Question

King Solomon- The Rich Farmer King Solomon is a rich farmer in Tetebia, a town in the Asou Municipal Assembly. He owns over 100,000 hectares of farmlands. However, he fears the worst might happen and wants to do some investments to secure his future and that of his children. He is contemplating several long term investments he could undertake to secure his future and that if his children. He is now 50 years old and he plans to retire in 10 years from active farm work. He expects to live for another 25 years after he retires –that is, until age 85. He heard about an investment in the financial market will help him plan his retirement well. He has no idea about financial markets and how they operate. You recently graduated and have just reported to work as an investment advisor at the brokerage firm of Cenden Ltd. King Solomon has approached your company for advice. Your boss after a discussion with King Solomon could gather the following information. King Solomon wants his first retirement payment to have the same purchasing power at the time he retires as GHȼ 40,000 has today. He wants all of his subsequent retirement payments to be equal to his first retirement payment. (Do not let the retirement payments grow with inflation: King Solomon realizes that the real value of his retirement income will decline year by year after he retires.) His retirement income will begin the day he retires, 10 years from today, and he will then receive 24 additional annual payments. Inflation is expected to be 5% per year from today forward. He currently has GHȼ 100,000 saved up, and he expects to earn a return on his savings of 8% per year with annual compounding. Again, he wants to have a secure university education for his lovely daughter Daisy. His daughter is now 13 years old. She plans to enroll at the University of Professional Studies, Accra in 5 years, and it should take her 4 years to complete her education. Currently, the cost per year (for everything – her food, clothing, tuition, books, transportation, and so forth) is GH¢ 12,000 per year. This cost is expected to remain constant throughout the four-year university education. The daughter recently received GH¢ 7,500 from her grandfather‟s (King David‟s) estate; this money will be invested at a rate of 8% to help meet the costs of Daisy‟s education. The rest of the costs will be met by money King Solomon will deposit in a savings account which also earns 8 percent compound interest per year. He will make 5 equal deposits into the account, one deposit per annum starting one year from now until his daughter starts university. These deposits will begin one year from now. (Assume that school fees are paid at the beginning of the year). Your firm also serves as the investment adviser for Zenzo Pharma Ltd which intends to issue bonds to finance the production of its new vaccine. The bond has a face value of GH¢10,000 at a coupon rate of 12% and a term to maturity of 10 years. The bond expects to pay coupons semi-annually. Your firm however insists on Zenzo Pharma including a call and a sinking fund provision in the bond indenture. The required rate of return on the market for bonds with similar features is 18% per annum. EXAMINER: ISAAC OFOEDA Page 5 Required b. To the nearest cedi, how much must he save during each of the next 10 years (with equal deposits being made at the end of each year, beginning a year from today) to meet his retirement goal? (Note: Neither the amount he saves nor the amount he withdraws upon retirement is a growing annuity.) c. What will be the present value of the cost of 4 years of education at the time the daughter Daisy turns 18? d. What will be the value of the GH¢ 7,500 that Daisy received from her grandfather‟s estate when she starts college at age 18? e. If King Solomon is planning to make the first of 5 deposits one year from now, how large must each deposit be for him to able to put his daughter through college? f. Explain to King Solomon what call provisions and sinking fund provisions are and how these provisions are expected to affect the risk of the bond g. Which value will you place on a bond of Zenzo Pharma Ltd?

Answer 1

Answer "F":

Call Provison give the issuer the right to call or buyback issed bond if interest rate fall. Increases the risk related to bond and therefore reduces the current price.

Sinking Fund Provison: Bound the issuer to set aside money require to repay. Reduces the risk

Answer "G":

On Financial Calculator type

N = 10 * 2, I/Y = 18 / 2 = 9, PMT = 10000 * 12% / 2 = 600, FV = 10000

Then Press CPT and then PV

PV = 7261.43