Problem Sets and Solutions For FNCE 604

+
Alex Edmans
Wharton School, University of Pennsylvania
aedmans@wharton.upenn.edu
Summer 2012

2318 Steinberg Hall - Dietrich Hall, 3620 Locust Walk, Philadelphia, PA 19104-6367. A substantial amount
of this material is taken from the problem sets of Professor Simon Gervais, who taught this course for many
years at Wharton. I am extremely grateful to Simon for allowing me to use his notes. I also thank Indraneel
Chakraborty, James Park and Laila Shabir for their help in typesetting this packet.
1
Contents
1 Problem Sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1 Compounding and Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Bond Pricing - Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 The NPV Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.4 Capital Budgeting under Certainty . . . . . . . . . . . . . . . . . . . . . . . . . 12
2 Solutions to Problem Sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.1 Compounding and Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2 Bond Pricing Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.3 The NPV Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.4 Capital Budgeting under Certainty . . . . . . . . . . . . . . . . . . . . . . . . . 31
3 Practice Placement Exams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.1 Sample Placement Exam A: Questions . . . . . . . . . . . . . . . . . . . . . . . 39
3.2 Sample Placement Exam A: Solutions . . . . . . . . . . . . . . . . . . . . . . . . 44
3.3 Sample Placement Exam B: Questions . . . . . . . . . . . . . . . . . . . . . . . 49
3.4 Sample Placement Exam B: Solutions . . . . . . . . . . . . . . . . . . . . . . . . 53
4 Additional Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
4.1 Solution to DiMaggios Vow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
4.2 Addition to How Treasury Securities Are Quoted: Example . . . . . . . . . . . . 61
4.3 Solution to BICCs Toad Ranch . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
4.4 Capital Budgeting Under Resource Constraints: A More Elaborate Technique . 64
4.5 Short Sales: An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4.6 Mathematics and Statistics: A Reminder . . . . . . . . . . . . . . . . . . . . . . 71
4.7 Linear Algebra: Simple Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
4.8 Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
2
1 Problem Sets
In this section, you will nd problem sets related to the material covered in the bulk pack
and in the textbook by BMA. These problems sets will not be collected and graded; they are
meant to facilitate your preparation for the exam. The checkpoints contained in the lecture
notes will guide you as to when you should start working on the dierent problem sets. These
problem sets are more dicult than the problems in the textbook. If you nd them too hard,
please start with the textbook problems listed at the end of each section of the notes, to work
your way up to these problems.
I have indicated the problems that should be viewed as optional. These problems are
meant to complement the material covered in the other problems, but should not be considered
required. I have also indicated the problems that are more dicult. Do not panic if you need
to spend a little more time on these problems.
3
1.1 Compounding and Discounting
1. Find the values of the 6-month, 1-year and 5-year discount factors (DF
0:5
, DF
1
, DF
5
)
when
(a) the annual percentage rate is 7% compounded annually;
(b) the annual percentage rate is 11% compounded semiannually;
(c) the monthly interest rate is 0.8%;
(d) the continuously compounded annual percentage rate is 9%;
(e) the annual percentage rate is 14.6% compounded daily (assuming 365 days a year).
Show all your calculations.
2. Suppose that a savings account oers you an annual percentage rate of 10% compounded
quarterly. Calculate the equivalent annual rate compounded
(a) every year;
(b) semiannually;
(c) monthly;
(d) daily;
(e) continuously.
Your answers should all show 2 decimals (e.g. 9.12%). Show all your calculations.
3. You have won the Florida state lottery. Lottery ocials oer you the choice of the
following alternative payments:
Alternative 1: $10,000 one year from now.
Alternative 2: $20,000 ve years from now.
Which alternative should you choose if the annual discount rate is
(a) 0%?
(b) 10%?
(c) 20%?
(d) What discount rate makes the two alternatives equally attractive to you?
4. Suppose you deposit $1,000 in an account at the end of each of the next four years. If the
account earns 12% annually, how much will be in the account at the end of seven years?
4
5. Find an expression for the exact eective annual rate of interest at which payments of
$300 at the present, $200 at the end of one year, and $100 at the end of two years will
accumulate to $700 at the end of two years.
6. Suppose that you invest a certain amount of money in a savings account which is earning
an annually compounded interest rate of r. In exactly how many years (as a function of
r) will that amount of money be doubled?
7. Suppose that you invest $100 in a savings account which is earning an annual percentage
rate of 8% (compounded annually). What is the rst year in which the interest credited
to your account for that year exceeds your original investment in the account?
8. The present value of two payments of $100 each to be made at the end of n years and 2n
years is $100. Find a general expression for n if the annual percentage rate (compounded
every year) is r.
9. Your parents make you the following oer: they will give you $500 at the end of every
month for the next ve years if you agree to pay them back $500 at the end of every
month for the following ten years. Should you accept this oer if your opportunity cost
is 12% a year (compounded annually)?
10. A man aged 40 wishes to accumulate a fund for retirement by depositing $1,000 at the
beginning of each year for 25 years. Starting at age 65, he will make 15 annual withdrawals
at the beginning of each year. Assuming that all payments are certain to be made, nd the
amount of each withdrawal starting at age 65 if the annual percentage rate (compounded
annually) is 4% during the rst 25 years but only 3.5% thereafter.
11. Vernal Pool wants to put aside a xed fraction of her annual income as savings for retire-
ment. Ms. Pool is now 40 years old and makes $40,000 a year. She expects her income
to increase 2% annually in real terms. She wants to accumulate $500,000 in real terms to
retire at age 70. What fraction of her income does she need to set aside? Assume that
her retirement fund are invested at an expected real rate of return of 5% a year. Ignore
taxes.
12. A pro-football team oers one of its players the choice between the following contracts:
(a) a yearly salary (payable at the end of every year) of $400,000 for 5 years;
(b) a quarterly salary (payable at the end of every quarter) of $95,000 for 5 years;
(c) a monthly salary (payable at the beginning of every month) of $31,000 for 5 years;
(d) a ve year contract with a lump sum salary of $1.5 million payable now.
5
Assuming an annual percentage rate of 8% compounded semi-annually, which contract
should this player accept? Show all your calculations.
13. Suppose that the annual percentage rate (compounded annually) is 10%. Calculate the
present value of the following perpetuities:
(a) a perpetuity that pays $500 every year with the rst payment occurring in 2 years
from now;
(b) a perpetuity that pays $500 every year with the rst payment occurring in 3 years
from now;
(c) a perpetuity that pays $500 every six months with the rst payment occurring in
4 years from now;
(d) a perpetuity payable annually with the rst payment of $100 now and each additional
payment growing at 2% annually.
14. A savings and loan association pays 4% annual interest on deposits at the end of each
year. At the end of every three years, a 2% bonus is paid on the balance (after interest)
at that time. Find the eective annual rate of interest earned by an investor if he leaves
his money on deposit
(a) two years;
(b) three years;
(c) four years.
15. A credit card company charges its customers an interest rate of 1.583% on their monthly
balance. The company claims that this is equivalent to an annualized rate of 18.996%.
Whats wrong with their claim? What does the rate of 18.996% represent?
16. An oil production platform in Alaskas Cook Inlet will operate for 15 more years. At
the end of that time, environmental regulations require dismantlement and removal. The
current cost of this would be $10 million, but the cost is expected to increase by 5% per
year.
(a) What is the present value of the future cost? Assume an annual discount rate of
11% (compounded annually).
(b) Suppose new regulations require the oil platforms owner to contribute an equal
annual nominal amount to build up a trust fund sucient to cover dismantlement
and removal at the end of year 15. The trust fund has to be invested in U.S. Treasury
bonds yielding 6.5% per year. How much will the oil company have to put in at the
end of each year?
6
17. (Optional): The present value of an annuity which pays $200 at the beginning of every
6-month period during the next 10 years and $100 at the beginning of every 6-month
period during the following 10 years is $4,000. The present value of a 10-year deferred
annuity which pays $250 at the beginning of every 6-month period for 10 years is $2,500.
Find the present value of an annuity paying $200 at the beginning of every 6-month period
during the next 10 years and $300 at the beginning of every 6-month period during the
following 10 years.
18. (Dicult): Suppose that the annual percentage rate (compounded annually) is r. Calcu-
late the present value of the following perpetuities:
(a) a perpetuity paying $C every n years, with the rst payment occurring at the end
of n years;
(b) a linearly growing perpetuity which pays $1 at the end of the rst year, $2 at the
end of the second year, $3 at the end of the third year, etc.
19. (Optional, Dicult): The one-year compounding factor when the annual percentage rate r
is compounded m times a year is given by
CF
1
=
_
1 +
r
m
_
m
:
Show that this compounding factor tends to e
r
as m tends to innity, i.e. show that
lim
mo
_
1 +
r
m
_
m
= e
r
:
7
1.2 Bond Pricing - Term Structure
1. A Treasury bond has the following characteristics:
Principal: $1,000.
Term to maturity: 20 years.
Coupon rate: 8 percent.
Semiannual payments.
Calculate the price of the bond if the stated annual percentage rate (compounded annu-
ally) is
(a) 8 percent;
(b) 10 percent;
(c) 6 percent.
2. A riskless bond with a par value of $1,000 is sold at $923.14. The bond has 15 years to
maturity and investors require a 5% semiannual yield on the bond. What is the coupon
rate for the bond if the coupon is paid semiannually?
3. A two-year bond with a face value of $1,000 pays annual coupons at a rate of 10% (in
other words, the bond pays interest of $100 at the end of each year, and its principal of
$1,000 is paid o in year 2). If the bond sells for $960, what is its yield to maturity?
4. You are given the following bond prices:
Bond Type Face Value Coupon Maturity Price
A Zero Coupon Bond $100 1 year $93.46
B Coupon Bond $100 4% 2 years $94.92
C Coupon Bond $100 8% 3 years $103.64
(a) Assuming that all the bonds make only annual payments, what spot rates are imbed-
ded in these prices?
