UNIVERSITY OF MELBOURNE

DEPARTMENT OF FINANCE
FNCE10002 Principles of Finance
Summer Semester 2019
Mid-semester Exam Questions and Answers
All questions are worth 1 mark. The total mark out of 15 will be scaled to a mark out of
20.
QUESTION 1 [1 mark]
Which one of the following is a fundamental difference between a broker and an intermediary?
(A) Cash lodged with a broker is held on trust but cash lodged with an intermediary becomes
an asset of the intermediary.
(B) Cash lodged with an intermediary is held on trust but cash lodged with a broker becomes
an asset of the broker.
(C) A broker may be a small firm but an intermediary is nearly always a large corporation.
(D) None of the above.
ANSWER 1
A
QUESTION 2 [1 mark]
Harold deposits $100,000 in an account that pays interest of 3.5% pa, with interest added to
the account annually. He can withdraw the balance of his account (including interest) at the
end of any year but not during a year. Harold’s objective is to achieve an account balance of
at least $150,000.
Harold should withdraw the balance of his account (including interest) after:
(A) 9 years
(B) 10 years
(C) 11 years
(D) None of the above.
ANSWER 2
D
If Harold could withdraw his money at any time, he would do so when:
n
$100, 000 (1.035 ) = $150, 000.

The value of n which solves this equation is:

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 log (1.5 )
n=
log (1.035 )

Using logs to base e :

0.405465108
n= ≈ 11.786 years
0.034401426
Using logs to base 10:
0.176091259
n= ≈ 11.786 years
0.014940349
Therefore, Harold should withdraw the balance of his account at the end of the twelfth year.
Alternatively,
You could just try the suggested terms and see what the outcome is. If you were lucky, and
tried option (C) first, you would find:
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$100, 000 (1.035 ) = $145,997 < $150, 000.

Therefore, 11 years is not long enough, so the answer must be 12 years or more. Hence (D) is
correct.
QUESTION 3 [1 mark]
Consider the following four interest rates:
i. 9.225% pa, payable half-yearly
ii. 9.109% pa, payable quarterly
iii. 9.084% pa, payable monthly
iv. 9.075% pa, payable continuously
Assume that all months are of equal length.
Based purely on the corresponding effective annual interest rates, which one of the following
is correct?
(A) Borrowers should choose (i); Lenders should choose (iii).
(B) Borrowers should choose (iii); Lenders should choose (ii).
(C) Borrowers should choose (iv); Lenders should choose (i).
(D) Borrowers should choose (ii); Lenders should choose (iv).

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ANSWER 3
D
The corresponding effective annual interest rates are:
2
 0.09225  2
(i) 1 +  − 1 = (1.046125 ) − 1 ≈ 9.4378% pa
 2 
4
 0.09109  4
(ii) 1 +  − 1 = (1.0227725 ) − 1 ≈ 9.4249% pa
 4 
12
 0.09084  12
(iii) 1 +  − 1 = (1.00757 ) − 1 ≈ 9.4719% pa
 12 
(iv) e0.09075 − 1 ≈ 9.4995% pa

Borrowers should choose the lowest effective annual interest rate, which is (ii).
Lenders should choose the highest effective annual interest rate, which is (iv).
QUESTION 4 [1 mark]
Assume that today is 20 January 2019, which is Terry’s 30th birthday. After talking with some
friends at his birthday dinner, he has decided to open a savings account tomorrow, with the
goal of having $35,000 in the account on the day after his 40th birthday. He intends to reach
this goal by depositing the same amount on the 21st of every month from tomorrow up to and
including the day after his 40th birthday. The savings account pays interest at the rate of 7.2%
pa, payable monthly.
The amount Terry should deposit each month is closest to:
(A) $186.26
(B) $188.88
(C) $197.68
(D) $200.00
ANSWER 4
C
Terry will make 121 deposits: one immediately and then one each month for the next 10 years.
The monthly interest rate is 7.2% / 12 = 0.6% = 0.006.

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Terry needs to solve:

 C  1   120
C + 1 − 120   (
1.006 ) = $35, 000
 0.006  (1.006 )  

( C + 85.36656977C ) × 2.0500180567 = $35, 000
177.0530275C = $35, 000
C = $197.68

QUESTION 5 [1 mark]
Horst and Ingrid have just borrowed $425,000 to buy a house. The interest rate is 4.8% pa,
payable monthly. They are contracted to make equal monthly repayments, with the first
repayment due in a month’s time. The loan will be repaid over a period of 25 years.
The amount of each repayment is closest to:
(A) $2435
(B) $2445
(C) $2516
(D) $2526
ANSWER 5
A
Monthly interest rate = 4.8% / 12 = 0.4%.
Term in months = 12 × 25 = 300
Therefore:

C  1 
1 −  = $425, 000
0.004  (1.004 )300 
The solution to this equation is C = $2435.24.

