years

Plugging these values into the formula:

0 8% (i) 1 2 …. 9 10 years
| | | | | |
80 80 80 80 Payment
1,000
PVM
850

YTM = [$80 + ($1000 - $850) / 10] / [($1000 + $850) / 2]

YTM = $95 / $925
YTM ≈ 10.27%
f. Interest rate (or price) risk is the risk that changes in the overall market interest rates will
impact the price or value of a bond. When interest rates rise, bond prices fall, and vice versa.
The longer the time to maturity, the greater the interest rate risk. Therefore, a 10-year bond
has more interest rate risk than an annual payment 5-year bond.

g. Reinvestment rate risk is the risk that future cash flows – either interest or principal – may
have to be reinvested in the future at a lower potential interest rate. The longer the bond's
duration, the higher the reinvestment rate risk because the cash flows will be reinvested over a
longer time period. Therefore, a 10-year bond has more reinvestment rate risk than a 5-year
bond.

h. The value of a 10-year, semiannual payment, 12 percent coupon bond with a nominal rate
of return (rd) of 8 percent is calculated as follows:

Coupon Payment = (12/100 * 1000) / 2 = $60 (Because it is semi-annual, we need to divide

the coupon payment by 2)

0 12% (i) 1 1.5 2 …. 9 9.5 10 years (semiannual)

| | | | | | | |
60 60 60 …. 60 60 60 payment

So, the bond value (semi-annual coupon) is calculated as:

Present Value = $60 * [1 - (1 / (1 + 0.04) ^ 20)] / 0.04 + $1000 * (1 / (1 + 0.04) ^ 20)

Present Value = $60 * 13.59033 + $1000 * 0.45639
Present Value = $815.42 + $456.39
Present Value = $1271.81

i. The nominal yield to call (YTC) is the rate of return earned on a bond when it is called
before its maturity date.

The bond in question is a 10-year, 12 percent semiannual coupon bond with a par value of
$1,000 that is currently selling for $1,150. However, the bond can be called after 5 years at a
price of $1,050.

In order to find the YTC, we need to equate the bond's price with the present value of its cash
flows until the call date, discounted at the YTC. The equation becomes:

$1,150 = $60 * [1 - (1 / (1 + YTC/2) ^ 10)] / (YTC/2) + $1,050 / (1 + YTC/2) ^ 10

This equation will allow us to find the bond's YTC. However, this equation cannot be solved
directly for YTC. We would need to use numerical methods or financial calculator software to
solve it. This would generally involve guessing a value for YTC, computing the right side of
the equation, comparing it to the actual price, and adjusting the guess based on whether the
calculated price was too high or too low.

Unfortunately, without a financial calculator or similar tool, it's not feasible to provide a
numerical answer here.
To solve for the yield to call (YTC) without a financial calculator requires an iterative
method, usually trial and error. You'll need to make an educated guess and then refine your
guess based on the result.

Here's a simplified illustration of how you might do this:

Step 1: Start with an initial guess for the YTC. A good place to start is the coupon rate or the
yield to maturity. Let's start with an annual rate of 10%, which is 5% semi-annually.

Step 2: Calculate the price of the bond using the assumed YTC and compare it to the actual
price. Here's how you would do that:

Price = $60 * [1 - (1 / (1 + 0.05) ^ 10)] / 0.05 + $1050 / (1 + 0.05) ^ 10

If you perform these calculations, you'll find the Price to be approximately $1,211.

Step 3: Compare this calculated price to the actual price of the bond ($1,150). In this case, our
calculated price is greater than the actual price, which means our YTC is lower than our initial
guess.

Step 4: Adjust the YTC downward and repeat steps 2-3. Let's try 4.5% semi-annually, or 9%
annually:

Price = $60 * [1 - (1 / (1 + 0.045) ^ 10)] / 0.045 + $1050 / (1 + 0.045) ^ 10

Performing these calculations yields a price of around $1,185.

This price is still higher than the actual price, so we need to adjust YTC further downwards.

Step 5: Continue this process until you have refined your guess to a point where the calculated
price is as close as possible to the actual price. In real-world calculations, this process is
typically done using financial software or a financial calculator, but it can be done manually
as shown here.

Remember that this is an iterative process that may not yield a precise answer. The actual
YTC for this bond would likely be somewhere between 4.5% and 5% semi-annually (or 9-
10% annually).

j. The yield to maturity (YTM) is the total return promised to the bondholder during the
lifetime of the bond. For Boeing's bonds issued with a YTM of 7.5 percent, it means if the
bond is held until maturity, the bondholder would achieve a return of 7.5 percent per annum.
This assumes that all interest payments are reinvested at an interest rate equal to the YTM and
the bond does not default. Thus, YTM could be seen as the promised return as it assumes that
everything goes according to plan. However, it is not the expected return as there may be risks
such as the bond issuer defaulting on the payments or the actual reinvestment rate being
different from the YTM.