(b) What forward rates are embedded in these prices?
(c) What should the price of a 3-year bond with a face value of $100 and a 6% annual
coupon be?
(d) (Optional, Dicult): A 3-year bond with a face value of $100 and a 4% annual
coupon is trading at $95.00. Show that this bond is mispriced by showing how you
would take advantage of its price. In doing so, make sure that your arbitrage prots
are realized today.
8
5. You are given the following information on three traded bonds making annual coupon
payments.
Bond Face Value Rate Maturity Yield to Maturity
A $1,000 0.00% 1 year 5.00%
B $1,000 5.00% 2 years 5.85%
C $1,000 10.00% 2 years 6.00%
(a) What are the prices of the above three bonds?
(b) (Optional, Dicult): Is it possible to make arbitrage prots using only these three
bonds? If so, give an arbitrage strategy (making sure that the prots are realized
today).
Hint: Try to solve for the discount factors.
6. You are given the following spot rates and forward rates: f
1
= 6:0%, r
2
= 6:25%, f
3
=
7:0%, and r
4
= 6:75%.
(a) Calculate r
1
, r
3
, f
2
, f
4
.
(b) Describe the shape of the term structure of (spot) interest rates (increasing, decreas-
ing, or . . . ).
(c) Calculate the price of a 4-year bond with a 9% coupon rate and annual coupons.
Assume that the face value of this bond is $1,000.
(d) Is the yield on this bond greater or smaller than 6.5%?
7. A 6%, 6-year bond yields 12%, and a 10%, 6-year bond yields 8%. Calculate the 6-year
spot rate r
6
. (Assume annual coupon payments for both bonds.)
9
1.3 The NPV Rule
1. In Figure 1, the sloping straight line represents the opportunities for investment in the
capital market, and the solid curved line represents the opportunities for investment in
plant and machinery (real assets). The companys only asset at present is $2.6 million in
cash.
Figure 1: This graph is used in problem #1
(a) What is the interest rate?
(b) How much should the company invest in plant and machinery?
(c) How much will this investment be worth next year?
(d) What is the average rate of return on the investment?
(e) What is the marginal rate of return?
(f) What is the present value of this investment?
(g) What is the net present value of this investment?
(h) What is the total present value of the company?
(i) How much will the individual consume today?
(j) How much will he consume tomorrow?
(k) Is he a borrower or a lender?
2. Casper Milktoast has $200,000 available to support consumption in periods 0 (now) and
1 (next year). He wants to consume exactly the same amount in each period. The interest
rate is 8%. There is no risk.
10
(a) How much should he invest, and how much can he consume in each period?
(b) Suppose Casper is given an opportunity to invest up to $200,000 at 10% risk-free.
The interest rate stays at 8%. What should he do, and how much can he consume
in each period
i. if he is not allowed to borrow against future income?
ii. if he is allowed to borrow against future income?
(c) What is the NPV of each opportunity in (b)?
11
1.4 Capital Budgeting under Certainty
1. The rm Nalyd is considering an investment in equipment to produce a new product.
The cost of the equipment is $150,000. This equipment falls into the 5-year asset class
and thus would have to be capitalized and depreciated over 6 years at rates 20%, 32%,
19.2%, 11.52%, 11.52%, and 5.76%. Nalyd expects to use the equipment for three years
and then to sell it for $60,000. For the three years of operation, the equipment will
generate revenues of $40,000 per year and will have operating costs of $3,000 per year. If
the opportunity cost of capital for Nalyd is 12% and its tax rate is 35%, should Nalyd
purchase this equipment?
2. (Dicult): Conocococonut is considering the purchase of a new harvester. They are cur-
rently involved in deliberations with the manufacturer and as of yet the parties have not
come to a settlement regarding the nal purchase price. The management of Conococo-
conut has hired you, a high-priced consultant, to establish the maximum price it should
be willing to pay for the harvester (i.e., the break-even price such that the NPV of the
project would be zero). This will be of obvious use to Conocococonut in their haggling
with the capital equipment manufacturer. You are given the following facts:
The new harvester would replace an existing one that has a current market value of
$20,000.
The new harvester is not expected to aect revenues, but before-tax operating costs
will be reduced by $10,000 per year for ten years.
The old harvester is now ve years old. It is expected to last for another ten years
and to have a resale value of $1,000 at the end of those ten years.
The old harvester was purchased for $50,000 and is being depreciated to zero on a
straight-line basis over ten years.
The new harvester will be depreciated straight-line over its 10 year life to a zero
book value. Conocococonut expects to be able to sell the harvester for $5,000 at the
end of the ten years.
The corporate tax rate is 34% and the rms cost of capital is 15%.
3. The Scampini Supplies Company recently purchased a new delivery truck. The new truck
costs $22,500, and it is expected to generate net after-tax operating cash ows, including
depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected
abandonment values (salvage values after tax adjustments) for the truck are given below.
abandonment value at the end of year
0 1 2 3 4 5
22,500 17,500 14,000 11,000 5,000 0
12
The companys opportunity cost of capital is 10%. Assume that the truck will be used
indenitely i.e. if the truck is sold early, it will be replaced with a new one. Should
the rm operate the truck until the end of its 5-year physical life or, if not, what is its
optimal economic life?
4. The Baldwin Company is considering investing in a machine that produces bowling balls.
The cost of the machine is $100,000 and production is expected to be 8,000 units per
year during the ve-year life of the machine. The expected resale value is $5,000 (in real
terms).
Since the interest in bowling is declining, the management believes that the nominal price
of bowling balls will increase at only 2% per year. The nominal price of bowling balls in
the rst year will be $20. On the other hand, plastic used to produce bowling balls is
rapidly becoming more expensive. Because of this, production costs are expected to grow
at 10% (nominally) per year. First-year nominal production costs will be $10 per unit.
The machine will be depreciated to zero on a straight-line basis over ve years. The
companys tax rate is 34% and its nominal cost of capital is 15%. The rate of ination is
5%.
Should the project be undertaken?
5. A project requires use of spare computer capacity. If the project is not terminated, the
company will need to buy an additional disk at the end of year 2. If it is terminated, the
disk will not be required until the end of year 4. Disks cost $10,000 and last 5 years. The
opportunity cost of capital is 10% (an annual rate compounded annually).
(a) What is the present value of the cost of this extra usage if the project is terminated
at the end of year 2?
(b) What if the project continues indenitely?
6. Pilot Plus Pens is considering when to replace its old machine. The replacement costs
$3 million now and requires maintenance costs of $750,000 at the end of each year during
the machines economic life of ve years. At the end of ve years the new machine would
have a resale value of $100,000. It will be fully depreciated (to zero after ve years) by
the straight-line method. The corporate tax rate is 34% and the appropriate discount
rate is 12%. Maintenance cost, resale value, depreciation and year-end book value of the
existing machine are given as follows.
Year Maintenance Depreciation Book Value Resale
0 - - 1,000,000 1,600,000
1 1,000,000 200,000 800,000 1,200,000
2 1,000,000 200,000 600,000 600,000
13
When should the company replace the machine (now, in one year, or in two years)?
7. (a) Construct an Excel spreadsheet that will calculate the IRR of any ve-year project,
and use it to calculate the IRR of the following two projects.
cash ow at the end of year
project 0 1 2 3 4 5
A -100 10 20 60 25 15
B -100 -50 30 40 60 90
(b) How would you use your spreadsheet to calculate the IRR of a three-year project?
Try it on the following project.
cash ow at the end of year
project 0 1 2 3
C -100 20 40 60
(c) How would you use your spreadsheet to calculate the yield on a ve-year bond with
annual coupon payments? Try it on a ve-year bond with a face value of $1,000 and
a coupon rate of 8%, trading for $950.
8. An engineering rm called Seltaeb is looking at three possible projects, knowing that
it can undertake any (positive) fraction of each project. The yearly cash ows for each
project are given in the following table, along with the number of engineer-hours required
for the projects over the next four years:
cash ow (in $millions) in year engineer-hours
Project 0 1 2 3 4 (in thousand)
A -4 2 2 1 0 25
B -6 -2 3 5 5 35
C -2 -3 0 7 4 60
Seltaeb is facing capital and labor constraints. In particular, the bank from which Seltaeb
is borrowing money for the projects demands that the present value of the rms total
costs for the rst year (i.e., PV of present and rst year costs minus revenues) be smaller
than $8 million. Also, there are currently 10 engineers working for Seltaeb, and the rm
does not want to hire any additional engineer for these projects (and does not expect any
of these engineers to quit the rm in the next four years). These engineers can work for
up to 50 hours a week for 48 weeks a year. Assuming an opportunity cost of capital of
12%, set up the linear programming problem that the rm will have to solve to choose
what fraction of each project to undertake.
Instructions: You should not solve the linear programming problem; just set it up
clearly for somebody else to solve it.
14
9. Project A has a cost of $10,000 and is expected to produce benets (cash ows) of $3,000
per year for ve years. Project B costs $25,000 and is expected to produce cash ows of
$7,400 per year for ve years. Calculate the two projects net present values (NPVs),
internal rates of return (IRRs), and protability indexes (PIs), assuming an opportunity
cost of capital of 12%.
(a) Which project would be selected assuming that they are mutually exclusive, using
each ranking method?
(b) Which should actually be selected?
(c) How could you adjust the method(s) giving you wrong answers in order for it (them)
to give you the right answer?
15
2 Solutions to Problem Sets
This section contains the solutions to the problem sets of section 1.
To optimize your learning and better prepare for the exam, it is highly recommended that
you try solving the problems before looking at their solutions.
16
2.1 Compounding and Discounting
1. (a) DF
0:5
=
1
(1:07)
1=2
= 0:967, DF
1
=
1
1:07
= 0:935, DF
5
=
1
(1:07)
5
= 0:713.
(b) DF
0:5
=
1
1:055
= 0:948, DF
1
=
1
(1:055)
2
= 0:898, DF
5
=
1
(1:055)
10
= 0:585.
(c) DF
0:5
=
1
(1:008)
6
= 0:953, DF
1
=
1
(1:008)
12
= 0:909, DF
5
=
1
(1:008)
60
= 0:620.
(d) DF
0:5
=
1
e
0:09(1=2)
= 0:956, DF
1
=
1
e
0:09(1)
= 0:914, DF
5
=
1
e
0:09(5)
= 0:638.
(e) DF
0:5
=
1
(1:0004)
365(1=2)
= 0:930, DF
1
=
1
(1:0004)
365(1)
= 0:864, DF
5
=
1
(1:0004)
365(5)
=
0:482.
2. (a) (1:025)
4
= 1 + ^ r then ^ r = (1:025)
4
1 = 10:38%.
(b) (1:025)
4
=
_
1 +
^ r
2
_
2
then ^ r = 2 [(1:025)
2
1] = 10:13%.
(c) (1:025)
4
=
_
1 +
^ r
12
_
12
then ^ r = 12
_
(1:025)
1=3
1

