Question 1: Time Value of Money and Bonds (10 marks total)
(a) According to an ANZ survey of Adult Financial Literacy in Australia, 73% of us have not made an
estimate of how much money we will need each year in retirement.1 Without knowing this, it is
difficult to develop and implement a realistic plan that will meet our retirement goals.
Working out how much we will need depends on many personal factors but some general
estimates are available as a starting point. The Association of Superannuation Funds of Australia
(ASFA) produces a Retirement Standard2
that gives budget breakdowns for ‘modest’ and
‘comfortable’ retirement lifestyles for singles and couples that assume retirees own their home.
A single retiree wanting a comfortable lifestyle needs $42,597 per year.
Your friend, Alice, has heard you are studying finance and has asked your advice on how much
money she will need to put into superannuation every year between now and retirement. Alice
is a 30 year old female, who would like to retire in 35 years and wants to make her retirement
plans based on remaining single and having a ‘comfortable’ retirement lifestyle. Alice currently
has no superannuation and expects to own her home before retirement.
Using the Australian Life Tables 2010-12 produced by the Australian Government Actuary3
have found that Australian females have a longer life expectancy than males and the average 30
year old female is predicted to live to be about 85. You estimate that the long-term average
annual inflation rate will be 4%. You also estimate that the expected average annual rate of
return on Alice’s superannuation investment prior to retirement will be 12% but after
retirement, when she shifts the weighting of her superannuation investments much more
towards cash and other less risky asset classes, the average annual rate of return is expected to
be 6%. (Round to the nearest dollar in the calculations below and ignore taxes.)
i) How much will the ASFA comfortable annual retirement income be at the time Alice
retires? (Assume it will rise at the same rate as average inflation.) (0.5 marks)
ii) What lump sum will Alice need in superannuation at retirement to receive the annual
income (in nominal terms) calculated in part i)? (Assume an ordinary annuity.) (0.5 marks)
iii) What amount will Alice need to put into superannuation at the end of each year until
retirement in order to have the lump-sum calculated in ii)? (0.5 marks)
iv) Now assume that Alice is 50, not 30, and has been working full-time for 20 years. She has
lived a great lifestyle until now, spending all her disposal income after paying down a
mortgage on her home. Recalculate iii) above assuming the same retirement income and
lump-sum as calculated in parts i) and ii) but now 15 years to retirement. (0.5 marks)
v) Comment on the difference in your results at part iii) and iv). (0.5 marks)
(b) Compounding is not restricted to money values – it can be applied to growth rates in many
business and economic values. In business jargon, it is often called the compound annual
growth rate or CAGR. This is the same as a compounding interest rate.
The International Air Transport Association predicts that, in 2017, 487.9 million passengers will
fly domestic routes in China, the second largest number in the world behind the U.S. This
prediction represents a 10.2% CAGR on 2012 passenger numbers.4
i) If this growth rate can be expected to continue beyond 2017, what is your prediction for
the number of passengers flying domestic routes in China in 2020? (0.5 marks)
ii) What is the CAGR for a Chinese domestic airline that carried 20 million passengers in 2012
and 28 million passengers in 2014? If this CAGR is expected to continue, what market share
do you predict for the airline in 2020? (1 mark)
(c) On 1 July 2014 you borrow $350,000 to buy an investment property at Coolangatta. The rate on
the loan is fixed for the first 5 years at 5.49% and the loan requires monthly payments, due on
the last day of the month, over a 30 year term.
i) What is the effective annual rate on your loan? (0.5 marks)
ii) Assume you can claim the interest on this loan as a tax deduction against the rental income
you receive from the property. How much interest will you be able to claim as an annual
tax deduction in the first financial year (1 July 2014 to 30 June 2015) and in the fifth
financial year? (2 marks)
(d) In December 2014, Moody’s Chief Economist John Lonski said in reference to US high-yield
bonds (which in this context are rated Ba or lower by Moody’s):
…the recent high-yield bond spread of 554 bp is too wide by … 60 bp. Given the positive outlook
for business activity, high-yield bonds are now attractively priced.5
i) Explain which component(s) of market interest rates account for high-yield bonds having
such large spreads over the yield on a Treasury bond of equivalent maturity and why a
‘positive outlook for business activity’ would have an impact on those spreads. (1.5 marks)
ii) What would happen to the prices of high yield bonds if Lonski’s prediction is correct?
