Question 1

A 25-year bond with a face value of $1,000 has a coupon rate of 4.50%, with semiannual payments.
a. What is the coupon payment for this bond?
b. Enter the cash flows for the bond on a timeline.

a. What is the coupon payment for this bond?

To determine the coupon payment:

Coupon Rate x Face value

4.50% x $1,000
Coupon = ---------------------------- = $22.50
2

b. Enter the cash flows for the bond on a timeline.

Here is the cash flow timeline for this bond (the unit of time on this timeline is six-month periods):

CF1 = $27.50 CF2 = $27.50 CF59 = $27.50 CF60 = $1,027.59

Question 2

Explain why the yield of a bond that trades at a discount exceeds the bond’s coupon rate.

A. The bond is trading at a discount because investors don’t like the bond.
B. Because the value of the bond is discounted, the return on the bond is reduced and the yield
exceeds the coupon.
C. The bond can be purchased for a discount, which give it an “extra return”; hence, the yield
exceeds the coupon.
D. The bond’s coupon yield is irrelevant. It trades at a discount because investors avoid these
bonds.
The bond can be purchased for a discount, which gives it an "extra return"; hence, the yield exceeds the
coupon. The "extra return" is the difference between the discounted price paid and the par value that will
be received at maturity.

Question 3

Assume the zero-coupon yields on default-free securities are as summarized in the following table:

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 Maturity 1 year 2 years 3 years 4 years 5 years

Zero-Coupon Yields 3.4% 3.6% 3.8% 3.9% 4.10%

Consider a four-year, default-free security with annual coupon payments and a face value of $1,000 that
is issued at par. What is the coupon rate of this bond?

The price of the bond is as follows:

which can be rewritten as this:

Solve the following equation:

Therefore, the par coupon rate is 3.89%.

Question 4
You are considering investing in a start up company. The founder asked you for $250,000 today and you
expect to get $980,000 in 11 years. Given the riskiness of the investment opportunity, your cost of capital
is 29%. What is the NPV of the investment opportunity? Should you undertake the
investment opportunity? Calculate the IRR and use it to determine the maximum deviation allowable in
the cost of capital estimate to leave the decision unchanged.

If the cost of capital of this investment opportunity is 29%, what is its NPV? Should you undertake the
investment opportunity?

The net present value (NPV) is given by:

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 where NPV is the net present value of the investment, C 0 is the amount of your investment, C1 is the
amount that you will receive in n year, and r is the opportunity cost.

Therefore,

The NPV is -$190,470.

We can also compute this result using a spreadsheet:

The NPV is -$190,470.

Since the NPV is negative, you should not take the deal!

Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital
estimate to leave the decision unchanged.

The internal rate of return (IRR) is given by:

The IRR is 13.22%

We can also compute this result using a spreadsheet:

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 The maximum deviation allowable in the cost of capital is:

Deviation = IRR – r

Therefore,

Deviation = 13.22% - 29% = -15.78%

The maximum deviation allowed in the cost of capital before you would change your decision is . A
change in your cost of capital by -15.78% would change your decision.

Question 5

Former President Bill Clinton reportedly was paid an advance of $12.0 million to write his book My Life.
Suppose the book took three years to write. In the time he spent writing, Clinton could have been paid to
make speeches. Given his popularity, assume that he could earn $8.0 million a year (paid at the end of
the year) speaking instead of writing. Assume his cost of capital is 9.7% per ear.

a. What is the NPV of agreeing to write the book (ignoring any royalty payments)?
b. Assume that, once the book is finished, it is expected to generate royalties of $4.7 million in the first
year (paid at the end of the year) and these royalties are expected to decrease at a rate of 30% per year
in perpetuity. What is the NPV of the book with the royalty payments?

a. What is the NPV of agreeing to write the book (ignoring any royalty payments)?