= 9:92%.
(d) (1:025)
4
=
_
1 +
^ r
365
_
365
then ^ r = 365
_
(1:025)
4=365
1

= 9:88%.
(e) (1:025)
4
= e
^ r
then ^ r = log [(1:025)
4
] = 4 log(1:025) = 9:88%.
3. (a) Alternative 2 because
10;000
1+0%
= 10;000 < 20;000 =
20;000
(1+0%)
5
.
(b) Alternative 2 because
10;000
1:1
= 9;090:91 < 12;418:43 =
20;000
(1:1)
5
.
(c) Alternative 1 because
10;000
1:2
= 8;333:33 > 8;037:55 =
20;000
(1:2)
5
.
(d) We seek to solve
10;000
1 +r
=
20; 000
(1 +r)
5
: = (1 +r)
4
= 2 = r = 2
1=4
1 = 18:92%:
4. There are many ways to attack this problem. One way is to calculate the present value
of your deposits, and then take that amount forward to the end of year 7. The present
value PV is
PV = 1;000a
4[12%
=
1;000
0:12
_
1
1
(1:12)
4
_
= 3; 037:35:
At the end of seven years, this is worth
FV = PV (1:12)
7
= 6; 714:61:
Another way to solve this problem is to notice the fact that the deposit made at the end
of the rst year will accrue interest for six years, the one made at the end of the second
year will accrue interest for ve years, and so on. Therefore,
PV = 1;000(1:12)
6
+ 1;000(1:12)
5
+ 1;000(1:12)
4
+ 1;000(1:12)
3
= 6; 714:61:
Of course, the rst method would be much faster if the deposits were made for 35 years
instead of just four!
17
5. We need to solve
300(1 +r)
2
+ 200(1 +r) + 100 = 700
== 3(1 +r)
2
+ 2(1 +r) 6 = 0
== 1 +r =
2
_
2
2
4(3)(6)
2(3)
=
2
_
76
6
=
1
_
19
3
:
This implies that
r =
1 +
_
19
3
1 =
_
19 4
3
= 11:96%;
since the other root implies r < 0, which does not make any economic sense.
6. We are looking for t which solves CF
t
=2. Since CF
t
= (1 +r)
t
, we have
(1 +r)
t
= 2 == t log(1 +r) = log 2 == t =
log 2
log(1 +r)
:
7. Suppose rst that the annual percentage rate is r. The interest credited to the account in
year t is then 100(1 +r)
t1
r. We are therefore looking for the smallest integer t
+
which
satises 100(1 +r)
t

1
r > 100. First, let us solve for t which satises
100(1 +r)
t1
r = 100 == (1 +r)
t1
r = 1 == (t 1) log(1 +r) + log(r) = 0:
This implies
t = 1
log r
log(1 +r)
;
and t
+
is equal to the smallest integer greater than t. For r = 8%, we have t = 33:82,
which means that year 34 is the rst year in which the interest credited to the account
will exceed the original investment.
8. We are looking for n which solves
100 =
100
(1 +r)
n
+
100
(1 +r)
2n
== 1 =
1
(1 +r)
n
+
1
(1 +r)
2n
== (1 +r)
2n
= (1 +r)
n
+ 1 == (1 +r)
2n
(1 +r)
n
1 = 0:
This means that
(1 +r)
n
=
1
_
1
2
4(1)(1)
2(1)
=
1
_
5
2
:
Since only the positive root makes economic sense, this is equivalent to
nlog(1 +r) = log
_
1 +
_
5
2
_
;
18
so that
n =
log
_
_
5+1
2
_
log(1 +r)
=
log
__
5 + 1
_
log 2
log(1 +r)
=
0:48121
log(1 +r)
:
9. First, let us solve for the equivalent monthly rate ^ r:
(1 + ^ r)
12
= 1:12 then ^ r = (1:12)
1=12
1 = 0:9489%:
The present value of what you get is therefore given by
PV
+
=
500
1 + ^ r
+
500
(1 + ^ r)
2
+ +
500
(1 + ^ r)
60
=
500
^ r
_
1
1
(1 + ^ r)
60
_
= 22;793:90:
The present value of what you will have to pay back is given by
PV

=
1
(1 + ^ r)
60
_
500
1 + ^ r
+
500
(1 + ^ r)
2
+ +
500
(1 + ^ r)
120
_
=
1
(1 + ^ r)
60
500
^ r
_
1
1
(1 + ^ r)
120
_
= 20;272:89:
Since the present value of the money you will get is larger than that you will have to pay
back (PV
+
> PV

), you should accept the oer.

10. First, let us recall some notation from the lecture notes: let a
n[r
(resp. a
n[r
) denote the
present value of an n-year annuity payable at the end (resp. beginning) of each year when
the annual rate of interest is r. From the lecture notes, we have
a
n[r
=
1
r
_
1
1
(1 +r)
n
_
; and (1)
a
n[r
=
1 +r
r
_
1
1
(1 +r)
n
_
: (2)
The amount of each yearly withdrawal, which we denote by W, must solve
1;000a
n[r
=
1
(1:04)
25
W a
n[r
:
Using (1) above, we have a
25[4
= 16:25 and a
15[3:5
= 11:92, so that
W =
1;000(16:25)(1:04)
25
11:92
= 3;633:38:
11. Let us solve this whole problem in real terms. The present value of what she wants to
accumulate is
500;000
(1:05)
30
. Her income, which grows at 2% in real terms, has a present value
19
of
40;000
_
1:02
1:05
+
(1:02)
2
(1:05)
2
+ +
(1:02)
30
(1:05)
30
_
:
This last expression is equal to 40;000a
30[^ r
, where 1 + ^ r =
1:05
1:02
. So, if she saves a fraction
of her income, she wants to make sure that:
40;000a
30[^ r
=
500;000
(1:05)
30
then = 14:64%:
12. In what follows, we calculate the present value of each of these contracts.
(a) The equivalent annual rate ^ r must solve 1 + ^ r = (1:04)
2
, which implies ^ r = 8:16%.
Using the notation from the last problem, the present value of this contract is there-
fore
400;000a
5[8:16%
=
400;000
0:0816
_
1
1
(1:0816)
5
_
= 1;590;371:72:
(b) The equivalent quarterly rate ^ r must solve (1 + ^ r)
4
= (1:04)
2
, which implies ^ r =
1:98%. The present value of this contract is therefore
95;000a
4[1:98%
=
95;000
0:0198
_
1
1
(1:0198)
20
_
= 1;556;329:80:
(c) The equivalent monthly rate ^ r must solve (1 + ^ r)
12
= (1:04)
2
, which implies ^ r =
0:656%. The present value of this contract is therefore
31;000a
12[0:656%
=
31;000(1:00656)
0:00656
_
1
1
(1:00656)
60
_
= 1;543;636:15:
(d) The present value of this lump-sum contract is obviously 1,500,000.
The player should accept contract (a).
13. (a) The value of the perpetuity at the end of the rst year is
PV
1
=
500
0:10
= 5;000:
Today, this is worth
PV =
PV
1
1:10
=
500
0:10
1
1:10
= 4;545:45:
(b) The value of the perpetuity at the end of the second year is
PV
2
=
500
0:10
= 5;000:
20
Today, this is worth
PV =
PV
2
(1:10)
2
=
500
0:10
1
(1:10)
2
= 4;132:23:
(c) The equivalent semiannual rate ^ r must solve (1+^ r)
2
= 1:1, which implies ^ r = 4:88%.
The present value of this perpetuity is therefore given by
PV =
1
(1:0488)
8

