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Tutorial 2

The document contains tutorial exercises on financial management, focusing on concepts such as present value of perpetuities and annuities, yield to maturity, and bond pricing. It includes calculations related to East Coast Yachts' bond issuance and sensitivity of bonds to interest rate changes. Additional exercises cover investment analysis, including present value calculations for mining operations and evaluating the feasibility of a money machine investment.

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2 views

Tutorial 2

The document contains tutorial exercises on financial management, focusing on concepts such as present value of perpetuities and annuities, yield to maturity, and bond pricing. It includes calculations related to East Coast Yachts' bond issuance and sensitivity of bonds to interest rate changes. Additional exercises cover investment analysis, including present value calculations for mining operations and evaluating the feasibility of a money machine investment.

Uploaded by

ns4xpg2k56
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Management for MAC

Tutorial exercises

Tutorial 2

1
Exercise II

The present value of a perpetuity can be calculated with the formula: C/r. Given
this formula, you can derive the formula to calculate the present value of an
annuity.

1) Show how you can derive the present value of an annuity formula from
the present value of a perpetuity formula.

Suppose the term structure of risk-free interest rates for zero-coupon bonds is
as shown below:

Term 1 year 2 years 3 years 5 years 7 years 10 years 20 years


Rate (EAR%) 1,99 2,41 2,74 3,32 3,76 4,13 4,93

2) What is the yield to maturity of an investment that pays $1000 in two


years and $4000 in five years for certain?

3) Explain why the PV you calculated in problem 2 must be the correct


answer, given the Law of One Price.

4) Calculate the present value of receiving $500 per year, with certainty, at
the end of the next five years. Hint: interpolate.

5) Draw the yield curve given the term structure of risk-free rates above.
What is the shape of the curve (normal, flat or inverted)? What
expectations are investors likely to have about future interest rates given
the shape of the yield curve?

We continue last week’s case about East Coast Yachts. Assume that East Coast
Yachts wants to issue $40 million in 20-year bonds. East Coast Yachts is also
considering whether to issue coupon bearing bonds or zero-coupon bonds. The
yield to maturity on either bond will be 6.5% (APR with semi-annual
compounding). The coupon bond would have a 6.5% coupon rate, paid semi-
annually. The principal amount of both bonds is $1.000.

6) How many of the coupon bonds must East Coast Yachts issue to raise $40
million? How many of the zero-coupon bonds must it issue?

7) In 20 years, what will be the principal repayment due if East Coast Yachts
issues the coupon bonds? What if it issues the zero-coupon bonds? Can
you explain the difference?

2
Assume that East Coast Yachts has issued 40,000 coupon bearing bonds with a
par (face) value of $1,000 that mature in 20 years. The bonds are selling at
87% of par value and have a coupon rate of 7% with annual compounding.

8) Is the yield to maturity of these bonds higher, lower or equal to the


coupon rate of 7%? Calculate the yield to maturity of these bonds?

9) There is an inverse relationship between interest rates and bond prices.


As interest rates rise, bond prices fall, and vice versa. This effect is
relatively stronger the longer the discounting period and the lower the
coupon rate. Show calculations in which you proof these statements.

3
Extra exercises

1) Consider the following bonds with par value of €100:

Coupon Rate Maturity Price at


Bond (annual payments) (years) 7%
A 0% 16 33,87
B 0% 12 44,40
C 2% 16 52,77
D 7% 12 100,00
a) Which of the bonds A–D are most sensitive to a 1%-point drop in
interest rates from 7% to 6% and why? Which bond is least sensitive?
Provide an intuitive explanation for your answer.

Par value 100,00


Yield to
maturity 7,00% Price at Percentage
Bond Coupon Rate Maturity Price 6,00% Change
A 0,00% 16 33,87 39,36 16,21%

B 0,00% 12 44,40 49,70 11,93%

C 2,00% 16 52,77 59,58 12,91%

D 7,00% 12 100,00 108,38 8,38%

The higher the coupon rate, all else the same, the lower the bond’s
sensitivity to interest rate changes, because you receive the cash
flows earlier.
The shorter the bond’s maturity, all else the same, the lower the
bond’s sensitivity to interest rate changes, because cash flows are
discounted over a shorter period of time.
A is the most sensitive to changes in bond yields, since it has the
lowest coupon rate and highest maturity of the four bonds.
D is the least sensitive to changes in bond yields, since it has the
highest coupon rate and lowest maturity of the four bonds.

2) You are thinking about investing in a mine that will produce €10,000
worth of ore in the first year. As the ore closest to the surface will be
removed first, over time it will become more difficult to extract additional
ore. Therefore, the value of the ore that you mine will decline at a rate of
6% per year forever. The appropriate discount rate is 8%. Calculate the
present value of this mining operation. (7 points)

PVP = C/(r - g) = 10,000/(.08 - (-.06)) = 10,000/.14 = 71,429


Note: the formula also works with negative growth rates.

4
3) Your buddy in mechanical engineering has invented a money machine. It
takes one full year to build this machine. The main drawback of the
machine is that it is slow: once the machine is available, it takes one year
to manufacture €105. However, once built, the machine will last forever
and will require no maintenance. Building the machine can start
immediately, and will cost €1,000 today. Your buddy wants to know if it is
smart to invest the money to construct it. If the cost of capital is 10% per
year, what should your buddy do? (7 points)

To decide whether to build the machine, you need to calculate the NPV: The
cash flows the machine generates are a perpetuity with first payment at date
2. Computing the PV at date 1 gives:

PV1 = 105 / 0.10 = 1,050

The value today is

PV0 = 1,050 / 1.1 = 954.55

Thus, NPV = –1,000 + 954.55 = –45.45 < 0.

He should not build the machine.

Note: usefulness of presenting CFs in a timeline.

4) What is the effective biennial rate (the rate over two years) of an
investment with an annual percentage rate (APR) of 10% with semi-
annual (twice a year) compounding? (5 points)

The return per invested euro on this investment over two years equals:

0.1 2𝑥2
(1 + ) − 1 = 0.2155 𝑜𝑟 21.55%.
2
Note the difference between effective rates and simple rates.

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