Topic 3: Investment principles /Direct Investment SolutionsQuestion 1There is a positive relationship between risk and return in that generally the higher theexpected return, the higher is the associated risk.An example can be provided by way of equities, where although the return is higher over thelonger term than other asset classes, there is generally a higher level of volatility in the shortto medium term.Question 2Ordinary shares:• represent equity• entitlement to voting rights• entitlement to dividend if profits allow• rank last for repayment if company is insolventPreference shares:• can be seen as a type of debt instrument• have priority for dividend before ordinary shareholders• dividends are fixed and are mostly cumulative• limited voting rights• may have priority above ordinary shareholders for repayments in the event ofinsolvencyQuestion 3(i) SolutionsEarnings Per Share (EPS) = Earnings after tax/No. of Ordinary shares= $850,000/1,200,000 = $0.708Price Earnings (P/E) ratio = Market Price/EPS= $5.60/0.708 = $7.91Dividend per share (DPS) = Dividends paid/No of Shares= $140,000/1,200,000 = $0.117Dividend Yield = DPS/Market Price= $0.117/$5.60 = 2.09%(ii) Fundamental analysisBenefits:• entails doing a thorough research of the company – from the company through to thestate of the economy• objective – based on actual data• historical data may be a good predictor of future value• determines an intrinsic worth which is not affected by market ups and downsLimitations:• some emphasis based on historical information which may not be relevant today• market may ignore intrinsic worth of company in its valuation of the company (eg.technology stocks)• based on accounting information which can be window dressed and manipulated• with some ratio calculations, comparing historical information with current data (eg.dividend yield) does not give relevant data(iii) There is insufficient information available to be able to properly assess the company.However, the company is generating low earnings per share, a low dividend per share anddividend yield which are a negative signals. P/E ratio appears also relatively low whencompared against average market P/E ratios. However, would need to consider the type ofmarket the company was in, and the performance of competitors, to be able to fully assess itsperformance. To properly assess the company, an analysis of the following factors would alsobe required: management ability, prior years data, economic climate, future prospects,competitive advantage, access to funding etc.Question 4(a) Dollar-cost averaging is a passive investment strategy used to diversify out the ‘timingrisk’ of share price over time. Is a strategy of investing fixed amounts at regular intervalsregardless of market trends. Smooths out the average cost of an investment because the fixedamount of money buys more units of the investment when the price is low and less when theprice is high(b)If he had acquired all the shares at the end of the month ($2.50), he would have onlybeen able to acquire 2,400 shares.Question 5(i) Additional information required:• -other investments held (issue of diversification)• -risk profile of client• -ability to service 2 mortgages from disposable income• -security of the couple’s employment positions• -ability to continue to service the 2 mortgages when Michelle leaves the• workforce in 5 years time to start a family• views on getting exposure to property through managed funds(ii) Consider the following issues:• -may be preferable to diversify into shares rather than all investments being inproperty• couple will have a considerable amount of debt on their hands – appears a little toohigh given their salaries• in whose name should the investments be held (tax purposes)• look at restructuring mortgages – loan on private residence should be minimised andloan on investment property should be maximised to take advantage of tax deductions• the order of preference in paying off the 2 mortgages (consider the options of renegotiating the first mortgage to an interest only loan)• is it the right time now to purchase propertyQuestion 6This is subjective question as it depends upon a number of individual factors. There is anincreasing number of people these days that are actively deciding to rent a residentialproperty instead of purchasing one. The rationale is that the money that would have otherwisehave been used on the deposit and purchase, is able to be used for investing and earn a higherrate of return than the returns generated from the capital growth in the owned property.Factors that would determine this decision may include:• individual preferences• risk profile• annual income and tax position• trends in the property business cycle• alternatives investments available• returns generated from other sourcesQuestion 7The factors that can potentially affect bond prices are as follows:• interest rate changes in the market – interest rates and bond prices are inversely• related (an increase in interest rates will generally cause bond prices to fall• because they are now less valuable compared to other recently issued bonds• paying a higher interest rate)• demand and supply• credit rating of institution• passage of time (price of bond will converge to face value towards maturity)Question 8(a) The bond’s coupon rate is the interest payable on the face value of the bond. This isusually the annual rate and paid semi-annually. The yield is the annual interest ÷ purchaseprice of the bond. At the time of issue, the coupon rate and the yield is the same. However,the yield can be higher or lower than the coupon rate as the bond can be sold on the open(secondary) market. The purchase price of the bond will increase if the current interest rate islower than the coupon rate; and willdecrease if the current interest rate is higher than the coupon rate.(b) John will not be able to sell his bond for $20,000 and will risk a capital loss on hisinitial investment as the prevailing interest rate is higher than the coupon rate ofthe government bond. An investor will not purchase the bond at 6% return whenthe current rate is 8%. John will have to lower the selling price of his bond(purchase price) .