QUESTION 6 [1 mark]
Ballarat Bank bought a 182-day Australian Treasury note at a yield of 2.35% pa and sold it 47
days later at a yield of 2.45% pa.
The effective annual rate of return made by Ballarat Bank is closest to:
(A) 2.063% pa
(B) 2.359% pa
(C) 2.386% pa
(D) 2.444% pa

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ANSWER 6
A
$100
Purchase price = = $98.84179085
182
1 + 0.0235 ×
365
$100
Sale price = = $99.10197322
135
1 + 0.0245 ×
365
365 47
 $99.10197322 − $98.84179085 
Effective annual rate of return = 1 +  − 1 ≈ 2.063% pa
 $98.84179085 
QUESTION 7 [1 mark]
A bond has a coupon rate of 4.50% pa and pays interest once each year. A coupon payment
was made yesterday. The bond will mature 15 years from today.
AQT Ltd bought one of these bonds today at a required rate of return (yield) of 4.70% pa.
If AQT sells the bond tomorrow at a yield of 4.60% pa, the rate of return earned by AQT Ltd
will be closest to:
(A) –0.1%
(B) 0.0%
(C) 0.1%
(D) 1.1%
ANSWER 7
D
The purchase price (per $100 par value) is:

$4.50  1  $100
P= 1 − 15 
+
0.047  (1.047 )  (1.047 )15
= $47.670220 + $50.211105
= $97.881325
The sale price (per $100 par value) is:

$4.50  1  $100
P= 1 − 15 
+
0.046  (1.046 )  (1.046 )15
= $47.997403 + $50.935988
= $98.933391

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The rate of return is:
$98.933391 − $97.881325
r= ≈ 1.1%
$97.881325
QUESTION 8 [1 mark]
Assume that all bonds pay coupon interest annually, have just paid a coupon and have a yield
to maturity of 4.25% pa.
If the yield to maturity on all bonds decreases to 4.15% pa, which of the following four bonds
will have the largest percentage price change?
(A) A three-year bond with a coupon rate of 7.5% pa.
(B) A three-year bond with a coupon rate of 8.0% pa.
(C) A five-year bond with a coupon rate of 7.7% pa.
(D) A six-year bond with a coupon rate of 7.5% pa.
ANSWER 8
D
Bond prices are more volatile the lower is the coupon rate and (with a very few exceptions that
we are ignoring in this subject) the longer is the term to maturity. Because D has both the
longest term and the (equal) lowest coupon, its price must be the most volatile of the four and
hence will increase the most in percentage terms.
If you do the arithmetic, the price increases are 0.2695% for A, 0.2685% for B, 0.4218% for C
and 0.4932% for D.
QUESTION 9 [1 mark]
Yesterday, Domain Transport Ltd (DTL) paid a dividend of $1.50 per share on its ordinary
shares. DTL pays one dividend per year. Shirley is an equity analyst and forecasts that DTL’s
dividend next year and the year after that will remain at $1.50 per share, but thereafter the
dividend will grow at a rate of 2.0% pa. Shirley has also estimated that the required return on
DTL shares is 9.5% pa. The risk-free rate is 4.0% pa.
Shirley’s estimate of the value of a DTL share today is closest to:
(A) $18.05
(B) $19.63
(C) $19.76
(D) $21.77

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ANSWER 9
B
The risk-free rate is irrelevant.
Imagine that a year has passed. DTL is about to pay a dividend of $1.50 per share. At this
date, future dividends conform to the assumptions of the Dividend Growth Model, where the
next dividend is D2 = $1.50, the growth rate (g) is 2.0% pa and the required rate of return (ke)
is 9.5% pa. Hence, the value of a DTL share in one year’s time is given by:

D2
P1 = D1 +
ke − g
$1.50
= $1.50 +
0.095 − 0.02
= $21.50
Discounting this value for one year gives:

$21.50
P0 =
1.095
≈ $19.63

QUESTION 10 [1 mark]
Magnetic Mining Ltd has on issue traditional preference shares with a face value of $12 and a
dividend rate of 9% pa. Dividends are paid once each year. A dividend was paid yesterday.
The required rate of return is 8.6% pa.
The price of one of these shares today is closest to:
(A) $11.47
(B) $12.56
(C) $13.64
(D) $14.13
ANSWER 10
B
0.09 × $12
P=
0.086
≈ $12.56

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QUESTION 11 [1 mark]
Cheltenham Tiles Ltd (CTL) has 900,000 shares on issue. The market price of a CTL share is
$25.00. The directors of CTL have decided to place 100,000 new shares with Tactical
Investments Ltd (TIL) at a price of $24.00 per share. Janice owns 15,610 CTL shares.
The most likely outcome of the placement is:
(A) Janice makes a capital loss of 4.00%; TIL makes a capital gain of about 4.17%.
(B) Janice makes neither a capital gain nor capital loss; TIL makes a capital gain of about
4.17%.
(C) Janice makes a capital loss of 0.40%; TIL makes a capital gain of 3.75%.
(D) Janice makes neither a capital gain nor capital loss; TIL makes neither a capital gain
nor capital loss.
ANSWER 11
C
The value of CTL shares on issue before the placement is 900,000 × $25.00 = $22,500,000.
The value of CTL shares on issue after the placement is $22,500,000 + 100,000 × $24.00 =
$24,900,000.
The number of CTL shares on issue before the placement is 900,000.
The number of CTL shares on issue after the placement is 900,000 + 100,000 = 1,000,000.
Therefore, the value of 1 CTL share after the placement is:
Value of CTL shares on issue after the placement
Number of CTL shares on issue after the placement
$24,900, 000
=
1, 000, 000
= $24.90