500(1:0488)
0:0488
= 7;338:33:
(d) Using the formula in the lecture notes, we have
PV =
100(1:10)
0:10 0:02
= 1;375:00:
14. For each question, let ^ r denote the equivalent annual rate.
(a) (1 + ^ r)
2
= (1:04)
2
then ^ r = 4%.
(b) (1 + ^ r)
3
= (1:04)
3
(1:02) then ^ r = 4:69%.
(c) (1 + ^ r)
4
= (1:04)
4
(1:02) then ^ r = 4:52%.
15. The credit card company claims that the annual percentage rate is 12 1:583% = 18:996%.
However, with monthly compounding, the eective annual rate is (1:01583)
12
1 =
20:74%. The rate of 18.996% corresponds to an annual rate compounded monthly.
16. (a) The removal cost will be 10;000;000(1:05)
15
in 15 years, so that the present value is
PV =
10;000;000(1:05)
15
(1:11)
15
= 4;345;050:
(b) The (end-of-year) annual payments A must accumulate to 10;000;000(1:05)
15
in 15
years. Since these payments are invested at 6.5%, equating present values yields:
A a
15[6:5
=
10;000;000(1:05)
15
(1:065)
15
then A = 859;694:
17. Denote the present value of an annuity paying $1 at the beginning of every 6-month period
during the next 10 years by PVA
1
. Denote the present value of a 10-year deferred annuity
paying $1 at the beginning of every 6-month period for 10 years by PVA
2
. We have:
21
200PV A
1
: + : 100PV A
2
= 4;000 and
250PV A
2
= 2;500:
Solving for PV A
1
and PV A
2
yields PV A
1
= 15 and PV A
2
= 10. The desired present
value is therefore given by
200PV A
1
+ 300PV A
2
= 6;000:
18. (a) We are interested in calculating
PV =
C
(1 +r)
n
+
C
(1 +r)
2n
+
C
(1 +r)
3n
+ :
Observe that
PV
(1 +r)
n
=
C
(1 +r)
2n
+
C
(1 +r)
3n
+ ;
so that
PV
PV
(1 +r)
n
=
C
(1 +r)
n
which, after rearranging, yields
PV =
C
(1 +r)
n
1
:
(b) Let PVP
t
denote the present value of a t-year deferred perpetuity paying $1 at the
beginning of every year. It can be shown that
PVP
t
=
1
(1 +r)
t

1 +r
r
=
1=r
(1 +r)
t1
:
Also, notice that the perpetuity that we are interested in is simply the sum of
a 1-year deferred perpetuity paying $1 at the beginning of every year;
a 2-year deferred perpetuity paying $1 at the beginning of every year;
a 3-year deferred perpetuity paying $1 at the beginning of every year;

