Suggested Answers to Discussion Questions

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Gervais Thornton
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1 Suggested Answers to Discussion Questions 1. Arguments for Mutual Fund Ownership Greater level of diversification Professional management Establish an investment program with a limited amount of capital Arguments for Direct Investment in Stocks and Bonds Greater control over the types of investments made Closer fit to risk preferences of the individual investor Greater liquidity when buying and selling 3. (a) Growth versus growth and income funds: Growth funds have more risk due to greater investment for capital gain and therefore newer growing companies. (b) Equity-income versus high-grade corporate bond funds: Bonds are less risky since they are rated investment quality as compared to ordinary common stock dividends that are declared after interest income to bondholders is paid. (c) Balanced versus sector funds: Sector funds lack diversification and therefore may contain higher nonsystematic risk than a balanced more diversified fund. (d) Global versus aggressive growth funds: This depends on what type of global fund is used. Global funds may also have aggressive growth targets but have political risk not associated with domestic aggressive growth funds. (e) Intermediate-term bonds versus high-yield municipal bond funds: High-yield municipal bonds usually have less risk since they are associated with cities and municipalities. However, these governmental units can have high risk depending on their credit ratings. 5. You can buy open-ended funds at their net asset value because you are dealing directly with the fund. Closed-end funds (CEFs) have both a market value (stock price) and a net asset value, which tend to differ. CEFs sell at a premium to net asset value in the unlikely case that the CEF s stock price exceeds the net asset value. It is uncommon for investors to pay more for a set of shares than their cost would be if bought directly. Discounts exist if more individuals were attempting to sell CEF shares than buy them. Discounts also exist if there was poor past fund performance, a low annual payout and yield, poor manager name recognition, when very little cash is held by the CEF making it difficult to take advantages of new opportunities, and if several shares in the portfolio have appreciated significantly. Although the value of these shares exceeds the purchase price by $X, investors would only realize $X(1 tax rate) after taxes. Advantages of buying CEFs include the enhanced dividend yield arising from investing less than full price. Beyond this, open-end and closed-end mutual funds should be evaluated on the expected price performance of the underlying assets and the distribution of proceeds from current income and capital gains. Investors should typically avoid CEFs selling at a premium and new CEFs.

2 Solutions to Problems 1. (a) Return for the year (all changes on a per share basis): Change in price ($9.10 $8.50) $0.60 Dividends received 0.90 Capital gains distributions 0.75 Total return $2.25 Holding period return $ % $8.50 (b) When all dividends and capital gains distributions are reinvested into additional shares of the fund ($8.75/share): Dividends and capital gains per share: $0.90 $0.75 $1.65 Total received from 200 shares: $ $ Additional shares acquired: $330/$ shares Value of shares held at end of year: shares $9.10 $2,163 Price paid for 200 shares 200 shares $8.50 $1,700 at beginning of year Thus, the holding period return would be: 3. Five-year Compounded Rate of Return $2,163 $1,700 $463 H.P.R 27.24% $1,700 $1, (b) Dividends (c) Capital (d) Closing Net Cash Flow Using a financial calculator, the 5-year compounded rate of return is 21 percent. Three-year Compounded Rate of Return (b) Dividends (c) Capital (d) Closing Net Cash Flow

3 Using a financial calculator, the three-year compounded rate of return is 26 percent. Five-year Holding Period Return Total profit per share Total dividends Total distributed capital over the 5-year period gains Capital gain on share price ($0.95 $0.85 $0.85 $0.75 $0.60) ($1.05 $1.00 $1.00) ($15.73 $10.00) $4.00 $ $12.78 per share She would have more than doubled her money. 5. Holding period returns for 2011 and 2008: Ending $64.84 $44.10 Beginning Net increase/(decrease) $6.24 ($15.75) Return for the year: Dividends received $0.83 $0.72 Capital gains distribution Net increase in 6.24 (15.75) Total return $9.49 ($6.01) Holding period return 16.2% 10.0% (Total return/beginning ) Holding period returns for 2011 and 2008 with a 3 percent load: With a front-end load of 3 percent on, the purchase price Beginning Total return before any load $9.49 ($6.01) Less: Load at 3% (1.76) (1.80) Total return with load $7.73 ($7.81) Purchase price $60.36 $61.65 HPR 12.81% 12.7% Since the front-end load decreases the total return and increases the purchase price, the cumulative effect will be a decrease in the HPR.

4 Average annual rate of return over the two periods: Capital Capital Dividends Dividends 1999 $0.58 $ $0.46 $ Compounded Return for the five-year Period with Loading (b) Dividends (c) Capital (d) Closing Net Cash Flow Using a financial calculator, the five-year compounded rate of return is percent. Compounded Return for the Ten-year Period with Loading (b) Dividends (c) Capital (d) Closing Net Cash Flow

5 Using a financial calculator, the ten-year compounded rate of return is 21 percent. If the fund charges a 3 percent load on, the beginning price would be different and that would change the yield: Beginning price, 1998 $ $30.71 Beginning price, 2003 $ $57.00 Compounded Return for the Five-year Period with Loading (b) Dividends (c) Capital (d) Closing Net Cash Flow Using a financial calculator, the five-year compounded rate of return is 11.9 percent. Compounded Return for the Ten-year Period with Loading (a) Beginning (b) Dividends (c) Capital (d) Closing Net Cash Flow (a) -based HPR for the year: $0.40 $0.95 ($11.69 $10.40) $ %

6 (b) Market-based HPR for the year: (i) Beginning period market price (market price ) premium (or discount) (market price $10.40) 0.18 $10.40 $8.53 market price (ii) Ending period market price (iii) (market price $11.69) 0.04 $11.69 $12.16 market price ($0.40 $0.95) ($12.16 $8.53) HPR $8.53 HPR 58.38% The market discount applied to the purchase price and the market premium applied to the sale, therefore, the investor s return benefited. (c) Market-based HPR for the year: (i) Beginning period market price (ii) Ending period market price (iii) (market price $10.40) 0.18 $10.4 $12.27 market price (market price $11.69) 0.04 $11.69 $11.22 market price ($0.40 $0.95) ($11.22 $12.27) HPR $12.27 HPR 2.44% Because the premium applied to the purchase price and the discount applied to the ending period price, the HPR is significantly lower. Obviously, both the premium and discount values affect the investor s HPR. 9. This is a single cash flow IRR problem. Initial investment is $20,000. Three years later, the value is $25,201 ($1,100$22.91). $20,000FVIF X%, 3 periods $25,201 8% factor $20, $25,200. Calculator Solution: 3N, 20,000PV, 25,201 FV; CPT I/Y 8.01%

7 11. The problem assumes that Oh Yes Mutual Fund is a no-load fund. HPR [DivDist + Dist + ( )]/Beginning Ending HPR [$ $ ($26.00 $25.00)}/$25.00 $4.50/$25.00 = 0.18 or 18%. Beginning 13. HPR [DivDist Dist (Ending Initial Cost)]/Initial Cost HPR = [$0.86 $0 ($18.50 $13.39)]/$13.39 = [$0.86 $5.11]/$ % 15. The fund is trading at a discount because the market price is below the. (Share price )/ ($20.00 $22.5)/$22.50 $2.50/$ or 11.11%.

Chapter Organization. The future value (FV) is the cash value of. an investment at some time in the future.

Chapter Organization. The future value (FV) is the cash value of. an investment at some time in the future. Chapter 5 The Time Value of Money Chapter Organization 5.2. Present Value and Discounting The future value (FV) is the cash value of an investment at some time in the future Suppose you invest 100 in a