Chapter 1: Goals and Governance of the Firm BASIC 1. Read the following passage: “Companies usually buy (a) assets. These include both tangible assets such as (b) and intangible assets such as (c). To pay for these assets, they sell (d ) assets such as (e). The decision about which assets to buy is usually termed the ( f f ) or (g) decision. The decision about how to raise the money is usually termed the (h) decision.” Now fit each of the following terms into the most appropriate space: inancing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names. 2. Which of the following are real assets, and which are financial?
a. A share of stock. b. A personal IOU. c. A trademark. d. A factory. e. Undeveloped land. f. The balance in the firm's checking account. g. An experienced and hardworking sales force. h. A corporate bond. 3. Vocabulary test. Explain the differences between: a. Real and financial assets. b. Capital budgeting and financing fin ancing decisions. c. Closely held and public corporations. d. Limited and unlimited liability. 4. Which of the following statements always apply to corporations? a. Unlimited liability. b. Limited life. c. Ownership can be transferred without affecting operations. d. Managers can be fired with no effect on ownership. p. Which of the following statements more accurately describe the treasurer than the 17 controller? 5. a. Responsible for investing the firm's spare cash. b. Responsible for arranging arrangin g any issue of common stock. c. Responsible for the company's tax affairs.
INTERMEDIATE 6. In most large corporations, ownership and management are separated. What are the main implications of this separation?
7. F&H Corp. continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H's CFO:
We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8% on investment. That's a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4% rate of return. a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities? Why or why not? b. Is F&H's opportunity cost of capital capit al 4%? How in principle should shoul d the CFO determine the cost of capital? 8. We can imagine the financial manager doing several things on behalf of the firm's stockholders. For example, the manager might: a. Make shareholders as wealthy as possible by investing in real assets. b. Modify the firm's investment plan pl an to help shareholders achieve ach ieve a particular time pattern of consumption. c. Choose high- or low-risk assets to match shareholders' risk preferences. d. Help balance shareholders' checkbooks.
9.
10. 11. 12.
But in well-functioning capital markets, shareholders will vote for only one of these goals. Which one? Why? Ms. Espinoza is retired and depends on her investments for her income. Mr. Liu is a young executive who wants to save for the future. Both are stockholders in Scaled Composites, LLC, which is building SpaceShipOne to take commercial passengers into space. This investment's payoff is many years away. Assume it has a positive NPV for Mr. Liu. Explain why this investment also makes sense for Ms. Espinoza. If a financial institution is caught up in a financial scandal, would you expect its value to fall by more or less than the amount of any fines and settlement payments? Explain. Why might one expect managers to act in shareholders' interests? Give some reasons. Many firms have devised defenses that make it more difficult or costly for other firms to take them over. How might such defenses affect the firm's agency problems? Are managers of firms with formidable takeover defenses more or less likely to act in the shareholders' interests rather than their own? What would you expect to happen to the share price when management proposes to institute such defenses?
7. F&H Corp. continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H's CFO:
We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8% on investment. That's a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4% rate of return. a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities? Why or why not? b. Is F&H's opportunity cost of capital capit al 4%? How in principle should shoul d the CFO determine the cost of capital? 8. We can imagine the financial manager doing several things on behalf of the firm's stockholders. For example, the manager might: a. Make shareholders as wealthy as possible by investing in real assets. b. Modify the firm's investment plan pl an to help shareholders achieve ach ieve a particular time pattern of consumption. c. Choose high- or low-risk assets to match shareholders' risk preferences. d. Help balance shareholders' checkbooks.
9.
10. 11. 12.
But in well-functioning capital markets, shareholders will vote for only one of these goals. Which one? Why? Ms. Espinoza is retired and depends on her investments for her income. Mr. Liu is a young executive who wants to save for the future. Both are stockholders in Scaled Composites, LLC, which is building SpaceShipOne to take commercial passengers into space. This investment's payoff is many years away. Assume it has a positive NPV for Mr. Liu. Explain why this investment also makes sense for Ms. Espinoza. If a financial institution is caught up in a financial scandal, would you expect its value to fall by more or less than the amount of any fines and settlement payments? Explain. Why might one expect managers to act in shareholders' interests? Give some reasons. Many firms have devised defenses that make it more difficult or costly for other firms to take them over. How might such defenses affect the firm's agency problems? Are managers of firms with formidable takeover defenses more or less likely to act in the shareholders' interests rather than their own? What would you expect to happen to the share price when management proposes to institute such defenses?
Chapter 2: How to Calculate Present Values BASIC 1. At an interest rate of 12%, the six-year discount factor is .507. How many dollars is $.507 worth in six years if invested at 12%? 2. If the PV of $139 is $125, what is the discount factor? 3. If the cost of capital is 9%, what is the PV of $374 paid in year 9? 4. A project produces a cash flow of $432 in year 1, $137 in year 2, and $797 in year 3. If the cost of capital is 15%, what is the project's PV? 5. If you invest $100 at an interest rate of 15%, how much will you have at the end of eight years? 6. An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9%, what is the NPV? 7. A common stock will pay a cash dividend of $4 next year. After that, the dividends are expected to increase indefinitely at 4% per year. If the discount rate is 14%, what is the PV of the stream of dividend payments? 8. The interest rate is 10%.
a. What is the PV of an asset that pays $1 a year in perpetuity? b. The value of an asset that appreciates app reciates at 10% per annum annu m approximately doubles in seven years. What is the approximate PV of an asset that pays $1 a year in perpetuity beginning in year 8? c. What is the approximate PV of an asset that pays $1 a year for each of the next seven years? d. A piece of land produces an income that grows by 5% per annum. If the first year's year's income is $10,000, what is the value of the land? 9. a. The cost of a new automobile is $10,000. If the interest rate is 5%, how much would you have to set aside now to provide this sum in five years? b. You have to pay $12,000 a year in school fees at the end of each e ach of the next six years. If the interest rate is 8%, how much do you need to set aside today to cover these bills? c. You have invested $60,476 at 8%. After paying the above school fees, how much would remain at the end of the six years? 10. The continuously compounded interest rate is 12%.
a. You invest $1,000 at this rate. What is the investment worth after five years? b. What is the PV of $5 million to be received receive d in eight years? c. What is the PV of a continuous stream of cash flows, amounting to $2,000 per year, starting immediately and continuing for 15 years? 11. You are quoted an interest rate of 6% on an investment of $10 million. What is the value of your investment after four years if interest is compounded: a. Annually? b. Monthly? or c. Continuously?
INTERMEDIATE 12. What is the PV of $100 received in: a. Year 10 (at a discount rate of 1%). b. Year 10 (at a discount rate rat e of 13%). c. Year 15 (at a discount rate of 25%). d. Each of years years 1 through 3 (at a discount rate of 12%). 13. a. If the one-year discount factor is .905, what is the one-year interest rate? b. If the two-year interest rate rat e is 10.5%, what is the two-year discount discou nt factor? c. Given these one- and two-year discount factors, calculate the two-year annuity factor. d. If the PV of $10 a year for three years is $24.65, what is the three-year annuity factor? e. From your answers to (c) and (d), calculate the three-year discount factor. 14. A factory costs $800,000. You reckon that it will produce an inflow after operating costs of $170,000 a year for 10 years. If the opportunity cost of capital is 14%, what is the net present value of the factory? facto ry? What will the factory be worth at the end of five years? 15. A machine costs $380,000 and is expected to produce the following cash flows: Visit us at www.mhhe.com/bma
If the cost of capital is 12%, what is the machine's NPV? 16. Mike Polanski is 30 years of age and his salary next year will be $40,000. Mike forecasts that his salary will increase at a steady rate of 5% per annum until his retirement at age 60. a. If the discount rate is 8%, what is the PV of these future salary payments? b. If Mike saves 5% of his salary salar y each year and invests these thes e savings at an interest rate of 8%, how much will he have saved by age 60? c. If Mike plans to spend these savings in even amounts over the subsequent 20 years, how much can he spend each year? 17. A factory costs $400,000. It will produce an inflow after operating costs of $100,000 in year 1, $200,000 in year 2, and $300,000 in year 3. The opportunity cost of capital is 12%. Calculate the NPV. 18. Halcyon Lines is considering the purchase of a new bulk carrier for $8 million. The forecasted revenues are $5 million Visit us at a year and operating costs are $4 million. A major refit costing www.mhhe.com/bma $2 million will be required after both the fifth and tenth years. After 15 years, the ship is expected to be sold for scrap at $1.5 million. If the discount rate is 8%, what is the ship's NPV? 19. As winner of a breakfast cereal competition, you can choose one of the following prizes: a. $100,000 now. b. $180,000 at the end of five fi ve years. c. $11,400 a year forever. d. $19,000 for each of 10 years.
e. $6,500 next year and increasing thereafter by 5% a year forever.
20.
21.
22.
23.
24.
25.
