FNCE20003 mid-semester test – Solutions Question 1 [1 mark] Which of the following is a sure sign that credit and debt may be getting the better of an individual: A. Money is being borrowed to pay off credit card debt. B. A car is bought under a lease rather than for cash. C. Credit is being used to invest. D. A mortgage is being used to buy a home. If someone is borrowing to pay off credit card debt, it suggests that they are under severe financial strain. Question 2 [2 marks] Michelle wants to save some money. She can afford to put $20,000 into a savings program. At the end of five years, assuming all interest is re-invested, which product will provide the best return A. Product A which pays 4.5% interest compounded and paid annually. B. Product B which pays 4% interest compounded and paid annually. C. Product C which pays 4% interest compounded and paid monthly. D. Product D which will grow to $12,500 by the end of five years. $12,500 gives the best result (FV of A: $12,462; B: $12,167; $12,210) Question 3 [1 mark] The ___ ratio is a measure of the cash surplus generated from after-tax income. A. Savings. B. Solvency. C. Liquidity. D. Debt service. Question 4 [2 marks] A friend gives you $500, which is the total of the sum you lent her one year ago plus an extra amount to cover interest for the period. You work out that the interest is equivalent to 3.5% pa calculated quarterly over one year. How much was initially lent A. $482.88. B. $435.72. C. $437.31. D. Can’t tell from the information provided. PV = $500 / (1 + 0.035/4)4 = $482.88 Question 5 [3 marks] William and Kate are planning on selling their family home, which they own (valued at $500,000) and moving to a more expensive area where they will need to pay around $1,100,000 for their new residence. If they borrow the difference from their bank at 3% pa with a term of 25 years, how much (to the nearest $50) will their monthly repayments be A. $2,850. B. $4,300. C. $2,580. D. $2,000. Use the present value annuity factor formula to compute the monthly repayment: PVAF = !”””””!”#!$%.%'(!) *”!) )(%.%'(!) = 2,845.27. Rounded to nearest $50: $2,850. Question 6 [1 mark] You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an Annual Percentage Rate of 12% (or 1% per month), how many years would it take you eliminate your credit card debt if you made no additional new charges A. Less than 5 years. B. Between 5 and 10 years. C. Never. D. Can’t tell from the information provided. The minimum payment is the same as the monthly interest charge, so your payments will not reduce your balance and you will never pay back your debt. Question 7 [1 mark] You purchase an appliance that costs $1,000. To pay for this appliance, you are given the following two options: (a) Pay 12 monthly instalments of $100 each; (b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer A. Option (a). B. Option (b). C. They are the same. D. Can’t tell from the information provided. Assuming an opportunity cost greater than zero, the future value of the 12 monthly instalments of $100 will be higher than $1,200. Therefore, option b is better. Question 8 [3 marks] It’s September 2021 and you are planning to go to Europe in July 2022, to recover from the COVID lockdowns. You expect that the trip will cost about $5,000 in total. You want to start putting money aside to safe up for the trip. Therefore, you decide to get a high-interest savings account and make weekly contributions (over a period of 40 weeks) to that account so that you reach your $5,000 savings goal by the time your trip begins. The interest rate on your savings account is 0.2% per annum. How much money will have to put in your savings account each week to reach your savings goal on time (Assume weekly compounding for simplicity.) A. 124.91 B. 125 C. 125.10 D. 124.20 Future value of annuity: $5,000 Present value annuity formula: = ,(1 + )# 1 3 Therefore, we have = ,(1 + )# 1 3$% = 5000 671 + 0.00252 8&” 10.00252 9 $% = 124.91 Question 9 [1 mark] Which of the following is NOT an advantage of investing in property A. Stability/security. B. Capital gains tax exemption for the main residence. C. Illiquidity of the investment. D. Possibility of substantial capital growth. Question 10 [1 mark] For which one of your clients is a strategy of “borrowing to invest” likely to be an appropriate strategy A. A client who cannot take on the risk of investing in high growth opportunities. B. A client with a highly fluctuating income. C. A client who has a short-term investment horizon. D. A client who has a sizeable amount of equity and a high tolerance for risk. Borrowing to invest is a highly risky investment strategy and therefore should only be pursued by investors with high risk tolerance and a sufficient equity buffer. Question 11 [1 mark] Negative gearing is A. Where the interest payments are approximately the same level as income earned from an investment B. Where income earned from the investment is significantly less than interest paid on the borrowing C. Where income earned from the investment is higher than interest paid on the borrowing D. The least risky gearing to use Question 12 [1 mark] Which of the below would NOT be considered a key function performed by the financial system A. Provision of payments system for the exchange of goods and services. B. Provision of a way to manage uncertainty and risk. C. Provision of price information that helps coordinate decentralised decision-making in various sectors of the economy. D. Ensuring equality in society. Option D is not one of the key functions performed by the financial system (cf. lecture slides and references therein). Question 13 [1 mark]: Reported financial wellbeing typically refers to: A. Outcomes as people perceive and experience them. B. Outcomes as they can be objectively and independently observed. C. Outcomes reported to the government. D. A person’s total net worth. See lecture slides and references therein. Question 14 [1 mark] A person is presented with a choice between $100 to be received today and $120 to be received in 2 months from now. The person chooses $100 to be received today. You know that