Question

A. SHORT QUESTIONS 1. What is the internal rate of return? 2. What is the difference between real and nominal interest rates? 3. What is risk and how to measure it? 4. What is the difference between idiosyncratic and systematic risk? 5. What is hedging? 6. Explain how diversification can be used to reduce risk. B. ANALYTICAL QUESTIONS QUESTION 1 Consider two investment alternatives, investment I and investment II, with their payoffs and their associated probabilities outlined in the following table: Investment I Payoff Probability 20 0.10 5 0.20 10 0.70 Investment II Payoff Probability 5 0.20 10 0.30 4 0.50 1. Compute the expected value for investment I and investment II; 2. Compute the variance for investment I and investment II; 3. Compute the standard deviation for investment I and investment II; 4. Compute the Return-Risk Index (RRI) for investment I and investment II; 5. Would you select investment I or investment II? Why? QUESTION 2 Assume you place $5000 in a saving account paying 4% a year. How much would you have in this saving account in 3 years? QUESTIONS Find the monthly payment needed to repay a 3-year car loan of $7,000 when the interest rate is 2%, compounded monthly. 1

Answer 1

SOLUTIONS:

A.SHORT QUESTIONS

1) IRR

IRR stands for internal rate of return method.IRR is one of the modern method among the various techniques of capital budgeting .capital budgeting is simple referred to as the decisions regarding investments. IRR is one of the modern method or discounting criteria method because here the time value of money is considered .Discounting by using the several discount rates till when the net present value of the project becomes zero.it is the rate at which the present value of cash inflows and outflows are same.it is a method considering all the cash flows over the whole life of the project.

2) DIFFERENCE BETWEEN REAL AND NOMINAL INETREST RATES

The real interest rate is the rate of interest that considers inflation rate, whereas the nominal interest rate doesn’t take the inflation rate into account.

REAL INTEREST RATE =NOMINAL RATE- INFLATION RATE.

NOMINAL RATE =REAL INTEREST RATE+INFLATION

And when the inflation becomes zero real interest rate =nominal rate.

3) Risk simply means the possibility of loss.it refers to the uncertainties that have to be taken by an investor to attain a gain.risks are of various types. Normally risk is measured by standard deviation or beta coefficient.

4) DIFFERENCE BETWEEN IDIOSYNCRATIC AND SYSTEMMATIC RISK

Systematic risk refers to the uncertainty to be affected to the market as a whole. They are un diversifiable and commonly called as market risk. Whereas idiosyncratic risks are the uncertainties to be affected for a company or a particular industry and they are specific and diversifiable. Idiosyncratic risk is also called as unsystematic risk.

5) HEDGING

Hedging simple refers as a contract or an agreement which is used to offset the risks coming from various transaction exposures. Hedging are of different types.it is an important tool or method of managing exposure risk.

6) DIVERSIFICATION

There is an idiom that doesn’t put all the eggs in one basket. This is an exact example for knowing about diversification. If we concentrate all the investments at one area itself there is a possibility for losing all. Diversification refers to the process of investing in different assets and this is done because different assets react differently due to the market conditions, and thus we can reduce the risk.

B.ANALYTICAL QUESTIONS

1)Calculation of expected value

EV or Expected value=p(x)*n

p(x)=the probabilities of the events

n=number of times

EV OF INVESTMENT 1

EV OF INVESTMENT 1=20*0.10+5*0.20+10*0.70

=2+1+7

=10

EV OF INESTMENT 2

EV OF INVESTMENT 2=5*0.20+10*0.30+4*0.50

=1+3+2

=6

So it is preferable to select the investment 1 because its expected value is greater than the expected value of investment 2

2) The amount at the end of 3 years is computed using the following formula:

P (1+NR/100)

P = THE PRINCIPAL AMOUNT

N = THE NUMBER OF YEARS.

R =THE RATE OF THE INTEREST PER ANNUM

   =5000(1+3×4/100)

   =5000(1+12/100)

   =5000(1+0.12)

   =5000(1.12)

   =5600

So the amount in the savings account at the end of 3 years =5600

3) INETREST FOR LOAN IS COMPUTED AS FOLLOWS

= P (1+R/100) ^N   -1

P = THE PRINCIPAL AMOUNT

N = THE NUMBER OF YEARS.

R =THE RATE OF THE INTEREST PER ANNUM

R=2/100=0.02

It is divided by 12 because it is compounded monthly.

=7000(1+0.02/12) ^3 -1

=7000(1.030301-1)

=212.107

So the amount of interest to pay =212.107