Therefore,
PV = PVP
1
+PVP
2
+PVP
3
+ = 1=r +
1=r
1 +r
+
1=r
(1 +r)
2
+
22
Observe that
PV
1 +r
=
1=r
1 +r
+
1=r
(1 +r)
2
+ ;
so that
PV
PV
1 +r
=
1
r
:
After rearranging terms, we nd that
PV =
1 +r
r
2
:
19. Recall that the limit of a function is the function of the limit. Also, observe that
lim
mo
log(CF
1
) = lim
mo
mlog
_
1 +
r
m
_
= lim
mo
log
_
1 +
r
m
_
1=m
= lim
mo
1
1+r=m
_
r
m
2
_
1=m
2
= lim
mo
r
1 +r=m
= r;
where we used LHpitals rule to start the second line. We therefore have
lim
mo
CF
1
= lim
mo
e
log(CF
1
)
= e
limm!1log(CF
1
)
= e
r
;
as desired.
23
2.2 Bond Pricing Term Structure
1. The semi-annual interest payment is $1;000
0:08
2
= $40. There are a total of 40 periods of
six months, i.e. two a year for 20 years. If the annual percentage rate is r, the appropriate
equivalent 6-month discount rate is obtained by solving for ^ r in
(1 + ^ r)
2
= 1 +r = ^ r =
_
1 +r 1:
The price of the bond is then
P = 40a
40[^ r
+
1;000
(1 + ^ r)
40
=
40
^ r
_
1
1
(1 + ^ r)
40
_
+
1;000
(1 + ^ r)
40
:
(a) ^ r = 3:923%; P = 1;015:41.
(b) ^ r = 4:881%; P = 846:35.
(c) ^ r = 2:956%; P = 1;242:96.
2. Let C denote the semiannual coupon. The bond price must satisfy
923:14 = Ca
30[5
+
1;000
(1:05)
30
= 923:14 = C 15:37245 +
1;000
(1:05)
30
= C = 45:
The coupon rate is therefore
452
1;000
= 9%.
3. Let DF =
1
1+y
denote the annual discount rate implied by the yield y. The bond price
must satisfy
960 = 100DF + 1;100DF
2
= 1;100DF
2
+ 100DF 960 = 0
= DF =
100 +
_
(100)
2
4(1;100)(960)
2(1;100)
= 0:88984936:
Note that we discarded the negative root, which does not make any economic sense. The
yield of the bond is therefore y =
1
DF
1 = 12:3786%.
4. (a) First, lets nd the discount factors for 1, 2, and 3 years: DF
1
, DF
2
, and DF
3
. We
know that the present value of a stream of cash ows is the sum of the present values
of each individual cash ow:
PV = (C
1
DF
1
) + (C
2
DF
2
) + + (C
T
DF
T
) :
24
Therefore, our three bonds must satisfy:
100DF
1
= 93:46
4DF
1
+ 104DF
2
= 94:92
8DF
1
+ 8DF
2
+ 108DF
3
= 103:64
Solving for DF
1
, DF
2
, and DF
3
, we get
DF
1
= 0:9346; DF
2
= 0:8767; DF
3
= 0:8255:
We can now solve for r
1
, r
2
, and r
3
using
r
t
=
_
1
DF
t
_
1=t
1; t = 1; 2; 3:
We nd r
1
= 7:00%, r
2
= 6:80%, and r
3
= 6:60%.
(b) The forward rates f
1
, f
2
, and f
3
are given by
f
1
=
1
DF
1
1 = 7:00% = r
1
;
f
2
=
DF
1
DF
2
1 = 6:60%;
f
3
=
DF
2
DF
3
1 = 6:21%:
(c) The price of this bond is given by:
P = 6DF
1
+ 6DF
2
+ 106DF
3
= 6(0:9346) + 6(0:8767) + 106(0:8255) = 98:37:
(d) The price of this bond should be given by:
P = 4DF
1
+ 4DF
2
+ 104DF
3
= 4(0:9346) + 4(0:8767) + 104(0:8255) = 93:09:
Since this is smaller than 95.00, we could sell this bond for $95.00, and buy a portfolio
of bonds A, B and C which would replicate it. Consider a portfolio consisting of n
A
of the A-bond, n
B
of the B-bond, and n
C
of the C-bond. This portfolio would pay
100n
A
+ 4n
B
+ 8n
C
25
at the end of the rst year. Since we would like to replicate a payo 4 at the end of
that year, we should choose n
A
, n
B
, and n
C
such that
100n
A
+ 4n
B
+ 8n
C
= 4: (3)
Similar reasonings for the second and third years result in:
104n
B
+ 8n
C
= 4; and (4)
108n
C
= 104: (5)
Solving (3), (4), and (5) for n
A
, n
B
and n
C
, we obtain
n
A
= n
B
=
25
702
; n
C
=
26
27
:
So consider the following strategy:
Strategy C
0
C
1
C
2
C
3
Sell 3-yr bond with 4% coupon 95.00 -4.00 -4.00 -104.00
Sell
25
702
A-bond 3.33 -3.56 0 0
Sell
25
702
B-bond 3.38 -0.14 -4.00 0
Buy
26
27
C-bond -99.80 7.70 7.70 104.00
Total 1.91 0 0 0
This $1.91 is an arbitrage opportunity.
5. (a) Using the denition of yield to maturity, the price of Bond A is given by
1; 000
1:05
= $952:381:
Similarly, the price of Bond B is given by
50
1:0585
+
1;050
(1:0585)
2
= $984:383;
and the price of Bond C is given by
100
1:06
+
1;100
(1:06)
2
= $1;073:336:
(b) We can use the rst two bonds to solve for the discount factors:
_
952:381 = 1;000 DF
1
984:383 = 50 DF
1
+ 1;050 DF
2
==
_
DF
1
= 0:952
DF
2
= 0:892
26
This implies that the price of the third bond should equal
100 DF
1
+ 1;100 DF
2
= 1;076:610:
Since this is not the case, there must be an arbitrage opportunity. In order to nd
the arbitrage opportunity we set up a portfolio of n
A
units of bond A and n
B
units
of bond B so as to replicate the cash ows of bond C:
_
100 = 1;000 n
A
+ 50 n
B
cash ow in 1 year
1;100 = 0 n
A
+ 1;050 n
B
cash ow in 2 years
This gives n
A
= 1=21 and n
B
= 22=21. The portfolio therefore has a cost of
n
A
(952:381) +n
B
(984:383) = $1;076:610:
In order to obtain an arbitrage, we buy bond C and (short) sell the replicating
portfolio (i.e., short sell n
A
units of bond A and n
B
units of bond B). This gives an
immediate prot of
1;076:610 1;073:336 = $3:274
and zero cash ows in years 1 and 2. Here is the complete arbitrage table:
Strategy C
0
C
1
C
2
Buy 1 C-Bond -1,073.336 100.000 1,100
Sell
1
21
A-bond 45.351 -47.619 0
Sell
22
21
B-bond 1,031.258 -52.381 -1,100
Total 3.274 0 0
6. (a) We have
r
1
= f
1
= 6:0%; and
f
2
=
(1 +r
2
)
2
1 +r
1
1 = 6:50059%:
The 3-year spot rate r
3
must solve:
(1 +r
3
)
3
= (1 +r
2
)
2
(1 +f
3
) = 1:2079297 then r
3
= 6:49941%:
Finally, we have
f
4
=
(1 +r
4
)
4
(1 +r
3
)
3
1 =
(1 +r
4
)
4
(1 +r
2
)
2
(1 +f
3
)
1 = 7:50530%:
(b) Since we have r
1
< r
2
< r
3
< r
4
, the term structure is increasing.
27
(c) The price of this bond is given by
P =
90
1 +r
1
+
90
(1 +r
2
)
2
+
90
(1 +r
3
)
3
+
1;090
(1 +r
4
)
4
= 1;078:5094:
(d) All we need to do is to discount the bonds cash ows with a (at) rate of 6.50%, and
see whether the result is greater than P (which implies a yield greater than 6.50%)
or smaller than P (which implies a yield smaller than 6.50%):
90
1:065
+
90
(1:065)
2
+
90
(1:065)
3
+
1;090
(1:065)
4
= 1;085:64:
Since 1;085:64 > P, the yield on this bond is greater than 6.50%.
7. By the denition of yield, the price of the rst bond is given by
P
1
=
60
1:12
+
60
(1:12)
2
+ +
60
(1:12)
5
+
1; 060
(1:12)
6
=
60
0:12
_
1
1
(1:12)
6
_
+
1;000
(1:12)
6
= 753:32:
Similarly, the price of the second bond is given by
P
2
=
100
1:08
+
100
(1:08)
2
+ +
100
(1:08)
5
+
1; 100
(1:08)
6
=
100
0:08
_
1
1
(1:08)
6
_
+
1;000
(1:08)
6
= 1;092:46:
Of course, we know that we can rewrite the expressions for these prices as
60DF
1
+ 60DF
2
+ + 1;060DF
6
= 753:32; (6)
and
100DF
1
+ 100DF
2
+ + 1;100DF
6
= 1;092:46: (7)
Now, let us subtract 0.6(7) from (6) (observing that DF
1
, : : :, DF
5
will cancel out):
1; 060DF
6
0:6(1;100)DF
6
= 753 0:6(1;092:46)
== 400DF
6
= 97:85 == DF
6
= 0:2446
==
1
(1 +r
6
)
6
= 0:2446 == r
6
= 26:45%:
28
2.3 The NPV Rule
1. (a)
5
4
1 = 25%.
(b) $2.6 million $1.6 million = $1.0 million.
(c) $3 million.
(d)
3
1
1 = 200%.
(e) 25%.
(f) $4 million $1.6 million = $2.4 million.
(g) $2.4 million $1 million = $4 million $2.6 million = $1.4 million.
(h) $4 million.
(i) $1 million.
(j) $3.75 million.
(k) He is a lender (since he consumes less than $1.6 million today).
2. (a) If Casper invests I, he will consume 200;000 I today, and I 1:08 next year. He
wants
200;000 I = I 1:08;
which implies an investment of I = 96;153:85. He can then consume 200;000
96;153:85 = 103;846:15 in each period.
(b) i. Casper must choose the amount I (to be invested at 10%) so that
200;000 I = I 1:10:
This implies that he invests I = 95;238:10, and consumes 200;000 95;238:10 =
104;761:90 in each period.
ii. If Casper is allowed to borrow against future income, he should invest the entire
$200; 000 at 10%, and borrow B (at a rate of 8%) so that
B = 200;000(1:10) B(1:08)
This implies B = 105; 769:23, and this is the amount that Casper can consume
in each period.
(c) i. The net present value of the opportunity in (b.i) is
NPV = 95; 238:10 +
95; 238:10(1:10)
1:08
= 1; 763:66:
29
ii. The net present value of the opportunity in (b.ii) is
NPV = 200; 000 +
200; 000(1:10)
1:08
= 3; 703:70:
30
2.4 Capital Budgeting under Certainty
1. The NPV of this project is given by
NPV =cost of equipment +PV (after-tax net operating prots)
+PV (depreciation tax shield) +PV (equipment sale) PV (tax on equipment sale):
These PVs are calculated as follows:
PV (after-tax net operating prots) = (1 0:35)
40;000 3;000
0:12
_
1
_
1
1:12
_
3
_
= 57;764:04;
PV (depreciation tax shield) = 0:35(150;000)
_
0:2
1:12
+
0:32
(1:12)
2
+
0:192
(1:12)
3
_
= 29;942:60;
PV (equipment sale) =
60;000
(1:12)
3
= 42;706:81;
PV (tax on equipment sale) =
0:35 [60;000 (1 0:2 0:32 0:192)150;000]
(1:12)
3
= 4;185:27:
This gives us NPV = 23;771:81 < 0, so that Nalyd should not purchase this equipment.
2. The current book value of the old harvester is
50;000 5
_
50;000
10
_
= $25;000:
The incremental cash ow at t = 0 if the new harvester is purchased is therefore
C
0
= 20;000 + 0:34(25;000 20;000) P = 21;700 P
where we have have taken into account the tax eect of the book loss on the sale of the
old harvester. The incremental cash ow between years 1 and 5 equals the after-tax cost
savings plus the tax eect of the incremental depreciation:
C
t
= (1 0:34)10;000 + 0:34
_
P
10
5;000
_
= 4;900 + 0:034P (t = 1; :::; 5)
After year 5, the old harvester would have been completely depreciated, so that the
incremental cash ow between years 6 and 9 is:
C
t
= (1 0:34)10;000 + 0:34
P
10
= 6;600 + 0:034P (t = 6; :::; 9)
Finally, the incremental cash ow in year 10 reects the incremental salvage value of the
31
new harvester and the consequent tax increase:
C
10
= (1 0:34)10;000 + 0:34
P
10
+ (5;000 1;000) 0:34(5;000 1;000)
= 9;240 + 0:034P
The NPV of the project is then:
NPV =
10

t=0
C
t
1:15
t
= 21;700 P +
4;900 + 0:034P
0:15
_
1
1
(1:15)
5
_
+
6;600 + 0:034P
0:15 (1:15)
5
_
1
1
(1:15)
4
_
+
9;240 + 0:034P
(1:15)
10
= 49;778 0:829P:
Setting NPV =0 and solving for P gives P = $60;019. This is the maximum price that
Conocococonut would be willing to pay for the new harvester.
3. If the truck is replaced after n years, its net present value is given by
NPV
n
= 22;500 +
6;250
0:1
_
1
1
(1:1)
n
_
+
A
n
(1:1)
n
;
where A
n
is the abandonment value of the truck at the end of year n (these values are
given in the problems table). These NPVs are calculated in the table below.
n
1 2 3 4 5
NPV
n
-909.09 -82.64 1,307.29 726.73 1,192.42
Since these ve mutually exclusive projects have dierent lives, we need to calculate the
equivalent annual cash ow for each of them. In particular, we need to calculate EACF
n
which solves
EACF
n
0:1
_
1
1
(1:1)
n
_
= NPV
n
;
for n = 1; : : : ; 5. These values are given in the following table:
n
1 2 3 4 5
EACF
n
-1,000 -47.62 525.68 229.26 314.56
Since the equivalent annual cash ow for the three-year project is the highest equivalent
annual cash ow, the optimal economic life of the new delivery truck is three years.
32
4. Recall that the present value of a T-year growing annuity paying C at the end of the rst
year and growing at an annual rate g is given by
C
r g
_
1
_
1 +g
1 +r
_
T
_
;
where r is the annual interest rate. First, let us calculate the real rate of interest R:
R =
1:15
1:05
1 = 9:52381%:
The NPV of this project is given by
NPV =cost of machine +PV (after-tax revenues) PV (after-tax production costs)
+PV (depreciation tax shield) +PV (sale of machine) PV (tax on machine sale):
These PVs are calculated as follows:
PV (after-tax revenues) = (1 0:34)
20 8;000
0:15 0:02
_
1
_
1:02
1:15
_
5
_
= 366;413:08;
PV (after-tax production costs) = (1 0:34)
10 8;000
0:15 0:1
_
1
_
1:1
1:15
_
5
_
= 210;452:24;
PV (depreciation tax shield) = 0:34
100;000
5

