Question

A. Bravo Ltd needs to save $50 million to expand its production lines in six years’ time. There are three investment options to consider:

• ABC bank: monthly payments due at the end of each month. The interest rate is 3.5% p.a. compounding monthly.
• XYZ bank: annual payments due at the end of each year. The interest rate is 3.55% p.a.
• CDC bank: payments to be made at the end of year 2, 4 and 6. The interest rate is 3.56% p.a.

i. Calculate the payments for each of these options,

ii. Indicate which one you prefer, and why.

b.

i. Is ‘risk’ a bad thing? Define risk in terms of investment.

ii Explain the Australian dividend imputation credit system and how it applies in Australia. Include an analysis of how the receipt of franking credits will result in differing returns for Australian resident and international investors. Provide an example.

Answer 1

A. i) Future Value = $ 50,000,000

Time Period = 6 years

Annuity Payment formula:

PMT = (FV * i/m) / ([1 + i/m]^m*Y - 1 )

Using this formula, we get the following periodic payment values:

Bank	Annuity Payment	Time Period (years)	Interest Rate	Compounding frequency	Future Value
ABC	$              6,25,087	6	3.50%	12	$        5,00,00,000
XYZ	$           76,23,827	6	3.55%	1	$        5,00,00,000
CDC	$        1,55,34,369	6	3.56%	0.5	$        5,00,00,000

ii) By comparing the Annual Percentage Yield (APY) of the three investment options, we arrive at the following figures:

APY= (1 + i/m )m – 1

Bank	Annuity Payment	Time Period (years)	Interest Rate	Compounding frequency	Future Value	APY
ABC	$              6,25,087	6	3.50%	12	$        5,00,00,000	3.56%
XYZ	$           76,23,827	6	3.55%	1	$        5,00,00,000	3.55%
CDC	$        1,55,34,369	6	3.56%	0.5	$        5,00,00,000	3.50%

From the above table, it is clear that APY is the highest for the first investment option with monthly annuity payments of $ 625,087. Hence, ABC's investment option should be preferred.

B.

i) Risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment. Risk is associated with uncertainty. Stating simply, it is a measure of the level of uncertainty of achieving the returns as per the expectations of the investor. It is the extent of unexpected results to be realized.

Risk is an important component in assessment of the prospects of an investment. Most investors while making an investment consider less risk as favorable. The lesser the investment risk, more lucrative is the investment. However, the thumb rule is the higher the risk, the better the return.

A riskier investment can lead to both - higher losses as well as higher returns. Therefore, any investment opportunity should be evaluated in terms of not just the expected returns, but also the risk associated. Risk is generally quantified with historical Standard Deviation.

ii) The Australian dividend imputation credit system is a taxation regime that allows the whole or part of the tax paid by corporates to be imputed to the shareholders by means of a tax credit system to lower the income tax liability on dividend income received by shareholders.

Franking credits and the system of dividend imputation were introduced to stop company profits being taxed twice. Previously, a company would pay tax on its profit and then sometimes distribute this tax-paid profit to shareholders, who would pay tax again. Shareholders now get a tax credit for the tax the company has already paid in Australia.

Fully franked vs Partially franked vs Unfranked dividends

• If you get a fully franked or 100 percent franked dividend, it means the dividend comes with the tax paid, up to the company tax rate of 30 percent.
• If you get a 50 percent franked dividend, it means the dividend comes with 50 percent tax paid on the dividend at the company tax rate.
• If you get a zero percent franked dividend, it means the dividend comes with no tax credit attached. This happens when the company has not paid tax in Australia, usually because it has offset prior losses against profit or because most or all its revenue comes from overseas.

Scenarios for Resident Investors

In the case of a fully franked or 100 percent franked dividend:

• If you are on a marginal tax rate greater than 30 percent, you pay the difference between tax at your marginal rate minus a tax credit at 30 percent (company rate).
• If you are on a marginal tax rate equal to 30 percent, you pay no tax on the dividend.
• If you are on a marginal tax rate under 30 percent, you are reimbursed the tax credit that has not been used.

Case of Non-Resident Investors

Non-resident or International investors are taxed differently than resident shareholders. Non-resident shareholders are not entitled to claim a tax credit or refund of imputation credits, nor are they required to gross-up their taxable income. Unfranked dividends received by non-residents are subject to a withholding tax, which does not apply to franked dividends.