the person discounts rewards exponentially. The person is given another choice, between $100 to be received in a year from now and $120 to be received in a year and 2 months from now. What would you expect the person to choose, based on the information provided A. The person would be expected to choose $100 to be received in a year from now. B. The person would be expected to choose $120 to be received in a year and 2 months from now. C. Can’t tell based on the information provided. With exponential discounting, only the relative difference in delays between payoffs matters for their relative values, not the absolute value of the delay (ceteris paribus). Question 15 [2 marks] Leanne can get a personal loan for the $10,000 at 8.5% interest (p.a., monthly compounding) for four years to buy a car. How much interest will she pay on the loan over the four years (rounded to the nearest dollar) A. $1,832 B. $1,945 C. $2,000 D. $2,500 Workings: = 10000 ,%$’%(%.%,(!) )”!) .%.%,(!) 3$% = 246.48; the sum of all payments made over the four years is 48 246.48 = 11831.19; therefore, the amount of interest paid is $1,832 (rounded to the nearest dollar). Question 16 [1 mark] Rational preferences are A. Transitive but not necessarily complete. B. Complete but not necessarily transitive. C. Both transitive and complete. D. Neither transitive nor complete. See definition in lecture slides. Question 17 [1 mark] Which of the following preference relations is not transitive A. a is preferred to b, b is preferred to c, a is preferred to c. B. z is preferred to y, z is preferred to x, y is preferred to x. C. d is preferred to f, d is preferred to e, e is preferred to f. D. l is preferred to m, m is preferred to n, n is preferred to l. Working: In case of D, we have . This means that preferences are cyclic and hence not transitive. Question 18 [1 mark] Which of the following are disadvantages of a barter system A. Lack of common measure of value. B. Requires ‘double coincidence of wants’. C. Cashless. D. All of the above. Question 19 [1 mark] Which of the following biases does the “Save more tomorrow” nudge, developed by Benartzi and Thaler, try to overcome A. Present bias. B. Optimism bias. C. Framing effect. D. Winner’s curse. See lecture slides and references therein. The nudge was specifically designed to overcome present bias. Question 20 [1 mark] Steve pays 6% interest on a mortgage of $300,000. The repayments are $1,800 per month. His gross income is $82,000 pa plus super of $7,400. His taxation and Medicare liability totals $20,000 pa. Calculate Steve’s debt service ratio (to the nearest percentage point). A. 22% B. 24% C. 26% D. 35% Workings: In the lecture slides, we defined the debt service ratio in terms of pre-tax income ($21,600 / $82,000 = 26%). However, the ratio is also often defined in terms of disposable income ($21,600 / $62,000 = 35%). In the actual test, we awarded 1 mark to both option C and option D (see comment in workings above). Question 21 [1 mark] According CBA-MI financial wellbeing model, a household’s material resources affect a person’s financial wellbeing A. Directly. B. Indirectly. C. Both directly and indirectly. D. Not at all. See lecture slides and references therein. Question 22 [1 mark] Choice overload refers to the finding according to which A. providing individuals with more options can be detrimental to choice. B. providing individuals with more options is beneficial for choice. C. providing individuals with less options is beneficial for choice. See lecture slides and references therein. Question 23 [1 mark] In financial services, the interests of a client and an advisers can be misaligned. Such a situation is typically referred to as A. Conflict of interest. B. Information asymmetry. C. Win-win situation. D. Value alignment. See lecture slides. Question 24 [1 mark] What is NOT an advantage of home ownership A. Security. B. Form of disciplined saving. C. Capital gains tax exemption. D. Interest rate risk. If a home is financed with a loan, interest rate risk can be substantial and constitute a material financial risk to the homeowner (and thus have adverse consequences on financial wellbeing). Question 25 [2 marks] Sarah is sick of lockdown and indulges herself in online shopping spree. She spends $3,000 on her credit card. She is cash-strapped and can only afford to make the monthly minimum repayment (maximum of $25 and 2.5% of balance outstanding). The interest rate on the credit card is 20% pa (compounded monthly). Of her first monthly minimum repayment, how much goes towards paying down her balance A. $25 B. $50 C. $75 D. $0 Workings: Sarah has a balance of $3,000. The minimum repayment is $75 (2.5% of $3,000, which is greater than $25). If she only makes the minimum payment, she has to pay interest on her balance for the entire month. Thus, interest due is $50 (3000 0.2 12B ), which means she pays off $25 of her balance. Question 26 [1 mark] Suppose an individual discounts exponentially. When enrolling this individual into Benartzi’s and Thaler’s “Save more tomorrow” program, the individual would be expected to save A. more. B. the same. C. less. In case of exponential discounting, we would expect the program to make no difference to savings behaviour. Question 27 [3 marks] Suppose a person discounts future rewards hyperbolically according to the function PV(x) = x / (1 + k*t), where PV denotes the present value, x denotes the reward to be received, k is the discount rate per period of time and t is the delay until the reward is received. You offer this person the following deal: You ask the person today to promise to pay you $10 in 100 days in exchange for $14 in 101 days. After 100 days, you offer the person $10 on that day (100 days from now) in exchange for $15 the next day (101 days from now). For what range of discount rates (per day) will this deal make you money A. Greater than 0.5. B. Less than 0.5. C. I can never make money. D. Greater than 0. The person’s discount rate has to be greater than 0.5. In this case the person would choose $15 tomorrow over $10 today but also $14 in 101 days over $10 in 100 days.