1
0:15
_
1
1
(1:15)
5
_
= 22;794:65;
PV (sale of machine) =
5;000
(1 +R)
5
= 3;172:69;
PV (tax on machine sale) =
0:34 (5;000 0)
(1 +R)
5
= 1;078:71:
This gives us NPV = 80;849:47 > 0, so that the project should be undertaken.
5. Let us rst calculate the equivalent annual cost C for the disk:
C a
5[10%
= 10;000 then C =
10;000
3:7908
= 2;637:9748:
(a) If the project is terminated, there is no extra usage required, so the cost is zero.
(b) If the project is terminated, the company only needs a new disk at the end of year 4.
Assuming that this investment will have to be renewed every ve years (the life of the
disk), the cash ows will look as follows:
0 1 2 3 4 5 6 7 ...
2,638 2,638 2,638 ...
33
On the other hand, if the project is not terminated, the new disk has to be purchased
at the end of two years. Assuming that the investment is renewed every ve years, the
cash ows will look as follows:
0 1 2 3 4 5 6 7 ...
2,638 2,638 2,638 2,638 2,638 ...
Comparing the last two gures, we conclude that the cost of the extra usage is given
by
2;637:9748
(1:1)
3
+
2;637:9748
(1:1)
4
= 3;783:72:
6. The PV of the cash outows from the new machine is
PV = 3;000;000 + (1 0:34)
750;000
0:12
_
1
1
(1:12)
5
_
0:34
600;000
0:12
_
1
1
(1:12)
5
_
(1 0:34)
100;000
(1:12)
5
= 4;011;539:70:
The equivalent annual cost (EAC) for the new machine solves
4;011;539:70 =
EAC
0:12
_
1
1
(1:12)
5
_
;
which implies
EAC = 1;112;840:15:
The PV of after-tax cash outows over the next two year for the dierent replacement
options are as follows.
Replace now:
PV = 1;600;000 + 0:34(1;600;000 1;000;000) +
EAC
0:12
_
1
1
(1:12)
2
_
= 484;756:64:
Replace in 1 year:
PV = (1 0:34)
1;000;000
1:12
0:34
200;000
1:12

1;200;000
1:12
+ 0:34
1;200;000 800;000
1:12
+
EAC
(1:12)
2
= 465;720:79:
34
Replace in 2 years:
PV = (1 0:34)
1;000;000
0:12
_
1
1
(1:12)
2
_
0:34
200;000
0:12
_
1
1
(1:12)
2
_