Illustrate your answer with a numerical example for a high-yield bond with 10 years to
maturity and 8% semi-annual coupon payments. Assume a 10 year Treasury bond yields
2.14% p.a. (2 marks)
Question 2: Company analysis, risk and returns (15 marks total)
You will be allocated an ASX listed company to study for this part of the assignment and part of
Assignment 2. You can find your allocated company in ‘View Grades’ on the unit site.
Assume that a stock advisor’s report dated 30 June 2014 recommends buying shares in your
allocated company. Your task is to analyse the company with a view to understanding its financial
performance and, with the benefit of hindsight, determining whether or not the recommendation to
buy was a good one in the short-term.
I recommend that you use DatAnalysis for your company financial data collection because most of
the needed information is available there. 6 Bond yield and index data can be found at websites
suggested in the Web Links section of the unit’s MySCU site. Before you start analysing the financial
data, do some background research on the company (e.g. industry, size, products, customers,
geography of operations etc.). This background will help you contextualise your financial analysis.
Your analysis should cover the following:
(a) Evaluate Statement of Cash Flows data for financial years ending 30 June 2013 and 30 June
2014. Do not include the statement of cash flows in your assignment answer. Evaluate the data,
rather than just repeating it. (1.5 marks)
(b) Evaluate the company’s free cash flow and return on invested capital for the 2013 and 2014
financial years ending 30 June. Assume that the company’s cost of capital (WACC) is the same as
the expected rate of return (cost of equity) you calculate in part (d) iii) below.7
(c) Provide a summary ratio analysis (5 marks).
Start your ratio analysis with an (extended) DuPont analysis based on the financial years ending
30 June 2013 and 2014. Doing the analysis for two years will give you a comparison over time.
The DuPont model allows us to decompose return on equity, an important overall indicator of
firm performance, into its three drivers: expense control, asset utilisation and debt utilisation.
The DuPont model provides a very useful starting point in analysing a company’s financials
because it provides structure to initial analysis. This saves time and helps avoid the potential
confusion that can occur when faced with an overwhelming number of ratios. With DuPont
analysis, you see the big picture first and then focus your attention on areas of strength and
(d) Analyse the market returns for the company’s shares from the end of their financial year (30
June 2014) to 27 February 2015 (the last trading day in February 2015). The following gives you
a step-by-step guide to doing this analysis:
i) Calculate the monthly percentage returns for the company’s shares during the period. (To
keep it simple, ignore dividends for this analysis and use adjusted monthly closing prices.)
Then calculate the average monthly percentage return and standard deviation of returns
and, using the procedure described in your text, annualise the returns and standard
deviation. (Assume that the shares are held for the entire period so that no capital gain is
realised during the period and consequently there is no reinvestment and compounding.)
ii) Repeat the process in i) for the same period but this time for the market as a whole, using
the All Ordinaries price index as a proxy. (0.5 marks)
iii) Calculate the expected return on the company’s shares at the end of their 2014 financial
year. To do this, use the yield to maturity on that date of a 10-year Australian Treasury
bond as a proxy for the risk-free rate, assume the market risk premium is 6.4% and use the
company’s current beta (thus assuming it has not changed since the financial year end).
iv) Using the figures you have calculated, evaluate the risk and return of the company in
comparison with the market actuals and the expected return. (2.5 marks)
In writing up part (d) of the assignment, as in part c above, use a table to present the figures
and then evaluate them. Limit your answer to one A4 pag