If the interest rate is 12%, which is the most valuable prize? Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He wishes to invest $20,000 in an annuity that will make a level payment at the end of each year until his death. If the interest rate is 8%, what income can Mr. Basset expect to receive each year? David and Helen Zhang are saving to buy a boat at the end of five years. If the boat costs $20,000 and they can earn 10% a year on their savings, how much do they need to put aside at the end of years 1 through 5? Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and then $300 a month for the next 30 months. Turtle Motors next door does not offer free credit but will give you $1,000 off the list price. If the rate of interest is 10% a year, (about .83% a month) which company is offering the better deal? Recalculate the NPV of the office building venture in Section 2.1 at interest rates of 5, 10, and 15%. Plot the points on a graph with NPV on the vertical axis and the discount rates on the horizontal axis. At what discount rate (approximately) would the project have zero NPV? Check your answer. If the interest rate is 7%, what is the value of the following three investments? a. An investment that offers you $100 a year in perpetuity with the payment at the end of each year. b. A similar investment with the payment at the beginning of each year. c. A similar investment with the payment spread evenly over each year. Refer back to Section 2.2. If the rate of interest is 8% rather than 10%, how much would you need to set aside to provide each of the following? a. $1 billion at the end of each year in perpetuity. b. A perpetuity that pays $1 billion at the end of the first year and that grows at 4% a year. c. $1 billion at the end of each year for 20 years. d. $1 billion a year spread evenly over 20 years.
26. How much will you have at the end of 20 years if you invest $100 today at 15% annually compounded? How much will you have if you invest at 15% continuously compounded? 27. You have just read an advertisement stating, “Pay us $100 a year for 10 years and we will pay you $100 a year thereafter in perpetuity.” If this is a fair deal, what is the rate of interest? 28. Which would you prefer? a. An investment paying interest of 12% compounded annually. b. An investment paying interest of 11.7% compounded semiannually. c. An investment paying 11.5% compounded continuously. Work out the value of each of these investments after 1, 5, and 20 years. 29. A leasing contract calls for an immediate payment of $100,000 and nine subsequent $100,000 semiannual payments at six-month intervals. What is the PV of these payments if the annual discount rate is 8%?
30. Several years ago The Wall Street Journal reported that the winner of the Massachusetts State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. The prize was $9,420,713, to be paid in 19 equal annual installments. (There were 20 installments, but the winner had already received the first payment.) The bankruptcy court judge ruled that the prize should be sold off to the highest bidder and the proceeds used to pay off the creditors.
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a. If the interest rate was 8%, how much would you have been prepared to bid for the prize? b. Enhance Reinsurance Company was reported to have offered $4.2 million. Use Excel to find the return that the company was looking for. 31. A mortgage requires you to pay $70,000 at the end of each of the next eight years. The interest rate is 8%. a. What is the present value of these payments? b. Calculate for each year the loan balance that remains outstanding, the interest payment on the loan, and the reduction in the loan balance. 32. You estimate that by the time you retire in 35 years, you will have accumulated savings of $2 million. If the interest rate is 8% and you live 15 years after retirement, what annual level of expenditure will those savings support? Unfortunately, inflation will eat into the value of your retirement income. Assume a 4% inflation rate and work out a spending program for your retirement that will allow you to increase your expenditure in line with inflation. 33. The annually compounded discount rate is 5.5%. You are asked to calculate the present value of a 12-year annuity with payments of $50,000 per year. Calculate PV for each of the following cases. a. The annuity payments arrive at one-year intervals. The first payment arrives one year from now. b. The first payment arrives in six months. Following payments arrive at one-year intervals (i.e., at 18 months, 30 months, etc.). 34. Dear Financial Adviser,
My spouse and I are each 62 and hope to retire in three years. After retirement we will receive $7,500 per month after taxes from our employers' pension plans and $1,500 per month after taxes from Social Security. Unfortunately our monthly living expenses are $15,000. Our social obligations preclude further economies. We have $1,000,000 invested in a high-grade, tax-free municipal-bond mutual fund. The return on the fund is 3.5% per year. We plan to make annual withdrawals from the mutual fund to cover the difference between our pension and Social Security income and our living expenses. How many years before we run out of money? p. 43 Sincerely,
Luxury Challenged Marblehead, MA You can assume that the withdrawals (one per year) will sit in a checking account (no interest). The couple will use the account to cover the monthly shortfalls. 35. Your firm's geologists have discovered a small oil field in New York's Westchester County. The field is forecasted to produce a cash flow of C 1 = $2 million in the first year. You estimate that you could earn an expected return of r = 12% from investing in stocks with a similar degree of risk to your oil field. Therefore, 12% is the opportunity cost of capital. What is the present value? The answer, of course, depends on what happens to the cash flows after the first year. Calculate present value for the following cases: a. The cash flows are forecasted to continue forever, with no expected growth or decline. b. The cash flows are forecasted to continue for 20 years only, with no expected growth or decline during that period. c. The cash flows are forecasted to continue forever, increasing by 3% per year because of inflation. d. The cash flows are forecasted to continue for 20 years only, increasing by 3% per year because of inflation.
CHALLENGE 36. Here are two useful rules of thumb. The “Rule of 72” says that with discrete compounding the time it takes for an investment to double in value is roughly 72/interest rate (in percent). The “Rule of 69” says that with continuous compounding the time that it takes to double is exactly 69.3/interest rate (in percent).
a. If the annually compounded interest rate is 12%, use the Rule of 72 to calculate roughly how long it takes before your money doubles. Now work it out exactly. b. Can you prove the Rule of 69? 37. Use Excel to construct your own set of annuity tables showing the annuity factor for a selection of interest rates and years. 38. You own an oil pipeline that will generate a $2 million cash return over the coming year. The pipeline's operating costs are negligible, and it is expected to last for a very long time. Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline by 4% per year. The discount rate is 10%.
a. What is the PV of the pipeline’s cash flows if its cash flows are assumed to last forever? b. What is the PV of the cash flows if the pipeline is scrapped after 20 years?
Chapter 3: Valuing Bonds BASIC 1. A 10-year bond is issued with a face value of $1,000, paying interest of $60 a year. If market yields increase shortly after the T-bond is issued, what happens to the bond's
a. Coupon rate? b. Price? c. Yield to maturity? 2. The following statements are true. Explain why. a. If a bond's coupon rate is higher than its yield to maturity, then the bond will sell for more than face value. b. If a bond's coupon rate is lower than its yield to maturity, then the bond's price will increase over its remaining maturity.
3. In February 2009 Treasury 6s of 2026 offered a semiannually compounded yield of 3.5965%. Recognizing that coupons are paid semiannually, calculate the bond's price.
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4. Here are the prices of three bonds with 10-year maturities:
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If coupons are paid annually, which bond offered the highest yield to maturity? Which had the lowest? Which bonds had the longest and shortest durations? 5. Construct some simple examples to illustrate your answers to the following: a. If interest rates rise, do bond prices rise or fall? b. If the bond yield is greater than the coupon, is the price of the bond greater or less than 100? c. If the price of a bond exceeds 100, is the yield greater or less than the coupon? d. Do high-coupon bonds sell at higher or lower prices than low-coupon bonds?
e. If interest rates change, does the price of high-coupon bonds change proportionately more than that of low-coupon bonds? 6. Which comes first in the market for U.S. Treasury bonds: a. Spot interest rates or yields to maturity? b. Bond prices or yields to maturity? 7. Look again at Table 3.4. Suppose that spot interest rates all change to 4% —a “flat” term structure of interest rates.
Visit us a. What is the new yield to maturity for each bond at www.mhhe.com/bma in the table? b. Recalculate the price of bond A.
8. a. What is the formula for the value of a two-year, 5% bond in terms of spot rates? b. What is the formula for its value in terms of yield to maturity? c. If the two-year spot rate is higher than the one-year rate, is the yield to maturity greater or less than the two-year spot rate? 9. The following table shows the prices of a sample of U.S. Treasury strips in August 2009. Each strip makes a single payment of $1,000 at maturity.
a. Calculate the annually compounded, spot interest rate for each year. b. Is the term structure upward- or downward-sloping, or flat? c. Would you expect the yield on a coupon bond maturing in August 2013 to be higher or lower than the yield on the 2013 strip?
10. a. An 8%, five-year bond yields 6%. If the yield remains unchanged, what will be its price one year hence? Assume annual coupon payments. b. What is the total return to an investor who held the bond over this year? c. What can you deduce about the relationship between the bond return over a particular period and the yields to maturity at the start and end of that period?
11. True or false? Explain.
a. b. c. d.
Longer-maturity bonds necessarily have longer durations. The longer a bond's duration, the lower its volatility. Other things equal, the lower the bond coupon, the higher its volatility. If interest rates rise, bond durations rise also.
12. Calculate the durations and volatilities of securities A, B, and C. Their cash flows are shown below. The interest rate is 8%.
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13. The one-year spot interest rate is r 1 = 5% and the two-year rate is r 2 = 6%. If the expectations theory is correct, what is the expected one-year interest rate in one year's time? 14. The two-year interest rate is 10% and the expected annual inflation rate is 5%.
a. What is the expected real interest rate? b. If the expected rate of inflation suddenly rises to 7%, what does Fisher's theory say about how the real interest rate will change? What about the nominal rate?