Here is the cash flow timeline for part (a):

Therefore,

We can also compute this result using a spreadsheet:

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 b. Assume that, once the book is finished, it is expected to generate royalties of $4.7 million in the first
year (paid at the end of the year) and these royalties are expected to decrease at a rate of 30% per year
in perpetuity. What is the NPV of the book with the royalty payments?

If you assume that, once the book is finished, it is expected to generate royalties of $4.7 million in the first
year (paid at the end of the year) and these royalties are expected to decrease at 30% per year in
perpetuity, you need to calculate the value of a declining perpetuity. Here is the value of the declining
perpetuity at year three:

You need to discount PV3 for three years to derive today’s value.
129,000

We can also compute this result using a spreadsheet:

Next, add the present value of the royalties to the NPV from part (a).

NPV = -$8.00 million + $8.968 million = $0.968 million

Question 6

You are considering an investment in a clothes distributer. The company needs $102,000 today and
expects to repay you $129,000 in a year from now. What is the IRR of this investment opportunity? Given
the riskiness of the investment opportunity, your cost of capital is 14%. What does the IRR rule say about
whether you should invest?

$129,000
IRR = --------------- - 1 = 0.2647 = 26.5%
$102,000

The IRR of this investment opportunity is 26.5%. (Round to one decimal place.)

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 Given the riskiness of the investment opportunity, your cost of capital is 14%. What does the IRR say
about whether you should invest?

Deviation = IRR – r = 26.5% - 14% = 12.5%

The IRR rule says that you should invest.

Question 7

You are considering opening a new plant. The plant will cost $102.5 million upfront and will take one year
to build. After that, it is expected to produce profits of $29.5 million at the end of every year of production.
The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost
of capital is 7.8%. Should you make the investment? Calculate the IRR. Does the IRR rule agree with the
NPV rule?

Calculate the NPV of this investment opportunity if your cost of capital is 7.8%.

Here is the cash flow timeline for this problem:

The net present value is:

Should you make the investment?

Since the NPV is greater than zero, you should make the investment.

Calculate the IRR.

The IRR solves:

Solving for the unknown r:

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 r = IRR = 23.34%

Does the IRR rule agree with the NPV rule?

Since the IRR exceeds the 7.8% discount rate, the IRR rules gives the same answer as the NPV rule.

Question 8

You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The
sign will cost $10,000 and will be posted for one year. You expect that it will generate additional revenue
of $1,260 a month. What is the payback period?

Here is the cash flow timeline for this problem:

Natasha's Flowers, a local florist, purchases fresh flowers each day at the local flower market. The buyer
has a budget of $1,240 per day to spend. Different flowers have different profit margins, and also a
maximum amount the shop can sell. Based on past experience the shop has estimated the following NPV
of purchasing each type:

What combination of flowers should the shop purchase each day?

You need to first compute the profitability index for each choice:

Profitability Index =

Then purchase the maximum amount of the flower type with the highest profitability index. If there is
money left over move on to the second highest flower type and keep going until the budget is used up.

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 What combination of flowers should the shop purchase each day?

Buy $270 of lilies, $420 of orchids, and $550 of roses.

Question 10

Andrew Industries is contemplating issuing a 30-year bond with a coupon rate of 5.81% (annual coupon
payments) and a face value of $1,000. Andrew believes it can get a rating of A from Standard and Poor's.
However, due to recent financial difficulties at the company, Standard and Poor's is warning that it may
downgrade Andrew Industries bonds to BBB. Yields on A-rated long-term bonds are currently 5.31%,
and yields on BBB-rated bonds are 5.71%.
a. What is the price of the bond if Andrew maintains the A rating for the bond issue?
b. What will the price of the bond be if it is downgraded?

a. What is the price of the bond if Andrew maintains the A rating for the bond issue?

To calculate the price of the bond with an A rating, here is the cash flow timeline:

Use the rate for A-rated long-term bonds, 5.31%

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 b. What will the price of the bond be if it is downgraded?

Use the rate for B-rated long-term bonds, 5.71%.

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