600;000
(1:12)
2
= 522;193:88:
Thus, it is best to replace in 1 year.
7. (a) The spreadsheet is available on webCaf and is called IRR.xls. It contains a macro
with instructions on how to run the macro. Alternatively, one can use the Tools
/ Goal Seek option to nd the IRR. The three inputs (for this spreadsheet) are as
follows:
Set cell: B18
To value: 0
By changing cell: B19
The IRR of project A is found to be 8.93%, and that of project B is 11.32%.
(b) One can specify cash ows of zero for years four and ve. The IRR of project C is
8.21%.
(c) The yield of a bond can be calculated as the IRR of a project which has an initial
cash ow equal to the (negative) price of the bond. In this case
The yield of the bond is calculated to be 9.30%.
8. First, the net present value of each of these three projects can be calculated to be (in
$millions): NPV
A
= 0:0918823, NPV
B
= 1:3423590, NPV
C
= 2:8459626. Also, the
present values of their rst year costs are given by
PVC
A
= 4
2
1:12
= 2:2142857;
PVC
B
= 6 +
2
1:12
= 7:7857143; and
PVC
C
= 2 +
3
1:12
= 4:6785714:
The total number of engineer-hours available to Seltaeb for these projects is 10 50
48 4 = 96;000. Letting x
A
, x
B
and x
C
denote the fractions of each project that will be
undertaken, we can therefore write the linear programming problem as follows:
35
Maximize 0.0918823x
A
+ 1.3423590x
B
+ 2.8459626x
C
Subject to 2.2142857x
A
+ 7.7857143x
B
+ 4.6785714x
C
_ 8
25 + 35x
B
+ 60x
C
_ 96
0_ x
A
_ 1; 0_ x
B
_ 1; 0_ x
C
_ 1
9. (a) First, let us calculate the present value of future benets for these two projects:
PV
A
=
3;000
0:12
_
1
1
(1:12)
5
_
= 10;814:33;
PV
B
=
7;400
0:12
_
1
1
(1:12)
5
_
= 26;675:34:
The net present values of the two projects are thus given by
NPV
A
= 10;000 +PV
A
= 814:33; and
NPV
B
= 25;000 +PV
B
= 1;675:34;
so project B would be chosen according to the NPV rule. Now, the internal rates of
return for these projects must solve
0 = 10;000 +
3;000
IRR
A
_
1
1
(1 +IRR
A
)
5
_
; and
0 = 25;000 +
7;400
IRR
B
_
1
1
(1 +IRR
B
)
5
_
:
Solving for the internal rates of return, we obtain IRR
A
= 15:24% > 14:67% =
IRR
B
, so the IRR rule would select project A. Finally, the protability indexes for
these two projects are given by
PI
A
=
NPV
A
10;000
= 0:081; and
PI
B
=
NPV
B
25;000
= 0:067:
Since PI
A
> PI
B
, the protability index rule would also select project A.
(b) Project B, since this is the project that will increase the shareholders wealth the
most.
(c) Let us look at the incremental project B-A. This project costs $25;000 $10;000 =
$15;000, and will produce benets of $7;400$3;000 = $4;000 per year for ve years.
The internal rate of return IRR
BA
must solve
0 = 15;000 +
4;400
IRR
BA
_
1
1
(1 +IRR
BA
)
5
_
;
36
which implies IRR
BA
= 14:29%. Since this rate is greater than the opportunity
cost of capital (12%), we should choose project B over project A. Also, the present
value of this incremental projects future benets is given by
PV
BA
=
4;400
0:12
_
1
1
(1:12)
5
_
= 15;861:02;
so that
PI
BA
=
NPV
BA
15;000
= 0:057:
Since this index is positive, we should again choose project B over project A.
37
3 Practice Placement Exams
This section contains two sample placement exams, along with their solutions.
38
3.1 Sample Placement Exam A: Questions
Part I: Multiple Choice Questions
(Total points: 25)
Instructions: A correct answer to each of these questions is worth 5 points. An incorrect
answer is worth 0. Also, for each question that you choose not to answer, you get 1 point.
If you do choose to answer, write your answer clearly on page 1 of your blue booklet. Your
answers should be capital letters written with a pen. Only the nal answer will be marked and
there shall be no partial credit for the multiple choice questions.
1. A 10-year annuity paying $x at the beginning of every year (i.e. the rst of ten payments
is made today) is worth the same (today) as an annuity of $300 payable every 6 months
for 10 years (20 payments), the rst payment of which is due 66 months from now. If the
annual interest rate (compounded annually) is 3%, nd x.
(a) 232.73
(b) 502.48
(c) 506.23
(d) 508.11
(e) 521.42
2. A machine costing $3,000 must be replaced at the end of 8 years. The resale value of the
machine at the time of replacement is $600. At what annual discount rate (compounded
annually) would it be equally economical to use a similar machine costing $4,000 with a
life of 8 years and a resale value of $1,900? (Assume that there are no taxes.)
(a) 2.4%
(b) 2.7%
(c) 3.0%
(d) 3.3%
(e) 3.6%
3. What is the present value of 15 payments of $100 each received every 18 months (the rst
one occurring in 18 months from now), if the annual discount rate (compounded annually)
is 9%?
(a) $620.43
(b) $875.56
39
(c) $930.61
(d) $951.28
(e) $1,209.10
4. Corporate managers can maximize shareholder wealth by choosing positive NPV projects
because:
(a) all investors have the same preferences.
(b) the unhappy shareholders can sell o their shares.
(c) given the existence of nancial markets, investors will be satised with the same real
investment decisions regardless of personal preferences.
(d) managers are wiser than shareholders regarding investments.
(e) none of the above.
5. In the gure below, the sloping straight line represents the opportunities for investment in
the capital market, and the solid curved line represents the opportunities for investment
in plant and machinery (real assets). The companys only asset at present is $21 million
in cash.
(Note that the gure is not drawn to scale, and that all the numbers are in millions)
Let I denote the optimal amount that should be invested in real assets, and r the interest
rate in capital markets. Calculate I=r.
(a) 3:2 million
(b) 12 million
(c) 32 million
(d) 40 million
(e) 60 million
40
Part II: Essay Questions
(Total points: 75)
Instructions: Each of the following questions is to be answered in the blue booklets. You
can use a pen or a pencil. The number of points for each question is indicated in parentheses
at the beginning of the question. In answering these questions, make sure to show all your
calculations; in particular, no points will be given for calculator shortcuts. Finally, please keep
in mind that I cant grade what I cant read.
1. (20 points) Every year, you receive your entire annual salary at the end of the year. This
year, your end-of-year salary will be $50,000 (in nominal terms). In real terms, you expect
your salary to increase at a rate of 2% per year in the future.
You have decided to start saving for retirement by putting money in a savings account.
You plan to retire in 35 years, and you expect to live for 25 years after that. You assess
that a reasonable lifestyle during those 25 years will require you to have, at the end of
every year, a disposable income of $25,000 in real terms (i.e. the same purchasing power
as $25,000 today).
The nominal interest rate on your savings account is 8%, and it is expected to stay at
that rate forever. The real interest rate is also expected to stay at its current level of
3.5%.
(a) What is the ination rate?
(b) How much money (in nominal terms) will you need to have in your savings account
when you retire, in 35 years (end of year 35), in order to be able to enjoy the lifestyle
that you nd reasonable?
Hint: First calculate the amount that you will need in real terms.
(c) Suppose that you will start saving for retirement at the end of the current year.
Suppose further that you plan to make 35 deposits (one at the end of every year).
All deposits are a xed fraction x of your salary. Find the fraction x that will allow
you to reach your reasonable lifestyle objective.
Hint: You will need to make use of the growing annuity formula.
2. (15 points) You are a nancial analyst for a company that is considering a new project.
If the project is accepted, it will use a fraction of a storage facility that the company
already owns but currently does not use. The project is expected to last 10 years, and
the annual discount rate is 10% (compounded annually).
You research the possibilities, and nd that the entire storage facility can be sold for
$100,000 and a smaller (but big enough) facility can be acquired for $40,000. The book
value of the existing facility is $60,000, and both the existing and the new facilities (if it
41
is acquired) would be depreciated straight line over 10 years (down to a zero book value).
The corporate tax rate is 40%. What is the opportunity cost of using the existing storage
capacity?
Hint: Think about what you would gain and lose if you did not.
3. (15 points) You own a rental building in the city and are interested in replacing the
heating system. You are faced with the following alternatives:
(a) A solar system, which will cost $12,000 to install and $500 at the end of every year
to run, and will last forever (assume that your building will too).
(b) A gas-heating system, which will cost $5,000 to install and $1,000 at the end of every
year to run, and will last 20 years.
(c) An oil-heating system, which will cost $3,500 to install and $1,200 at the end of
every year to run, and will last 15 years.
If your opportunity cost of capital (discount rate) is 10%, which of these three options is
best for you?
4. (25 points) The following bonds are traded in a well functioning market:
Face
Bond Type Value Coupon Maturity Price
A Zero Coupon Bond $100 1 year $92.00
B Coupon Bond $100 8% 2 years $101.32
(a) Assuming that the coupon bond (bond B) makes only annual payments, what dis-
count factors (DF
1
, DF
2
) are imbedded in these prices?
Note: Show all your calculations; no points will be given for answers found by a
sophisticated calculator.
(b) What are the 1-year, and 2-year spot rates (r
1
and r
2
)?
(c) Suppose that you would like to purchase a two-year coupon bond with a face value
of $10,000 and a coupon rate of 6% (with annual coupon payments). Since such a
bond is not traded in this economy, what portfolio of bonds A and B could you form
to satisfy your needs (i.e. how can you replicate this bond using the original two
bonds).
Note: Make sure to describe that portfolio clearly, i.e. what you are buying/selling.
(d) What is the exact yield to maturity on
i. bond A;
42
ii. bond B.
Note: Again, show all your calculations; no points will be given for answers found by
a sophisticated calculator. In particular, you will need to use the following formula
for the roots of ax
2
+bx +c = 0:
x =
b
_
b
2
4ac
2a
:
Your answers should have at least two decimals, like 9.53%.
43
3.2 Sample Placement Exam A: Solutions
PART I: Multiple Choice Questions
1. C. We must have
x ~ a
10[3%
=
300
(1:03)
5
a
20[^ r
;
where the equivalent semiannual interest rate ^ r must satisfy
(1 + ^ r)
2
= 1:03 ^ r = 1:4889157%:
Since ~ a
10[3%
= 8:7861089 and a
20[^ r
= 17:1874132, we nd x = 506:23.
2. D. The interest rate r must satisfy:
3;000 +
600
(1 +r)
8
= 4;000 +
1;900
(1 +r)
8
== 1;000 =
1;300
(1 +r)
8
== r =
_
1;300
1;000
_
1=8
1 = 3:33%:
3. A. First, let us nd the equivalent 18-month rate ^ r:
(1:09)
3=2
= 1 + ^ r = ^ r = 13:79934%:
The present value PV of the annuity is therefore
PV = 100a
15[^ r
=
100
0:1379934
_
1
1
(1:1379934)
15
_
= 620:43:
4. C. See Section I.3.1 of the lecture notes.
5. D. The amount invested in real assets is given by
I = 21 million 15 million = 6 million:
The slope of the straight line (capital market investment opportunities) is (1 +r), that
is
(1 +r) =
34:5
30
= r = 15%:
Therefore, I=r = 40 million.
PART II: Essay Questions
44
1. (a) (4 points) The ination rate is given by
i =
1 +r
1 +R
1 =
1:08
1:035
1 = 4:3478261%:
(b) (8 points) At the end of year 35, the present value PV
R
in real terms of your retire-
ment income is
PV
R
= 25;000a
25[3:5%
=
25;000
0:035
_
1
1
(1:035)
25
_
= 412;037:86:
Since this amount is in real terms, we need to inate it for 35 years. Therefore, the
nominal amount PV
n