INTERMEDIATE 15. A 10-year German government bond (bund) has a face value of €100 and a coupon rate of 5% paid annually. Assume that the interest rate (in euros) is equal to 6% per year. What is the bond's PV? 16. A 10-year U.S. Treasury bond with a face value of $10,000 pays a coupon of 5.5% (2.75% of face value every six months). The semiannually compounded interest rate is 5.2% (a six-month discount rate of 5.2/2 = 2.6%).
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a. What is the present value of the bond? b. Generate a graph or table showing how the bond's present value changes for semiannually compounded interest rates between 1% and 15%. 17. A six-year government bond makes annual coupon payments of 5% and offers a yield of 3% annually compounded. Suppose that one year later the bond still yields 3%. What return has the bondholder earned over the 12-month period? Visit us Now suppose that the bond yields 2% at the end of the year. at www.mhhe.com/bma What return would the bondholder earn in this case? 18. A 6% six-year bond yields 12% and a 10% six-year bond yields 8%. Calculate the six-year spot rate. Assume annual coupon payments. ( Hint : What would be your cash flows if Visit us you bought 1.2 10% bonds?) at www.mhhe.com/bma 19. Is the yield on high-coupon bonds more likely to be higher than that on low-coupon bonds when the term structure is upward-sloping or when it is downward-sloping? Explain.
Visit us at www.mhhe.com/bma 20. You have estimated spot rates as follows: r 1 = 5.00%, r 2 = 5.40%, r 3 = 5.70%, r 4 = 5.90%, r 5 = 6.00%.
a. What are the discount factors for each date (that is, the Visit us at www.mhhe.com/bma present value of $1 paid in year t )? b. Calculate the PV of the following bonds assuming annual coupons: (i) 5%, two-year bond; (ii) 5%, fiveyear bond; and (iii) 10%, five-year bond. c. Explain intuitively why the yield to maturity on the 10% bond is less than that on the 5% bond. d. What should be the yield to maturity on a five-year zero-coupon bond? e. Show that the correct yield to maturity on a five-year annuity is 5.75%. f. Explain intuitively why the yield on the five-year bonds described in part (c) must lie between the yield on a five-year zero-coupon bond and a five-year annuity. 21. Calculate durations and modified durations for the 4% coupon bond and the strip in Table 3.1. The answers for the strip will be easy. For the 4% bond, you can follow the procedure set out in Table 3.3 for the 11¼% coupon bonds. Visit us Confirm that modified duration predicts the impact of a 1% at www.mhhe.com/bma change in interest rates on the bond prices.
22. Find the “live” spreadsheet for Table 3.3 on this book's Web site, www.mhhe.com/bma. Show how duration and volatility change if (a) the bond's coupon is 8% of face value Visit us and (b) the bond's yield is 6%. Explain your finding. at www.mhhe.com/bma 23. The formula for the duration of a perpetual bond that makes an equal payment each year in perpetuity is (1 + yield)/yield. If each bond yields 5%, which has the longer duration — a perpetual bond or a 15-year zero-coupon bond? What if the yield is 10%? 24. Look up prices of 10 U.S. Treasury bonds with different coupons and different maturities. Calculate how their prices would change if their yields to maturity increased by 1 percentage point. Are long- or short-term bonds most affected by the change in yields? Are high- or low-coupon bonds most affected? 25. Look again at Table 3.4. Suppose the spot interest rates change to the following downward-sloping term structure: r 1
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= 4.6%, r 2 = 4.4%, r 3 = 4.2%, and r 4 = 4.0%. Recalculate discount factors, bond prices, and yields to maturity for each Visit us of the bonds listed in the table. at www.mhhe.com/bma 26. Look at the spot interest rates shown in Problem 25. Suppose that someone told you that the five-year spot interest rate was 2.5%. Why would you not believe him? How could you make money if he was right? What is the minimum sensible value for the five-year spot rate? 27. Look again at the spot interest rates shown in Problem 25. What can you deduce about the one-year spot interest rate in three years if … a. The expectations theory of term structure is right? b. Investing in long-term bonds carries additional risks? 28. Suppose that you buy a two-year 8% bond at its face value. a. What will be your nominal return over the two years if inflation is 3% in the first year and 5% in the second? What will be your real return? b. Now suppose that the bond is a TIPS. What will be your real and nominal returns? 29. A bond's credit rating provides a guide to its price. As we write this in Spring 2009, Aaa bonds yield 5.41% and Baa bonds yield 8.47%. If some bad news causes a 10% fiveyear bond to be unexpectedly downrated from Aaa to Baa, what would be the effect on the bond price? (Assume annual coupons.)
CHALLENGE 30. Write a spreadsheet program to construct a series of bond tables that show the present value of a bond given the coupon rate, maturity, and yield to maturity. Assume that coupon payments are semiannual and yields are compounded semiannually. 31. Find the arbitrage opportunity (opportunities?). Assume for simplicity that coupons are paid annually. In each case the face value of the bond is $1,000.
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32. The duration of a bond that makes an equal payment each year in perpetuity is (1 + yield)/yield. Prove it. 33. What is the duration of a common stock whose dividends are expected to grow at a constant rate in perpetuity?
34.
a. What spot and forward rates are embedded in the Visit us following Treasury bonds? The price of one-year strips is at www.mhhe.com/bma 93.46%. Assume for simplicity that bonds make only annual payments. ( Hint : Can you devise a mixture of long and short positions in these bonds that gives a cash payoff only in year 2? In year 3?)
b. A three-year bond with a 4% coupon is selling at 95.00%. Is there a profit opportunity here? If so, how would you take advantage of it? 35. Look one more time at Table 3.4. a. Suppose you knew the bond prices but not the spot interest rates. Explain how you would calculate the spot rates. ( Hint : You have four unknown spot rates, so you need four equations.) b. Suppose that you could buy bond C in large quantities at $1,040 rather than at its equilibrium price of $1,058.76. Show how you could make a zillion dollars without taking on any risk.
SOLUTIONS
CHAPTER 1 Introduction to Corporate Finance
Answers to Problem Sets 1.
a.
real
b.
executive airplanes
c.
brand names
d.
financial
e.
bonds
*f.
investment or capital budgeting
*g.
capital budgeting or investment
h.
financing
*Note that f and g are interchangeable in the question. Est time: 01-05
2.
A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets. Real assets are identifiable items with intrinsic value. The others in the list are financial assets, that is, these assets derive value because of a contractual claim.
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3.
a.
Financial assets, such as stocks or bank loans, are claims held by investors. Corporations sell financial assets to raise the cash to invest in real assets such as plant and equipment. Some real assets are intangible.
b.
Capital budgeting means investment in real assets. Financing means raising the cash for this investment.
c.
The shares of public corporations are traded on stock exchanges and can be purchased by a wide range of investors. The shares of closely held corporations are not publicly traded and are held by a small group of private investors.
d.
Unlimited liability: Investors are responsible for all the firm’s debts. A sole proprietor has unlimited liability. Investors in corporations have limited liability. They can lose their investment, but no more.
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4.
Items c and d apply to corporations. Because corporations have perpetual life, ownership can be transferred without affecting operations, and managers can be fired with no effect on ownership. Other forms of business may have unlimited liability and limited life.
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5. Separation of ownership and management typically leads to agency problems, where managers prefer to consume private perks or make other decisions for their private benefit—rather than maximize shareholder wealth. Est time: 01-05
6.
a. on
Assuming that the encabulator market is risky, an 8% expected return the F&H encabulator investments may be inferior to a 4% return on
U.S. government securities. b.
Unless their financial assets are as safe as U.S. government securities, their cost of capital would be higher. The CFO could consider what the expected return is on assets with similar risk.
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7.
Shareholders will only vote for: (a) maximize shareholder wealth. Shareholders can modify their pattern of consumption through borrowing and lending, match risk preferences, and hopefully balance their own checkbooks (or hire a qualified professional to help them with these tasks).
Est time: 01-05
8.
If the investment increases the firm’s wealth, it will increase the value of the firm’s shares. Ms. Espinoza could then sell some or all of these more valuable shares in order to provide for her retirement income.
Est time: 06-10
9.
As the Goldman Sachs example illustrates, the firm’s value typically falls by significantly more than the amount of any fines and settlements. The firm’s reputation suffers in a financial scandal, and this can have a much larger effect than the fines levied. Investors may also wonder whether all of the misdeeds have been contained.
Est time: 01-05
10.
Managers would act in shareholders’ interests because they have a legal duty to act in their interests. Managers may also receive compensation, either bonuses or stock and option payouts whose value is tied (roughly) to firm performance. Managers may fear personal reputational damage that would result from not acting in shareholders’ interests. And managers can be fired by the board of directors, which in turn is elected by shareholders. If managers still fail to act in shareholders’ interests, shareholders may sell their shares, lowering the stock price and potentially creating the possibility of a takeover, which can again lead to changes in the board of directors and senior management.
Est time: 01-05
11.
Managers that are insulated from takeovers may be more prone to agency problems and therefore more likely to act in their own interests rather than in shareholders’. If a firm instituted a new takeover defense, we might expect to see the value of its shares decline as agency problems increase and less shareholder value maximization occurs. The counterargument is that defensive measures allow managers to negotiate for a higher purchase price in the face of a takeover bid — to the benefit of shareholder value.