Hence, a shareholder (such as Janice) sees the share price fall from $25.00 to $24.90, which is
a capital loss of $0.10 / $25.00 = 0.40%.
TIL pays $24.00 per share which will be worth $24.90 per share when they are listed, thus
making a capital gain of $0.90 / $24.00 = 3.75%.

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QUESTION 12 [1 mark]
Ranjit owns shares in Eureka Stone Ltd (ESL). Recently, ESL announced a 1-for-7
renounceable rights issue. Ranjit has decided to renounce and sell his rights.
Which one of the following is most likely to be correct?
(A) Ranjit will lose proportionate voting power but will not suffer any loss of wealth.
(B) Ranjit will not lose proportionate voting power but will suffer a loss of wealth.
(C) Ranjit will lose proportionate voting power and will suffer a capital loss.
(D) Ranjit will not lose proportionate voting power and will not suffer a capital loss.
ANSWER 12
A
By selling the rights, Ranjit will maintain his wealth but by not taking up the rights he will own
a smaller proportion of the post-rights shares on issue, thus suffering a loss of proportionate
voting power.
QUESTION 13 [1 mark]
Consider the following statements.
When a firm borrows:
1. Its return on equity becomes more variable.
2. Its risk of bankruptcy increases.
3. Its shareholders bear more risk.
Which one of the following is correct?
(A) Statements 1, 2 and 3 are true.
(B) Statement 1 is false; Statements 2 and 3 are true.
(C) Statements 1 and 3 are true; Statement 2 is false.
(D) Statements 1 and 2 are true; Statement 3 is false.
ANSWER 13
A

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QUESTION 14 [1 mark]
Virat has been investigating two mutually exclusive project proposals, Q and R. Both projects
have the same risk. The forecast end-of-year cash flows are shown in the following table.
Forecast cash flows
Year Project Q Project R
0 –$2,100,000 –$865,000
1 $130,000 $515,000
2 $575,000 $400,000
3 $1,750,000 $358,000
4 $1,800,000 $323,000

Virat has estimated (correctly) that the IRRs of projects Q and R are 25.1% pa and 33.3% pa,
respectively.
Consider the following statements.
1. If the required rate of return is 12% pa, then project Q should be accepted.
2. If the required rate of return is 23% pa, then project R should be accepted.
3. If the required rate of return is 37% pa, then neither project should be accepted.
4. If the required rate of return is 26% pa, then project R should be accepted.
Which one of the following is correct?
(A) Statements 1 and 2 are false; Statements 3 and 4 are true.
(B) Statements 1, 2, 3 and 4 are true.
(C) Statements 1, 3 and 4 are true; Statement 2 is false.
(D) Statement 1 is true; Statements 2, 3 and 4 are false.

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ANSWER 14
B
This is a textbook case of conflicting ranks. If the required rate of return is zero, then the NPV
of Q is $2,155,000 and the NPV of R is $731,000. The IRRs are 25.1% for Q and 33.3% for
R. Hence, the NPV profiles must look something like this:

$2155

PROJECT Q

$731
PROJECT R

25.1% 33.3%

Virat should use the NPV rule. From the diagram, it is clear that Statements 1, 3 and 4 are true.
Statement 2 could be true or false depending on whether 23% pa is less than, or greater than,
the rate of return at which the NPVs are equal. To decide this question, we could estimate the
rate of return at which the NPVs are equal. But a quicker (and just as accurate) way is simply
to calculate the NPVs of Q and R if the required rate of return is 23% pa.
The calculations are (in thousands of dollars):
$130 $575 $1750 $1800
NPVQ = + + + − $2100
1.23 (1.23) (1.23)3 (1.23)4
2

= $112.593
$515 $400 $358 $323
NPVR = + + + − $865
1.23 (1.23) (1.23) (1.23) 4
2 3

= $151.593
Therefore, R is preferred to Q, so Statement 2 is true.

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QUESTION 15
Which one of the following provides the best description?
(A) The depreciation tax shield is treated as a cash outflow because both depreciation and
income tax represent cash outflows.
(B) The depreciation tax shield is treated as a cash inflow because it is equivalent to a refund
of income tax previously paid.
(C) The depreciation tax shield is treated as a cash outflow because depreciation is the
allocation over time of the initial cash outlay on an investment and income tax is a cash
outflow.
(D) The depreciation tax shield is treated as a cash inflow because it is equivalent to the
reduction in income tax made possible by depreciation being an allowable deduction
against income.
ANSWER 15
D

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