Question

1. Suppose an investor wishes to invest in a computer manufacturing firm whose main business is exporting computers. The firm has several rival companies that also export computers to the same market.

From the perspective ofthe investor, is the following a systematic risk or an unsystematic risk? How can an investor manage such risks when making investment decision? Explain your views.

1. The firm has a very high level of debt, and there are concerns that it may collapse in future if the business operation does not improve.
2. There are concerns that demand for computers is dropping in the target market.       

Q) You are to decide between two mutually exclusive projects. Let us name the projects as Project A, and Project B. Project A and Project B haveIRR of 20% and 17%years, respectively. However, Project A and Project B haveNPV of $10,000 and $20,000, respectively.The company’s cost of capital is 10%. Which project will you recommend the company to choose, and why? Explain.        (4marks)

Q) Explain how the price of a bond varies with interest rate. Does coupon rate ofa bond have any impact on its risk? Explain your views.                                                                                  (4marks)

Answer 1

1. The following risk is unsystematic risk as it is related to ap particular industry and not economy as a whole. It has narrow impact instead of broader impact.

Investor can manage such risk while making investment decisions through diversifying. It can be done by adding more securities to the portfolio.

2. In my opinion, Project B is recommended because it is suggested that the NPV is better technology for evaluation as it employs more realistic reinvestment rate assumption. And NPV of Project B is higher and hence, recommended.

3. Interest rate and price of bond are inversely related ie, if the interest rate increases, price of bond falls. This is explained through an example below -

If a band has coupon of 5% and interest rate prevailing in the market rise from 5% to 6%, the bond will become less attractive to the investors and they will be willing to pay less for it. And therefore, price of bond will fall in the market.

Coupon rate of a bond has large impact on its price. Therefore it has impact on the risk.