12.
Answers will vary. The principles of good corporate governance discussed in the chapter should apply.
Est time: 06-10 Appendix Questions:
1. Both would still invest in their friend’s business. A invests and receives $121,000 for his investment at the end of the year —which is greater than the $120,000 it would receive from lending at 20% ($100,000 x 1.20 = $120,000). G also invests, but borrows against the $121,000 payment, and thus receives $100,833 ($121,000 / 1.20) today. Est time: 01-05
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up to $216,000 next year (200,000 x 1.08, forgoing all consumption this year). He should invest all of his wealth to earn $216,000 next year. To choose the
same consumption (C) in both years, C = (200,000 – C) x 1.08, or C = $103,846. Dollars Next Year 220,000 216,000
203,704 200,000
Dollars Now
b. He should invest all of his wealth to earn $220,000 ($200,000 x 1.10) next year. If he consumes all this year, he can now have a total of $203,703.70(200,000 x 1.10/1.08) this year or $220,000 next year. If he consumes C this year, the amount available for next year’s consumption is (203,703.7 – C) x 1.08. To get equal consumption in both years, set the amount consumed today equal to the amount next year: C = (203,703.70 – C) x 1.08 C = $105,769.20 Est time: 06-10
CHAPTER 2 How to Calculate Present Values
Answers to Problem Sets 1. If the discount factor is .507, then .507 x 1.126 = $1. Est time: 01-05
2. DF x 139 = 125. Therefore, DF =125/139 = .899. Est time: 01-05
3.
PV = 374/(1.09)9 = 172.20.
Est time: 01-05
4.
PV = 432/1.15 + 137/(1.152) + 797/(1.153) = 376 + 104 + 524 = $1,003.
Est time: 01-05
5. FV = 100 x 1.158 = $305.90. Est time: 01-05
6.
NPV = −1,548 + 138/.09 = −14.67 (cost today plus the present value of the perpetuity).
Est time: 01-05
7. PV = 4/(.14 − .04) = $40. Est time: 01-05
8. a. PV = 1/.10 = $10. b.
Since the perpetuity will be worth $10 in year 7, and since that is roughly double the present value, the approximate PV equals $5. You must take the present value of years 1 –7 and subtract from the total present value of the perpetuity: PV = (1/.10)/(1.10)7 = 10/2= $5 (approximately).
c.
A perpetuity paying $1 starting now would be worth $10, whereas a perpetuity starting in year 8 would be worth roughly $5. The difference between these cash flows is therefore approximately $5. PV = $10 – $5= $5 (approximately).
d.
PV = C/(r − g) = 10,000/(.10-.05) = $200,000.
Est time: 06-10
9.
a. not
PV = 10,000/(1.055) = $7,835.26 (assuming the cost of the car does appreciate over those five years).
b.
The six-year annuity factor [(1/0.08) – 1/(0.08 x (1+.08)6)] = 4.623. You need to set aside (12,000 × six-year annuity factor) = 12,000 × 4.623 = $55,475.
c.
At the end of six years you would have 1.086 × (60,476 - 55,475) = $7,935.
Est time: 06-10
10.
a.
FV = 1,000e.12 x 5 = 1,000e.6 = $1,822.12.
b.
PV = 5e−.12 x 8 = 5e-.96 = $1.914 million.
c.
PV = C (1/r – 1/rert) = 2,000(1/.12 – 1/.12e .12 x15) = $13,912.
Est time: 01-05
11. a.
FV = 10,000,000 x (1.06)4 = 12,624,770.
b.
FV = 10,000,000 x (1 + .06/12)(4 x 12) = 12,704,892.
c.
FV = 10,000,000 x e(4 x .06) = 12,712,492.
Est time: 01-05
12. a.
PV = $100/1.0110 = $90.53.
b.
PV = $100/1.1310 = $29.46.
c.
PV = $100/1.2515 = $3.52.
d.
PV = $100/1.12 + $100/1.122 + $100/1.123 = $240.18.
Est time: 01-05
13.
a.
DF1
1 0.905 r 1 = 0.1050 = 10.50%. 1 r 1
b.
DF2
1 1 0.819. 2 (1 r 2 ) (1.105)2
c.
AF2 = DF1 + DF2 = 0.905 + 0.819 = 1.724.
d.
PV of an annuity = C [annuity factor at r % for t years]. Here: $24.65 = $10 [AF3] AF3 = 2.465
e.
AF3 = DF1 + DF2 + DF3 = AF2 + DF3
2.465 = 1.724 + DF3 DF3 = 0.741 Est time: 06-10
14.
The present value of the 10-year stream of cash inflows is:
1 1 PV $170,000 $886,739.66 10 0.14 0.14 (1.14) Thus: NPV = – $800,000 + $886,739.66 = +$86,739.66
At the end of five years, the factory’s value will be the present value of the five
remaining $170,000 cash flows:
1 1 PV $170,000 $583,623.76 5 0.14 0.14 (1.14) Est time: 01-05
15. 10
NPV t0
Ct $50,000 $57,000 $75,000 $80,000 $85,000 $380,000 1.12 (1.12)t 1.12 2 1.123 1.12 4 1.12 5
$92,000 $92,000 $80,000 $68,000 $50,000 $23,696.15 1.12 6 1.12 7 1.128 1.12 9 1.1210
Est time: 01-05
16.
a.
Let St = salary in year t. 30
PV t 1
40,000 (1.05)t 1 (1.08)t
1 (1.05)30 40,000 $760,662.53 30 (.08 .05) (.08 .05) (1.08)
b.
PV(salary) x 0.05 = $38,033.13 Future value = $38,033.13 x (1.08)30 = $382,714.30
c.
1 1 PV C t r r (1 r) 1 1 $382,714.30 C 20 0.08 0.08 (1.08) 1 1 $38,980.30 C $382,714.30 20 0.08 0.08 (1.08) Est time: 06-10
17. Period 0 1 2 3
Present Value
400,000.00
+100,000/1.12 = +200,000/1.122 = +300,000/1.123 =
+89,285.71 +159,438.78 +213,534.07
Total = NPV = $62,258.56 Est time: 01-05
18.
We can break this down into several different cash flows, such that the sum of these separate cash flows is the total cash flow. Then, the sum of the present values of the separate cash flows is the present value of the entire project. (All dollar figures are in millions.)
Cost of the ship is $8 million PV = $8 million
Revenue is $5 million per year, and operating expenses are $4 million. Thus, operating cash flow is $1 million per year for 15 years.
1 1 $8.559 million. 15 0.08 0.08 (1.08)
PV $1 million
Major refits cost $2 million each and will occur at times t = 5 and t = 10. PV = ($2 million)/1.085 + ($2 million)/1.0810 = $2.288 million.
Sale for scrap brings in revenue of $1.5 million at t = 15. PV = $1.5 million/1.0815 = $0.473 million.
Adding these present values gives the present value of the entire project: NPV = $8 million + $8.559 million $2.288 million + $0.473 million NPV = $1.256 million
Est time: 06-10
19.
a.
PV = $100,000.
b.
PV = $180,000/1.125 = $102,136.83.
c.
PV = $11,400/0.12 = $95,000.
d.
1 1 PV $19,000 $107,354.24. 10 0.12 0.12 (1.12)
e.
PV = $6,500/(0.12 0.05) = $92,857.14. Prize (d) is the most valuable because it has the highest present value.
Est time: 01-05
20.
Mr. Basset is buying a security worth $20,000 now, which is its present value. The unknown is the annual payment. Using the present value of an annuity formula, we have:
1 1 PV C t r r (1 r) 1 1 $20,000 C 12 0.08 0.08 (1.08) 1 1 $2,653.90 C $20,000 0.08 0.08 (1.08)12 Est time: 01-05
21.
Assume the Zhangs will put aside the same amount each year. One approach to solving this problem is to find the present value of the cost of the boat and then equate that to the present value of the money saved. From this equation, we can solve for the amount to be put aside each year. PV(boat) = $20,000/(1.10)5 = $12,418
1 1 5 0.10 0.10 (1.10)
PV(savings) = annual savings
Because PV(savings) must equal PV(boat):
1 1 $12,418 5 0.10 0.10 (1.10)
Annual savings
1 1 $3,276 5 0.10 0.10 (1.10)
Annual savings $12,418
Another approach is to use the future value of an annuity formula:
(1 .10)5 1 $20,000 Annual savings .10 Annual savings =
$ 3,276
Est time: 06-10
22.
The fact that Kangaroo Autos is offering “free credit” tells us what the cash payments are; it does not change the fact that money has time value. A 10% annual rate of interest is equivalent to a monthly rate of 0.83%: r monthly = r annual /12 = 0.10/12 = 0.0083 = 0.83% The present value of the payments to Kangaroo Autos is:
1 1 $1,000 $300 $8,938 30 0.0083 0.0083 (1.0083) A car from Turtle Motors costs $9,000 cash. Therefore, Kangaroo Autos offers the better deal, i.e., the lower present value of cost. Est time: 01-05
23.
