Question

Q.4. a) Examine why the economic analysis is important for any investment decision?

b) Mr. Ahmad’s bond portfolio manager advises him to buy a 7 year, OMR 5000 face value bond that gives 7 percent annual coupon payments. The appropriate discount rate is 8%.The bond is currently selling at OMR.4700. Should Ahmad adhere to the manager’s advice?

Answer 1

4a. Any Investment decision requires analysis of two major component ir, Return and Risk.

Economic analysis is required to assess the return and risk of any investment decision.

Economic analysis takes into account cost of capital, risk and the discounted cash flows and returns . It compares the return and risk with the cost of capital to arrive at a decision.

Without economic analysis we may choose a project which will not give adequate return . Or we may select a wrong project out of the available alternatives.

Economic analysis helps in taking decision based on objective criteria instead of subjective feeling of the owner.

b),

	Annual Coupon Payment	350	(5000*0.07)
	Appropriate discount rate	8%
	Fair Value of the bond=Sum of Present values of future cash flows
	Present value(PV) of cash flow=(Cash flow)/((1+i)^N)
	i=discount rate=8%=0.08
	N=Year of cash flow
	Year wise cash flows and PV of Cash flows are given below:
	N	A	B=A/(1.08^N)
	Year	Cash flow	PV of cashflow
	1	350	324.0740741
	2	350	300.0685871
	3	350	277.8412844
	4	350	257.2604485
	5	350	238.204119
	6	350	220.5593694
(5000+350)	7	5350	3121.673615
		SUM	4739.681497

Fair Value of the bond=4739.68

Current selling price=4700

It is available at less than fair value

Ahmed should adhere to the manager’s advice