Corporate Finance Module

Practice Questions from Berk and DeMarzo

1: Bonds and Time Value of Money

4-11. Suppose you receive $100 at the end of each year for the next three years.
a. If the interest rate is 7%, what is the present value of these cash flows?
b. What is the future value in three years of the present value you computed in (a)?
c. Suppose you deposit the cash flows in a bank account that pays 7% interest per year. What is
the balance in the account at the end of each of the next three years (after your deposit is
made)? How does the final bank balance compare with your answer in (b)?
a. PV = 100 / 1.071 + 100 / 1.072 + 100 / 1.073 = $93.46 + 87.34 + 81.63 = $262.43
b. FV = 262.43 × 1.073 = $321.49
c. Year 1: FV = 100; Year 2: FV = 100*1.07+100 = 207; Year 3: FV = 100*1.07^2+100*1.07+100 =
321.49 which is the same as in b.

4-12. You have just received a windfall from an investment you made in a friend’s business. He will be
paying you $32,049 at the end of this year, $64,098 at the end of the following year, and $96,147 at
the end of the year after that (three years from today). The interest rate is 12.9% per year.
a. What is the present value of your windfall?
b. What is the future value of your windfall in three years (on the date of the last payment)?
a. Timeline:
0 1 2 3

32,049 64,098 96,147

PV = 32,049 / 1.1291 + 64,098 / 1.1292 + 96,147 / 1.1293 = $145,486.08

b. FV = 145,486.08 × 1.1293 = $209,364.61

4-13. You have a loan outstanding. It requires making five [original text said ‘three’] annual payments
at the end of the next three years of $4000 each. Your bank has offered to restructure the loan so
that instead of making five payments as originally agreed, you will make only one final payment
at the end of the loan in five years. If the interest rate on the loan is 5.63%, what final payment will
the bank require you to make so that it is indifferent between the two forms of payment?

(Try to make use of the annuity formula here)

Timeline:
0 1 2 3 4 5

4000 4000 4000 4000 4000

FV5 = 4,000  1.05634 + 4,000  1.05633 + 4,000  1.05632 + 4,000  1.05631 + 4,000 = $22,382.40
4-16. Your buddy in mechanical engineering has invented a money machine. The main drawback of the
machine is that it is slow. It takes one year to manufacture $900. However, once built, the machine
will last forever and will require no maintenance. The machine can be built immediately, but it
will cost $9000 to build. Your buddy wants to know if he should invest the money to construct it.
If the interest rate is 9.5% per year, what should your buddy do?
Timeline:
0 1 2 3

–9,000 900 900 900

To decide whether to build the machine you need to calculate the NPV. The cash flows the machine
generates are a perpetuity, so by the PV of a perpetuity formula:
PV = 900 / 0.095 = $9,476.68
Thus, NPV = –9,000 + 9,476.68 = $476.68 > 0. He should build it.

4-19. What is the present value of $4000 paid at the end of each of the next 73 years if the interest rate
is 3% per year?

(Hint: you need a short cut from having to insert 73 cash flows)
Timeline:
0 1 2 3 73

4,000 4,000 4,000 4,000

The cash flows are a 73-year annuity, so by the annuity formula:
4, 000  1 
PV  1  73 
 $117, 922.67
0.03  1.03 

4-24. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in one year
and will be $2000. Each year after that, on the anniversary of the last payment you will receive a
payment that is 8% larger than the last payment. This pattern of payments will go on forever. If
the interest rate is 15% per year,
a. What is today’s value of the bequest?
b. What is the value of the bequest immediately after the first payment is made?
a. Timeline:
0 1 2 3

2,000 2,000(1.08) 2,000(1.08)2

Using the formula for the PV of a growing perpetuity gives:

 2, 000 
PV     $28, 571.43
 0.15  0.08 
b. Timeline:
1 2 3 4
0 1 2 3
 1,000 1,000(1.08)2 1,000(1.08)3
Using the formula for the PV of a growing perpetuity gives:
2, 000(1.08)
PV   $30, 857.14
0.15  0.08

4-36. You have decided to buy a perpetuity. The bond makes one payment at the end of every year
forever and has an interest rate of 4%. If you initially put $5000 into the bond, what is the payment
every year?

(Hint: Use the formula for the price of a perpetuity P = C/r)

Timeline:
0 1 2 3

–5,000 C C C
C
P  C  P  r  5, 000  4%  200
r

6-3. The following table summarizes prices of various default-free, zero-coupon bonds (expressed as a
percentage of face value):

a. Compute the yield to maturity for each bond.

b. Plot the zero-coupon yield curve (for the first five years).
c. Is the yield curve upward sloping, downward sloping, or flat?

a. YTM1 =100/95.77-1=4.42%; YTM2 = (100/91.46)^(1/2) -1 = 4.56%; YTM3= (100/86.93)^(1/3)-

1=4.78%; YTM4=(100/82.25)^(1/4)-1=5.01%; YTM5=(100/77.09)^(1/5)-1=5.34%

b. yield

time to maturity

c. It is upward sloping.
(Hint: Start with the formula: Price of a zero-coupon bond with maturity of n years is
P = FV/(1+r)^n. But here you are given price and FV and n = 1,2,3,4,5. You need the formula
arranged for the yield r).

6-2. Assume that a bond will make payments every six months as shown on the following timeline:
 a. What is the maturity of the bond (in years)?
b. What is the coupon rate (in percent)?
c. What is the face value?
a. The maturity is 12 years (2 payments per year).
b. (50/1000) × 2 = 10%, so the coupon rate is 10%.
c. The face value is $1000.

6-9. Explain why the yield of a bond that trades at a discount exceeds the bond’s coupon rate.
Bonds trading at a discount generate a return both from receiving the coupons and from receiving a face
value that exceeds the price paid for the bond. As a result, the yield to maturity of discount bonds exceeds
the coupon rate.

6-2. Assume that a bond will make payments every six months as shown on the following timeline:

a. What is the maturity of the bond (in years)?

b. What is the coupon rate (in percent)?
c. What is the face value?
a. The maturity is 12 years (2 payments per year).
b. (50/1000) × 2 = 10%, so the coupon rate is 10%.
c. The face value is $1000.

12-14. In mid-2012, Ralston Purina had AA-rated, 10-year bonds outstanding with a yield to maturity of
1.73%.
a. What is the highest expected return these bonds could have?
b. At the time, similar maturity Treasuries have a yield of 1.5%. Could these bonds actually have
an expected return equal to your answer in part (a)?
c. If you believe Ralston Purina’s bonds have 1.2% chance of default per year, and that expected
loss rate in the event of default is 26%, what is your estimate of the expected return for these
bonds?
a. Risk-free => y = 1.73%
b. No. Expected return would be lower because of default risk. Recall that YTM is based on promised
cash flows (i.e., the best-case scenario) and therefore is the highest return you could think of (i.e.,
when there is no default risk). If there is any default risk, your expected return would be lower than
YTM.
c. y – d  loss = 1.73% – 1.2%(0.26) = 1.418%