The NPVs are: at 5%
NPV $700,000
$30,000 $870,000 $117,687 1.05 (1.05)2
at 10% NPV $700,000
$30,000 870,000 $46,281 1.10 (1.10)2
at 15% NPV $700,000
$30,000 870,000 $16,068 1.15 (1.15)2
The figure below shows that the project has zero NPV at about 13.5%. As a check, NPV at 13.5% is: NPV $700,000
$30,000 870,000 $1.78 1.135 (1.135)2
Est time: 06-10
24.
a.
This is the usual perpetuity, and hence: PV
b.
C $100 $1,428.57 r 0.07
This is worth the PV of stream (a) plus the immediate payment of $100: PV = $100 + $1,428.57 = $1,528.57
c.
The continuously compounded equivalent to a 7% annually compounded rate is approximately 6.77%, because: Ln(1.07) = 0.0677 or e0.0677 = 1.0700
Thus: PV
C $100 $1,477.10 r 0.0677
Note that the pattern of payments in part (b) is more valuable than the pattern of payments in part (c). It is preferable to receive cash flows at the start of every year than to spread the receipt of cash evenly over the year; with the former pattern of payment, you receive the cash more quickly.
Est time: 06-10
25.
a.
PV = $1 billion/0.08 = $12.5 billion.
b.
PV = $1 billion/(0.08 – 0.04) = $25.0 billion.
c.
1 1 $9.818 billion. PV $1 billion 20 0.08 0.08 (1.08)
d.
The continuously compounded equivalent to an 8% annually compounded rate is approximately 7.7%, because: Ln(1.08) = 0.0770 or e0.0770 = 1.0800
Thus: 1 1 PV $1 billion $10.203 billion (0.077)(20 ) 0.077 0.077 e This result is greater than the answer in Part (c) because the endowment is now earning interest during the entire year. Est time: 06-10
26.
With annual compounding: FV = $100 (1.15)20 = $1,636.65. With continuous compounding: FV = $100 e(0.15×20) = $2,008.55.
Est time: 01-05
27.
One way to approach this problem is to solve for the present value of: (1) $100 per year for 10 years, and (2) $100 per year in perpetuity, with the first cash flow at year 11. If this is a fair deal, these present values must be equal, and thus we can solve for the interest rate (r ). The present value of $100 per year for 10 years is:
1 1 PV $100 10 r (r) (1 r) The present value, as of year 10, of $100 per year forever, with the first payment in year 11, is: PV 10 = $100/r . At t = 0, the present value of PV10 is:
1 $100 PV 10 (1 r) r Equating these two expressions for present value, we have:
1 1 $100 1 $100 10 10 r (r) (1 r) (1 r) r Using trial and error or algebraic solution, we find that r = 7.18%. Est time: 06-10
28.
Assume the amount invested is one dollar. Let A represent the investment at 12%, compounded annually. Let B represent the investment at 11.7%, compounded semiannually. Let C represent the investment at 11.5%, compounded continuously. After one year: FV A = $1 (1 + 0.12)1
= $1.1200
FVB = $1 (1 + 0.0585)2
= $1.1204
FVC = $1 e(0.115
= $1.1219
1)
After five years: FV A = $1 (1 + 0.12)5
= $1.7623
FVB = $1 (1 + 0.0585)10 = $1.7657 FVC = $1 e(0.115
5)
= $1.7771
After twenty years: FV A = $1 (1 + 0.12)20
= $9.6463
FVB = $1 (1 + 0.0585)40 = $9.7193 FVC = $1 e(0.115
20)
= $9.9742
The preferred investment is C. Est time: 06-10
29.
Because the cash flows occur every six months, we first need to calculate the equivalent semiannual rate. Thus, 1.08 = (1 + r /2)2 => r = 7.846 semiannually compounded APR. Therefore the rate for six months is 7.846/2, or 3.923%:
1 1 $846,147 9 . 0 03923 0 03923 1 03923 . ( . )
PV $100 ,000 $100 ,000 Est time: 06-10
30.
a.
Each installment is: $9,420,713/19 = $495,827.
1 1 PV $495,827 $4,761,724 19 0.08 0.08 (1.08) b.
If ERC is willing to pay $4.2 million, then:
1 1 $4,200,000 $495,827 19 r r (1 r) Using Excel or a financial calculator, we find that r = 9.81%. Est time: 06-10
31.
1 1 PV $70,000 $402,264.73 8 0.08 0.08 (1.08)
a. b.
Year 1 2 3 4 5 6 7 8
Beginning-ofYear Balance ($) 402,264.73 364,445.91 323,601.58 279,489.71 231,848.88 180,396.79 124,828.54 64,814.82
Year-End Interest on Balance ($) 32,181.18 29,155.67 25,888.13 22,359.18 18,547.91 14,431.74 9,986.28 5,185.19
Total Year-End Payment ($) 70,000.00 70,000.00 70,000.00 70,000.00 70,000.00 70,000.00 70,000.00 70,000.00
Amortization of Loan ($) 37,818.82 40,844.33 44,111.87 47,640.82 51,452.09 55,568.26 60,013.72 64,814.81
End-of-Year Balance ($) 364,445.91 323,601.58 279,489.71 231,848.88 180,396.79 124,828.54 64,814.82 0.01
Est time: 06-10
32.
This is an annuity problem with the present value of the annuity equal to $2 million (as of your retirement date), and the interest rate equal to 8% with 15 time periods. Thus, your annual level of expenditure (C) is determined as follows:
1 1 PV C t r r (1 r) 1 1 $2,000,000 C 15 0.08 0.08 (1.08) 1 1 $233,659 C $2,000,000 0.08 0.08 (1.08)15 With an inflation rate of 4% per year, we will still accumulate $2 million as of our retirement date. However, because we want to spend a constant amount
per year in real terms (R, constant for all t), the nominal amount (Ct) must increase each year. For each year t: R = Ct /(1 + inflation rate)t Therefore: PV [all Ct ] = PV [all R (1 + inflation rate)t] = $2,000,000
(1 0.04)1 (1 0.04)2 (1 0.04)15 R . . . $2,000,000 1 2 15 (1 0.08) (1 0 .08) (1 0.08) R [0.9630 + 0.9273 + . . . + 0.5677] = $2,000,000 R 11.2390 = $2,000,000 R = $177,952 (1 0 .08) 1 .03846. Then, (1 0.04) redoing the steps above using the real rate gives a real cash flow equal to:
Alternatively, consider that the real rate is
1 1 $177,952 C $2,000,000 0.03846 0.03846 (1.03846)15 Thus C1 = ($177,952 1.04) = $185,070, C2 = $192,473, etc. Est time: 11-15
33.
a.
1 1 PV $50,000 $430,925.89 12 0.055 0.055 (1.055)
b.
The annually compounded rate is 5.5%, so the semiannual rate is: (1.055)(1/2) – 1 = 0.0271 = 2.71% Since the payments now arrive six months earlier than previously: PV = $430,925.89 × 1.0271 = $442,603.98
Est time: 06-10
34.
In three years, the balance in the mutual fund will be: FV = $1,000,000 × (1.035)3 = $1,108,718 The monthly shortfall will be: $15,000 – ($7,500 + $1,500) = $6,000. Annual withdrawals from the mutual fund will be: $6,000 × 12 = $72,000. Assume the first annual withdrawal occurs three years from today, when the balance in the mutual fund will be $1,108,718. Treating the withdrawals as an annuity due, we solve for t as follows:
1 1 PV C (1 r) t r r (1 r)
1 1 1.035 $1,108,718 $72,000 t 0.035 0.035 (1.035) Using Excel or a financial calculator, we find that t = 21.38 years. Est time: 06-10
35.
a. PV = 2/.12 = $16.667 million.
1 1 b. PV = $2 $14.939 million. 20 0.12 0.12 (1.12) c. PV = 2/(.12-.03) = $22.222 million
1 1.0320 $18.061 million. d. PV = $2 20 (0.12 .03) (0.12 .03) (1.12)
Est time: 06-10
36.
a. First we must determine the 20-year annuity factor at a 6% interest rate. 20-year annuity factor = [1/.06 – 1/.06(1.06)20) = 11.4699. Once we have the annuity factor, we can determine the mortgage payment. Mortgage payment = $200,000/11.4699 = $17,436.91.
b. Beginning Balance ($)
Year
Year-End Interest ($)
Total YearEnd Payment ($)
Amortization End-of-Year of Loan ($) Balance ($)
1
200,000.00
12,000.00
17,436.91
5,436.91
194,563.09
2
194,563.09
11,673.79
17,436.91
5,763.13
188,799.96
3
188,799.96
11,328.00
17,436.91
6,108.91
182,691.05
4 5
182,691.05 176,215.60
10,961.46 10,572.94
17,436.91 17,436.91
6,475.45 6,863.98
176,215.60 169,351.63
6
169,351.63
10,161.10
17,436.91
7,275.81
162,075.81
7
162,075.81
9,724.55
17,436.91
7,712.36
154,363.45
8
154,363.45
9,261.81
17,436.91
8,175.10
146,188.34
9
146,188.34
8,771.30
17,436.91
8,665.61
137,522.73
10
137,522.73
8,251.36
17,436.91
9,185.55
128,337.19
11
128,337.19
7,700.23
17,436.91
9,736.68
118,600.51
12
118,600.51
7,116.03
17,436.91
10,320.88
108,279.62
c.
