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Applied Foundations of Finance FINM7006

Tutorial 3 Solutions

Question One

Describe the characteristics of a corporation that differentiate it from other forms of business organization such as partnerships and sole proprietorships?

The corporation differs from other forms of business organization in three main ways, namely:

· Ownership is usually more widely dispersed: Not only is ownership dispersed, shareholdings are freely transferable between different shareholders and this can be done without interfering with the operation of the corporation itself;

· Shareholders have no right to participate in the daily running of the corporation in which they hold shares: The objectives of a corporation are determined by its board of directors. However, the board itself is elected / reelected by the shareholders and the board must report to the shareholders regarding the operations of / decisions made regarding the company; and,

· The liability of shareholders for debts incurred by the corporation is usually “limited”: This concept and its implication for shareholders is discussed in detail in the solution to Question Two.

Question Two

What is meant if a shareholder has limited liability? How does this differ from a situation where a shareholder has no liability?

The liability of shareholders in limited liability corporations is limited to the amount unpaid, if any, on their shares. In contrast, the liability of shareholders in a no liability company only extends to the amount they have paid on shares they hold.

The difference between the liability of shareholders in limited versus no liability companies is best illustrated by way of an example: refer to the example in section 2.1 of lecture 3. Compare the liability of shareholders in limited and no liability companies with the owners of sole proprietorships or partnerships. If a sole proprietorship or partnership fails to meet its obligation to creditors, creditors can dispose of the owners’ personal assets in order to obtain amounts owning to them.

Question Three

What is the difference between a preference share and an ordinary share?

Ordinary and preference shares are similar insofar as they are both equity securities as both represent ownership in a corporation. In the case of ordinary shares, the holder has the right to vote and the right to any dividend declared by the board of directors. However, ordinary shareholders rank last in the event of liquidation. Preference shares are given priority over ordinary shares for dividends (fixed) and in the event of liquidation. However, these shares generally have no voting rights attached to them.

Question Four

The ordinary shares of NCP paid $1.32 in dividends last year. Dividends are expected to grow at an 8% annual rate for an indefinite number of years. (a) If you required rate of return is 10.5%, what is the value of the shares for you? (b) Should you make the investment?

(b) If the investor’s expected value of the share is greater than the current market price, the investor should buy more shares because the share would be under-priced. Conversely, if the investor’s expected value of the share is less than the current market price, the investor should sell the shares because the share would be overpriced.

Question Five

Describe the difference between a coupon-paying bond and a discount security.

A coupon-paying bond is a medium-to-long term fixed interest security that pays a regular coupon (interest payment), almost always six monthly. In addition to coupon payments, the face value of the bond is redeemed at the maturity date. Discount securities are short-term debt instruments that are issued at a discount (ie these instruments cost less than their face value to purchase), with the full face value paid to the holder of the instrument at maturity. The difference between the issue price and the face value represent the interest accruing to the holder over the life of the instrument. Examples of discount securities include bank-accepted bills, promissory notes, treasury notes and certificates of deposit.

Question Six

Calculate the price of a 90-day bank accepted bill quoted as having a yield of 10% p.a.

Question Seven

Enterprise Ltd bonds have a 9% annual coupon rate. The interest is paid semi-annually and the bonds mature in eight years. Their face value is $1000. If the market’s required yield to maturity on a comparable-risk bond is 8%, what is the value of the bond? What is its value if the interest is paid annually?

Question Eight

Find the price of a 10%, $100 Commonwealth Government bond with exactly 3 and three quarters years to maturity given a required rate of return of 8% p.a.

Question Nine

A bond of the Telink Corporation pays $110 in annual interest, with a $1000 face value. The bond matures in 20 years. The market’s required yield to maturity on a comparable-risk bond is 9%.

(a) Calculate the value of the bond.

(b) How does the value change if the market’s required yield to maturity on a comparable-risk bond (i) increases to 12%, or (ii) decreases to 6%?

(c) Interpret your findings in part (a) and (b). What is the primary role of financial markets?