13
108,279.62
6,496.78
17,436.91
10,940.13
97,339.49
14
97,339.49
5,840.37
17,436.91
11,596.54
85,742.95
15
85,742.95
5,144.58
17,436.91
12,292.33
73,450.61
16
73,450.61
4,407.04
17,436.91
13,029.87
60,420.74
17 18
60,420.74 46,609.07
3,625.24 2,796.54
17,436.91 17,436.91
13,811.67 14,640.37
46,609.07 31,968.71
19
31,968.71
1,918.12
17,436.91
15,518.79
16,449.92
20
16,449.92
986.99
17,436.91
16,449.92
0.00
Nearly 69% of the initial loan payment goes toward interest ($12,000/$17,436.79 = .6882). Of the last payment, only 6% goes toward interest (987.24/17,436.79 = .06). After 10 years, $71,661.21 has been paid off ($200,000 – remaining balance of $128,338.79). This represents only 36% of the loan. The reason that less than half of the loan has paid off during half of its life is due to compound interest.
Est time: 11-15
37.
a.
Using the Rule of 72, the time for money to double at 12% is 72/12, or six years. More precisely, if x is the number of years for money to double, then: (1.12)x = 2 Using logarithms, we find: x (ln 1.12) = ln 2 x = 6.12 years
b.
With continuous compounding for interest rate r and time period x: e rx = 2 Taking the natural logarithm of each side: rx = ln(2) = 0.693
Thus, if r is expressed as a percent, then x (the time for money to double) is: x = 69.3/(interest rate, in percent). Est time: 06-10
38.
Spreadsheet exercise.
Est time: 11-15
39..
a.
This calls for the growing perpetuity formula with a negative growth rate (g = –0.04):
PV b.
$2 million $2 million $14.29 million 0.10 ( 0.04) 0.14
The pipeline’s value at year 20 (i.e., at t = 20), assuming its cash flows
last forever, is: C21 C1 (1 g)20 PV20 r g r g With C1 = $2 million, g = –0.04, and r = 0.10: ($2 million) (1 0.04)20 $0.884 million PV20 $6.314 million 0.14 0.14 Next, we convert this amount to PV today, and subtract it from the answer to Part (a): $6.314 million $13.35 million PV $14.29 million (1.10)20 Est time: 06-10
CHAPTER 3 Valuing Bonds
Answers to Problem Sets
1.
a.
Does not change. The coupon rate is set at time of issuance.
b.
Price falls. Market yields and prices are inversely related.
c.
Yield rises. Market yields and prices are inversely related.
Est. Time: 01-05
2.
a.
If the coupon rate is higher than the yield, then investors must be expecting a decline in the capital value of the bond over its remaining life. Thus, the bond’s price must be greater than its face value.
b.
Conversely, if the yield is greater than the coupon, the price will be
below face value and it will rise over the remaining life of the bond. Est. Time: 01-05
3.
The yield over six months is 2.7/2 = 1.35%. The six-month coupon payment is $6.25/2 = $3.125. There are 18 years between today (2012) and 2030; since coupon payments are listed every six months, there will be 36 payment periods. Therefore, PV = $3.125 / 1.0135 + $3.125 / (1.0135)2 + . . . $103.125 / (1.0135)36 = $150.35.
Est. Time: 01-05
4.
Yields to maturity are about 4.3% for the 2% coupon, 4.2% for the 4% coupon, and 3.9% for the 8% coupon. The 8% bond had the shortest duration (7.65 years), the 2% bond the longest (9.07 years).The 4% bond had a duration of 8.42 years. Est. Time: 01-05
5.
a. Fall. Example: Assume a one-year, 10% bond. If the interest rate is 10%, the bond is worth $110/1.1 = $100. If the interest rate rises to 15%, the bond is worth $110/1.15 = $95.65. b. Less (e.g., see 5a—if the bond yield is 15% but the coupon rate is lower at 10%, the price of the bond is less than $100). c. Less (e.g., with r = 5%, one-year 10% bond is worth $110/1.05 = $104.76). d. Higher (e.g., if r = 10%, one-year 10% bond is worth $110/1.1 = $100, while one-year 8% bond is worth $108/1.1 = $98.18). e.
No. Low-coupon bonds have longer durations (unless there is only one period to maturity) and are therefore more volatile (e.g., if r falls from 10% to 5%, the value of a two-year 10% bond rises from $100 to $109.3 (a rise of 9.3%). The value of a two-year 5% bond rises from $91.3 to $100 (a rise of 9.5%).
Est. Time: 01-05
6.
a.
Spot interest rates. Yield to maturity is a complicated average of the separate spot rates of interest.
b.
Bond prices. The bond price is determined by the bond’s cash flows and the spot rates of interest. Once you know the bond price and the bond’s cash flows, it is possible to calculate the yield to maturity.
Est. Time: 01-05
7.
a.
4%; each bond will have the same yield to maturity.
b.
PV = $80/(1.04) + $1,080/(1.04)2 = $1,075.44.
Est. Time: 01-05
8.
5
PV
b.
PV
c.
Less (it is between the one-year and two-year spot rates).
1 r 1 5 1 y
105
a.
1 r 2 2 105
1 y 2
Est. Time: 01-05
9.
The two-year spot rate is r 2 = (100/99.523).5 – 1 = 0.24%. The three-year spot rate is r 3 = (100/98.937).33 – 1 = 0.36%. The four-year spot rate is r 4 = (100/97.904).25 – 1 = 0.53%. The five-year spot rate is r 5 = (100/96.034).2 – 1 = 0.81%. Upward-sloping.
a.
b. c.
Higher (the yield on the bond is a complicated average of the separate spot rates). Est. Time: 01-05
10.
a.
Price today is $108.425; price after one year is $106.930.
b. c.
Return = (8 + 106.930)/108.425 - 1 = .06, or 6%. If a bond’s yield to maturity is unchanged, the return to the bondholder is equal to the yield.
Est. Time: 01-05
11.
a.
False. Duration depends on the coupon as well as the maturity.
b.
False. Given the yield to maturity, volatility is proportional to duration.
c.
True. A lower coupon rate means longer duration and therefore higher volatility.
d.
False. A higher interest rate reduces the relative present value of (distant) principal repayments.
Est. Time: 01-05
12. Proportion Year
Security A
Ct
PV(Ct)
Value
× Time
40
37.04
0.3593
0.3593
2
40
34.29
0.3327
0.6654
3
40
31.75
0.3080
0.9241
103.08
1.00
=
Duration =
1.9487
1
20
18.52
0.1414
0.1414
2
20
17.15
0.1310
0.2619
3
120
95.26
0.7276
2.1828
130.93
1.00
9.26
0.0881
V
Security C
Proportion
1
V
Security B
of Total
1
=
10
Duration =
2.5861
10
8.57
0.0815
0.1631
3
110
87.32
0.8304
2.4912
105.15
1.00
=
1.80
2.39
0.0881
2
V
Volatility
Duration =
2.7424
2.54
Est. Time: 06-10
13.
7.01%; the extra return that you earn for investing for two years rather than one year is 1.062/1.05 – 1 = .0701.
Est. Time: 01-05
14.
a.
Real rate = 1.10/1.05 – 1 = .0476, or 4.76%.
b.
The real rate does not change. The nominal rate increases to 1.0476 × 1.07 – 1 = .1209, or 12.09%.
Est. Time: 01-05
15.
With annual coupon payments:
1 1 100 PV 5 €92.64 10 10 0.06 0.06 (1.06) (1.06) Est. Time: 01-05
16.
a.
1 10,000 1 PV 275 $10,231.64 20 20 0.026 0.026 (1.026) (1.026)
b. Interest
PV of
PV of
Rate
Interest
Face Value
1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%
$5,221.54 4,962.53 4,721.38 4,496.64 4,287.02 4,091.31 3,908.41 3,737.34 3,577.18 3,427.11 3,286.36 3,154.23 3,030.09 2,913.35 2,803.49
$9,050.63 8,195.44 7,424.70 6,729.71 6,102.71 5,536.76 5,025.66 4,563.87 4,146.43 3,768.89 3,427.29 3,118.05 2,837.97 2,584.19 2,354.13
PV of Bond
$14,272.17 13,157.97 12,146.08 11,226.36 10,389.73 9,628.06 8,934.07 8,301.21 7,723.61 7,196.00 6,713.64 6,272.28 5,868.06 5,497.54 5,157.62
Est. Time: 06-10 17.
Purchase price for a six-year government bond with 5% annual coupon:
1 1,000 1 $1,108.34 PV 50 6 6 0.03 0.03 (1.03) (1.03) The price one year later is equal to the present value of the remaining five years of the bond:
1 1,000 1 PV 50 $1,091.59 5 5 0.03 0.03 (1.03) (1.03) Rate of return = [$50 + ($1,091.59 – $1,108.34)]/$1,108.34 = 3.00% Price one year later (yield = 2%):
1 1,000 1 PV 50 $1,141.40 5 5 0.02 0.02 (1.02) (1.02) Rate of return = [$50 + ($1,141.40 – $1,108.34)]/$1,108.34 = 7.49%. Est. Time: 06-10
18.
The key here is to find a combination of these two bonds (i.e., a portfolio of bonds) that has a cash flow only at t = 6. Then, knowing the price of the
portfolio and the cash flow at t = 6, we can calculate the six-year spot rate. We begin by specifying the cash flows of each bond and using these and their yields to calculate their current prices: Investment
Yield
C1
...
C5
6% bond 10% bond
12% 8%
60 100
... ...
60 100
C6
1,060 1,100
Price
$753.32 $1,092.46
From the cash flows in years 1 through 5, we can see that buying two 6% bonds produces the same annual payments as buying 1.2 of the 10% bonds. To see the value of a cash flow only in year 6, consider the portfolio of two 6% bonds minus 1.2 10% bonds. This portfolio costs: ($753.32 × 2) – (1.2 $1,092.46) = $195.68 The cash flow for this portfolio is equal to zero for years 1 through 5 and, for year 6, is equal to: (1,060 × 2) – (1.2 1,100) = $800 Thus: $195.68 (1 + r 6)6 = $800 r 6 = 0.2645 = 26.45% Est. Time: 06-10
19.
Downward sloping. This is because high-coupon bonds provide a greater proportion of their cash flows in the early years. In essence, a high-coupon bond is a “shorter ” bond than a low-coupon bond of the same maturity.
Est. Time: 01-05
20.
a. Year
1 2 3 4 5
b.
i.
Discount Factor
1/1.05 = 0.952 1/(1.054)2 = 0.900 1/(1.057)3 = 0.847 1/(1.059)4 = 0.795 1/(1.060)5 = 0.747
50 1050 $992.79 1.05 (1.054)2
5%, five-year bond: PV
iii.
(1.0542 /1.05) – 1 = 0.0580 = 5.80% (1.0573 /1.0542 ) – 1 = 0.0630 = 6.30% (1.0594 /1.0573 ) – 1 = 0.0650 = 6.50% (1.0605 /1.0594 ) – 1 = 0.0640 = 6.40%
5%, two-year bond: PV
ii.
Forward Rate
50 50 50 50 1,050 $959.34 1.05 (1.054)2 (1.057)3 (1.059)4 (1.060)5
10%, five-year bond: PV
100 100 100 100 1,100 $1,171.43 2 3 4 1.05 (1.054) (1.057) (1.059) (1.060)5
c.
First, we calculate the yield for each of the two bonds. For the 5% bond, this means solving for r in the following equation:
$959.34
50 50 50 50 1,050 1 r (1 r ) 2 (1 r )3 (1 r)4 (1 r)5
r = 0.05964 = 5.964%
For the 10% bond: $1,171.43
100 100 100 100 1,100 1 r (1 r)2 (1 r)3 (1 r)4 (1 r)5
r = 0.05937 = 5.937%
The yield depends upon both the coupon payment and the spot rate at the time of the coupon payment. The 10% bond has a slightly greater proportion of its total payments coming earlier, when interest rates are low, than does the 5% bond. Thus, the yield of the 10% bond is slightly lower. d.
The yield to maturity on a five-year zero-coupon bond is the five-year spot rate, here 6.00%.
e.
First, we find the price of the five-year annuity, assuming that the annual payment is $1: PV
1 1 1 1 1 $4.2417 1.05 (1.054)2 (1.057)3 (1 .059)4 (1.060)5
Now we find the yield to maturity for this annuity: $4.2417
1 1 1 1 1 2 3 4 1 r (1 r) (1 r) (1 r) (1 r)5
r = 0.05745 = 5.745%
f.
The yield on the five-year note lies between the yield on a five-year zero-coupon bond and the yield on a five-year annuity because the cash flows of the Treasury bond lie between the cash flows of these other two financial instruments during a period of rising interest rates. That is, the annuity has fixed, equal payments; the zero-coupon bond has one payment at the end; and the bond’s payments are a combination of these.
Est. Time: 06-10
21.
To calculate the duration, consider the following table similar to Table 3.4:
Year Payment ($)
1
2
3
4
5
6
7
30
30
30
30
30
30
1,030
Totals
PV(C t) at 4% ($) Fraction of total value [PV(C t) /PV] Year × fraction of total value
28.846
27.737
26.670
25.644
24.658
23.709
782.715
939.980
0.031
0.030
0.028
0.027
0.026
0.025
0.833
1.000
0.031
0.059
0.085
0.109
0.131
0.151
5.829
Duration (Years)
6.395
The duration is the sum of the year × fraction of total value column, or 6.395 years. The modified duration, or volatility, is 6.395/(1 + .04) = 6.15. The price of the 3% coupon bond at 3.5%, and 4.5% equals $969.43 and $911.64, respectively. This price difference ($57.82) is 5.93% of the original price, which is very close to the modified duration. Est. Time: 06-10
22. a. If the bond coupon payment changes from 9% as listed in Table 3.4 to 8%, then the following calculation for duration can be made: Year Payment ($) PV(C t) at 4% ($) Fraction of total value [PV(C t) /PV] Year × fraction of total value
1
2
3
4
5
a.
7
Totals
80
80
80
80
80
80
1,080
76.923
73.964
71.120
68.384
65.754
63.225
820.711
1,240.082
0.062
0.060
0.057
0.055
0.053
0.051
0.662
1.000
0.062
0.119
0.172
0.221
0.265
0.306
4.633
Duration (years)
5.778
A decrease in the coupon payment will increase the duration of the bond, as the duration at an 8% coupon payment is 5.778 years. The volatility for the bond in Table 3.4 with an 8% coupon payment is: 5.778/(1.04) = 5.556.The bond therefore becomes less volatile if the coupon payment decreases. b. For a 9% bond whose yield increases from 4% to 6%, the duration can be calculated as follows: Year Payment ($) PV(C t) at 6% ($) Fraction of total value [PV(C t) /PV] Year × fraction of total value
1
2
3
4
5
6
7
90
90
90
90
90
90
1090
84.906
80.100
75.566
71.288
67.253
63.446
724.912
1,167.471
0.073
0.069
0.065
0.058
0.058
0.054
0.621
1.000
0.07272611
0.13722
0.19418
0.23042
0.288
0.32607
4.346475
Duration (years)
There is an inverse relationship between the yield to maturity and the duration. When the yield goes up from 4% to 6%, the duration decreases
Totals
5.595
slightly. The volatility can be calculated as follows: 5.595/(1.06) = 5.278. This shows that the volatility decreases as well when the yield increases. Est. Time: 06-10
23.
The duration of a perpetual bond is: [(1 + yield)/yield]. The duration of a perpetual bond with a yield of 5% is: D5 = 1.05/0.05 = 21 years
The duration of a perpetual bond yielding 10% is: D10 = 1.10/0.10 = 11 years
Because the duration of a zero-coupon bond is equal to its maturity, the 15year zero-coupon bond has a duration of 15 years. Thus, comparing the 5% perpetual bond and the zero-coupon bond, the 5% perpetual bond has the longer duration. Comparing the 10% perpetual bond and the 15-year zero, the zero has a longer duration. Est. Time: 06-10
24.
Answers will differ. Generally, we would expect yield changes to have the greatest impact on long-maturity and low-coupon bonds.
Est. Time: 06-10
25.
The new calculations are shown in the table below: 1
2
3
4
Spot rates (%) Discount factors
4.60 0.9560
4.40 0.9175
4.20 0.8839
4 0.8548
Bond A (8% coupon): Payment (C t) PV(C t)
$80 $76.48
$1,080 $990.88
Bond B (8% coupon): Payment (C t) PV(C t)
$80 $76.48
$80 $73.40
$1,080 $954.60
Bond C (8% coupon): Payment (C t) PV(C t)
$80 $76.48
$80 $73.40
$80 $70.71
26.
$1,080 $923.19
Bond Price (PV)
YTM (%)
$1,067.37
4.407%
$1,104.48
4.222%
$1,143.78
4.036%
We will borrow $1,000 at a five-year loan rate of 2.5% and buy a four-year strip paying 4%. We may not know what interest rates we will earn on the last year (45), but our $1,000 will come due, and we put it under our mattress earning 0% if necessary to pay off the loan. Let’s turn to present value calculations: As shown above, the cost of the strip
is $854.80. We will receive proceeds from the 2.5% loan = $1,000/(1.025) 5 = $883.90. Pocket the difference of $29.10, smile, and repeat. The minimum sensible value would set the discount factors used in year 5 equal to that of year 4, which would assume a 0% interest rate from year 4 to 5. We can solve for the interest rate where 1/(1 + r )5 = 0.8548, which is roughly 3.19%. Est. Time: 06-10
27. a.
If the expectations theory of term structure is right, then we can determine the expected future one-year spot rate (at t = 3) as follows: investing $100 in a three-year instrument at 4.2% gives us $100(1 + .042)3 = 113.136. Investing $100 in a four-year instrument at 4.0% gives us $100 × (1+.04)4 = 116.986. This reveals a one-year spot rate from year 3 to 4 of ($116.98 – 113.136)/113.136 = 3.4%.
b.
If investing in long-term bonds carries additional risks, then the risk equivalent of a one-year spot rate in year 3 would be even less
(reflecting the fact that some risk premium must be built into this 3.4% spot rate). Est. Time: 06-10
28. a.
Your nominal return will be 1.082 -1 = 16.64% over the two years. Your real return is (1.08/1.03) × (1.08/1.05) - 1 = 7.85%.
b.
With the TIPS, the real return will remain at 8% per year, or 16.64% over two years. The nominal return on the TIPS will equal (1.08 × 1.03) × (1.08 × 1.05) – 1 = 26.15%.
Est. Time: 01-05
29. The bond price at a 5.3% yield is: 1 1 1,000 $1,201.81 PV 100 5 5 0.053 0.053 (1.053) (1.053) If the yield decreases to 5.9%, the price would rise to:
1 1 1,000 PV 100 $1,173.18 5 5 0.059 0.059 (1.059) (1.059) 30.
Answers will vary by the interest rates chosen. a. Suppose the YTM on a four-year 3% coupon bond is 2%. The bond is selling for: 1 1,000 1 PV 30 $1,038.08 4 4 0.02 0.02 (1.02) (1.02) If the YTM stays the same, one year later the bond will sell for :
1 1,000 1 PV 30 $1,028.84 3 3 0.02 0.02 (1.02) (1.02) The return over the year is [$30 + (1,028.84 - 1,038.08)]/$1,038.08= 0.02, or 2%. b. Suppose the YTM on a four-year 3% coupon bond is 4%. The bond is selling for: 1 1,000 1 PV 30 $963.70 4 4 0.04 0.04 (1.04) (1.04) If the YTM stays the same, one year later the bond will sell for :
1 1,000 1 PV 30 $972.25 3 3 0.04 0.04 (1.04) (1.04) The return over the year is [$30+(972.25-963.70)]/$963.70 = 0.04, or 4%. Est. Time: 06-10
31.
Spreadsheet problem; answers will vary.
Est. Time: 06-10
32.
Arbitrage opportunities can be identified by finding situations where the implied forward rates or spot rates are different. We begin with the shortest-term bond, Bond G, which has a two-year maturity. Since G is a zero-coupon bond, we determine the two-year spot rate directly by finding the yield for Bond G. The yield is 9.5%, so the implied twoyear spot rate (r 2) is 9.5%. Using the same approach for Bond A, we find that the three-year spot rate (r 3) is 10.0%. Next we use Bonds B and D to find the four-year spot rate. The following position in these bonds provides a cash payoff only in year four: a long position in two of Bond B and a short position in Bond D. Cash flows for this position are: [( –2 $842.30) + $980.57] = –$704.03 today [(2 $50) – $100] = $0 in years 1, 2 and 3 [(2 $1,050) – $1,100] = $1,000 in year 4 We determine the four-year spot rate from this position as follows: $704.03
$1,000 (1 r 4 ) 4
r 4 = 0.0917 = 9.17% Next, we use r 2, r 3, and r 4 with one of the four-year coupon bonds to determine r 1. For Bond C: $1,065.28
120 120 120 1,120 120 978.74 1 r 1 (1.095)2 (1.100)3 (1.0917)4 1 r 1
r 1 = 0.3867 = 38.67% Now, in order to determine whether arbitrage opportunities exist, we use these spot rates to value the remaining two four-year bonds. This produces the following results: for Bond B, the present value is $854.55, and for Bond D, the present value is $1,005.07. Since neither of these values equals the current market price of the respective bonds, arbitrage opportunities exist. Similarly, the spot rates derived above produce the following values for the three-year bonds: $1,074.22 for Bond E and $912.77 for Bond F.
Est. Time: 11-15
33.
We begin with the definition of duration as applied to a bond with yield r and an annual payment of C in perpetuity: 1C 2C 3C tC 1 r (1 r)2 (1 r)3 (1 r)t DUR C C C C 1 r (1 r)2 (1 r)3 (1 r)t
We first simplify by dividing both the numerator and the denominator by C: 1 2 3 t 2 3 (1 r) (1 r) (1 r) (1 r)t DUR 1 1 1 1 2 3 1 r (1 r) (1 r) (1 r)t
The denominator is the present value of a perpetuity of $1 per year, which is equal to (1/r ). To simplify the numerator, we first denote the numerator S and then divide S by (1 + r ): S 1 2 3 t (1 r) (1 r)2 (1 r)3 (1 r)4 (1 r)t
1
Note that this new quantity [S/(1 + r )] is equal to the square of denominator in the duration formula above, that is:
1 S 1 1 1 (1 r) 1 r (1 r)2 (1 r)3 (1 r)t Therefore: 2 S 1 r 1 S 2 (1 r) r r
2
Thus, for a perpetual bond paying C dollars per year: DUR
1 r 1 1 r 2 r (1 / r) r
Est. Time: 06-10
34.
We begin with the definition of duration as applied to a common stock with yield r and dividends that grow at a constant rate g in perpetuity: 1C(1 g) 2C(1 g)2 3C(1 g)3 tC(1 g)t 1 r (1 r)2 (1 r)3 (1 r)t DUR C(1 g) C(1 g)2 C(1 g)3 C(1 g)t 1 r (1 r)2 (1 r)3 (1 r)t We first simplify by dividing each term by [ C(1 + g)]:
1 2(1 g) 3(1 g)2 t(1 g)t 1 1 r (1 r)2 (1 r)3 (1 r)t DUR 1 1 g (1 g)2 (1 g)t 1 1 r (1 r)2 (1 r)3 (1 r)t
The denominator is the present value of a growing perpetuity of $1 per year, which is equal to [1/(r - g)]. To simplify the numerator, we first denote the numerator S and then divide S by (1 + r ): S 1 2(1 g) 3(1 g)2 t(1 g)t 2 (1 r) (1 r)2 (1 r)3 (1 r)4 (1 r)t 1 Note that this new quantity [S/(1 + r )] is equal to the square of denominator in the duration formula above, that is: S (1 r)
1 1 g (1 g)2 (1 g)t 1 2 3 t 1 r (1 r) (1 r) (1 r)
2
Therefore: S (1 r)
2
1 1 r S (r g)2 r g
Thus, for a perpetual bond paying C dollars per year: DUR
1 r 1 1 r 2 (r g) [1 / (r g)] r g
Est. Time: 11-15
35.
a.
We make use of the one-year Treasury bill information in order to determine the one-year spot rate as follows: $93.46
$100 1 r 1
r 1 = 0.0700 = 7.00% The following position provides a cash payoff only in year two: a long position in 25 two-year bonds and a short position in 1 one-year Treasury bill. Cash flows for this position are: [( –25 $94.92) + (1 $93.46)] = –$2,279.54 today [(25 $4) – (1 $100)] = $0 in year 1 (25 $104) = $2,600 in year 2 We determine the two-year spot rate from this position as follows: $2,279.54
$2,600 (1 r 2 ) 2
r 2 = 0.0680 = 6.80% The forward rate f 2 is computed as follows: f 2 = [(1.0680)2/1.0700] – 1 = 0.0660 = 6.60% The following position provides a cash payoff only in year 3: a long position in the three-year bond and a short position equal to (8/104) times a package consisting of a one-year Treasury bill and a two-year bond. Cash flows for this position are: [( –1 $103.64) + (8/104) ($93.46 + $94.92)] = –$89.15 today [(1 $8) – (8/104) ($100 + $4)] = $0 in year 1 [(1 $8) – (8/104) $104] = $0 in year 2 1 $108 = $108 in year 3 We determine the three-year spot rate from this position as follows: $89.15
$108 (1 r 3 ) 3
r 3 = 0.0660 = 6.60% The forward rate f 3 is computed as follows: f 3 = [(1.0660)3/(1.0680)2] – 1 = 0.0620 = 6.20%
b.
We make use of the spot and forward rates to calculate the price of the 4% coupon bond: P
40 40 1040 $931.01 (1.07) (1.07) (1.066) (1.07) (1.066) (1.062)
The actual price of the bond ($950) is significantly greater than the price deduced using the spot and forward rates embedded in the prices of the other bonds ($931.01). Hence, a profit opportunity exists. In order to take advantage of this opportunity, one should sell the 4% coupon bond short and purchase the 8% coupon bond. Est. Time: 11-15
36.
a.
We can set up the following three equations using the prices of bonds A, B, and C:
Using bond A: $1,076.19 = $80/(1+r 1) + $1,080/(1+r 2)2 Using bond B: $1,084.58 = $80/(1+r 1) + $80/(1+r 2)2 + $1,080 / (1+r 3)3 Using bond C: $1,076.20 = $80/(1+r 1) + $80/(1+r 2)2 + $80/(1+r 3)3 + $1,080/(1+r 4)4 We know r 4 = 6% so we can substitute that into the last equation. Now we have three equations and three unknowns and can solve this with variable substitution or linear programming to get r 1 = 3%, r 2 = 4%; r 3 = 5%, r 4 = 6%.