needed in the account in 35 years is
PV
n
= 412;037:86(1:043478261)
35
= 1;827;495:55:
(c) (8 points) The present value at time 0 of the amount needed in the account in
35 years is
PV
0
=
412;037:86
(1:035)
35
= 123;601:83:
Alternatively, we could do the calculations in nominal terms:
PV
0
=
1;827;495:55
(1:08)
35
= 123;601:83:
The present value of your 35 contributions should be equal to this amount. In real
terms:
123;601:83 =
50;000x=(1:043478261)
0:035 0:02
_
1
_
1:02
1:035
_
35
_
= x = 9:6713%:
Again, the calculations could have been done in nominal terms, in which case they
grow at g = (1:02)(1 +i) 1 = 6:4347826%:
123;601:83 =
50;000x
0:08 0:064347826
_
1
_
1:064347826
1:08
_
35
_
= x = 9:6713%:
2. (15 points) By selling the existing facility, the company would
gain $100,000 from the sale;
pay a tax of
($100;000 $60;000)(40%) = $16;000
on the capital gain resulting from this sale;
45
lose the yearly depreciation tax shield of
$60;000
10
(40%) = $2;400
for 10 years.
By acquiring the new facility, the company would
pay $40,000 to buy the facility;
gain a yearly depreciation tax shield of
$40;000
10
(40%) = $1;600
for 10 years.
The present value PV of all these gains and losses represents the opportunity cost of using
the existing storage capacity:
PV = 100;000 16;000 2;400a
10[10%
40;000 + 1;600a
10[10%
= 100;000 16;000
2;400
0:10
_
1
1
(1:10)
10
_
40;000 +
1;600
0:10
_
1
1
(1:10)
10
_
= 39;084:35:
3. (15 points) There are two equivalent approaches for solving this problem: (i) repeat the
cash ows to innity (which is already done for alternative A), and calculate and compare
the net present values; (ii) Calculate and compare the equivalent annual costs of the three
alternatives. Let us use the second approach.
(a) The present value of the costs is
PV
A
= 12;000 +
500
0:10
= 17;000:
The equivalent annual cost C
A
must solve
17;000 =
C
A
0:10
=C
A
= 1;700:
(b) The present value of the costs is
PV
B
= 5;000 +
1;000
0:10
_
1
1
(1:10)
20
_
= 13;513:56:
46
The equivalent annual cost C
B
must solve
13;513:56 =
C
B
0:10
_
1
1
(1:10)
20
_
=C
B
= 1;587:30:
(c) The present value of the costs is
PV
C
= 3;500 +
1;200
0:10
_
1
1
(1:10)
15
_
= 12;627:30:
The equivalent annual cost C
C
must solve
12;627:30 =
C
C
0:10
_
1
1
(1:10)
15
_
=C
C
= 1;660:16:
Therefore, alternative B is the best alternative, since it involves the lowest costs.
4. (a) (6 points) Since the price of every bond must be the sum of its discounted cash ows,
the discount factors must solve:
100DF
1
+ = 92:00 (1)
8DF
1
+ 108DF
2
= 101:32 (2)
Using (1), we have DF
1
= 0:92. Using this value for DF
1
in (2), we get
DF
2
=
101:32 8(0:92)
108
= 0:87:
(b) (4 points) The discount factors can be written as
DF
t
=
1
(1 +r
t
)
t
:
Therefore,
r
1
=
1
DF
1
1 = 8:69565%; and (8)
r
2
=
1
DF
1=2
2
1 = 7:21125%: (9)
(c) (7 points) The bond that you would like to purchase will pay 6%($10;000) = $600
at the end of the rst year, and $10,600 at the end of the second year. Let us form
a portfolio containing a quantity n
A
of bond A, and n
B
of bond B. We would like
this portfolio to pay $600 at the end of the rst year, and $10,600 at the end of the
47
second year. Mathematically we would like n
A
and n
B
to satisfy:
100 n
A
+ 8 n
B
= 600 (1)
+ 108 n
B
= 10;600 (2)
Using (2), we have n
B
=
10;600
108
= 98:148148. Using this value for n
B
in (1), we get
n
A
=
600 8(98:148148)
100
= 1:851852:
Therefore, the portfolio that would replicate the 6% coupon bond would consist in
selling 1.851852 units of bond A, and buying 98.148148 units of bond B.
(d) i. (3 points) The yield on a zero-coupon bond with a maturity of t years is simply
the t-year spot rate. Therefore the yield y
A
of bond A is y
A
= r
1
= 8:69565%.
ii. (5 points) The yield to maturity y
B
for bond B has to satisfy
101:32 =
8
1 +y
B
+
108
(1 +y
B
)
2
== 108x
2
+8x101:32 = 0; where x =
1
1 +y
B
:
Solving for x using the quadratic equation formula, we nd
1
1 +y
B
= x =
8
_
(8)
2
4(108)(101:32)
2(108)
= 0:9327379:
Solving for y
B
(ignoring the minus root, which has no economic meaning), we
nd y
B
= 7:26721%.
48
3.3 Sample Placement Exam B: Questions
Part I: Multiple Choice Questions
(Total points: 25)
Instructions: A correct answer to each of these questions is worth 5 points. An incorrect
answer is worth 0. Also, for each question that you choose not to answer, you get 1 point.
If you do choose to answer, write your answer clearly on page 1 of your blue booklet. Your
answers should be capital letters written with a pen. Only the nal answer will be marked and
there shall be no partial credit for the multiple choice questions.
1. In the gure below, the sloping straight line represents the opportunities for investment in
the capital market, and the solid curved line represents the opportunities for investment
in plant and machinery (real assets). The companys only asset at present is $4.2 million
in cash.
(Note that the gure is not drawn to scale, and that all the numbers are in millions)
Let A denote the average rate of return on the optimal real investment, and M the
marginal rate of return on that real investment (i.e. the return on the last dollar invested
in real assets). What is A M?
A) 0 B) 30% C) 60% D) 80% E) 160%
2. Which of the following should be treated as incremental cash ows when deciding whether
to invest in a new manufacturing plant? The site is already owned by the company, but
existing buildings would need to be demolished.
I. The market value of the site and existing buildings.
II. Lost earnings on other products due to executive time spent on the new facility.
III. Future depreciation of the new plant.
49
A) I and II B) I and III C) II and III D) I, II and III
E) fewer than two should be considered as incremental cash ows.
3. A man deposits $200 at the end of every 9 months to a fund earning an annual rate of
6% compounded semiannually. If the fund amounts to $4,500 after 6 years, what was the
initial value of the fund?
A) $1,177 B) $1,839 C) $1,878 D) $2,839 E) $3,849
4. In the gure below, the sloping straight line represents the opportunities for investment in
the capital market, and the solid curved line represents the opportunities for investment
in plant and machinery (real assets). The companys only asset at present is $6.3 million
in cash.
(Note that the gure is not drawn to scale, and that all the numbers are in millions)
Let I denote the amount invested in real assets, and N the net present value of that
investment. What is N I?
A) 2:4 million B) 1:2 million C) 0 D) 1:2 million E) 2:4 million
5. A fund of $5,000 is set up to pay $123.50 at the end of a regular interval indenitely. If
the equivalent semiannual rate on the fund is 5% (this is not the annual rate compounded
semiannually), how frequently are the payments made?
A) monthly B) every 2 months C) every 3 months D) semiannually
E) every 9 months
50
Part II: Essay Questions
(Total points: 75)
Instructions: Each of the following questions is to be answered in the blue booklets. You
can use a pen or a pencil. The number of points for each question is indicated in parentheses
at the beginning of the question. In answering these questions, make sure to show all your
calculations; in particular, no points will be given for calculator shortcuts. Finally, please keep
in mind that I cant grade what I cant read.
1. (20 points) The Baldwin Company is considering investing in a machine that produces
bowling balls. The cost of the machine is $100,000 and production is expected to be 8,000
units per year during the ve-year life of the machine. The expected resale value is $5,000
(in real terms).
Since the interest in bowling is declining, the management believes that the nominal price
of bowling balls will increase at only 2% per year. The nominal price of bowling balls in
the rst year will be $20. On the other hand, plastic used to produce bowling balls is
rapidly becoming more expensive. Because of this, production costs are expected to grow
at 10% (nominally) per year. First-year nominal production costs will be $10 per unit.
As usual, assume that the revenues and costs are realized at the end of every year.
The machine will be depreciated to zero on a straight-line basis over ve years. The
companys tax rate is 34% and its nominal cost of capital is 15%. The rate of ination is
5%.
Should the project be undertaken?
2. (20 points) Anna is turning thirteen today. Her birthday resolution is to start saving
towards the purchase of a sports car that she wants to buy on her 18th birthday. The car
costs $16,000 today, and she expects that the price will grow at 2% per year.
Anna has heard that a local bank oers a savings accounts paying an interest rate of 6%
per year, compounded monthly. She plans to make 60 monthly contributions of $100 each
to the savings account (with the rst contribution made today), and to use the funds in
the account on her 18th birthday as a down payment for the car, nancing the balance
through the car dealer.
She expects that the dealer will oer the following terms for nancing: 48 equal monthly
payments (with the rst one due one month after she takes possession of the car) at an
annual percentage rate (APR) of 8% (compounded annually).
(a) What amount will need to be nanced through the dealer?
(b) Assuming that she is correct about the interest rate charged by the dealer, what will
be the amount of her monthly payment?
51
3. (15 points) You are a small-business owner and are considering two alternatives for your
phone system/equipment:
Plan A Plan B
Initial Cost $50,000 $120,000
Annual maintenance cost $9,000 $6,000
Systems life 20 years 35 years
Salvage value $10,000 $15,000
The appropriate annual discount rate is 8% (compounded annually). Also, for both plans,
the system is depreciated annually on a straight line basis over its life down to its salvage
value. The company will be able to resell the phone system at the end of its life for the
salvage value. The companys tax rate is 35%. Which alternative would you pick?
4. (20 points) Today is your 35th birthday, and you are considering your retirement needs.
You expect to retire at age 65 (on your 65th birthday), and your actuarial tables suggest
that you will live to be 100. You want to move to the Bahamas when you retire. You
estimate that it will cost you $300,000 to make the move (on your 65th birthday), and
that your living expenses will be $30,000 a year after that (starting on your 66th birthday,
and continuing until you die on your 100th birthday). You expect to earn an annual rate
of 8% (compounded annually) on your money.
(a) How much will you need to have saved by your retirement date to be able to aord
this course of action?
(b) You already have $50,000 in savings. How much would you need to save at the end
of each of the next 30 years to be able to aord this retirement plan?
(c) If you did not have any current savings and did not expect to be able to start saving
money for the next ve years (i.e. rst savings payment on your 41st birthday),
how much would you have to set aside each year after that to be able to aord this
retirement plan?
52
3.4 Sample Placement Exam B: Solutions
PART I: Multiple Choice Questions
1. C. The average rate of return on the real investment is
A =
2:88
4:2 2:6
1 = 80%;
and the marginal rate of return on the real investment is equal to the interest rate, that
is
M =
6
5
1 = 20%:
Therefore A M = 60%.
2. A. (I) TRUE. This is part of the opportunity cost of investing in a new manufacturing
plant, as the site and existing buildings could be sold for their market value otherwise.
(II) TRUE. These lost earnings on other products are incremental costs, as they are the
direct result of the new manufacturing plant. (III) FALSE. Depreciation is never a cash
ow.
3. B. The equivalent 9-month interest rate ^ r has to satisfy
(1 + ^ r)
2
=
_
1 +
0:06
2
_
3
then ^ r = 4:533583%:
The present value of the fund today is
4;500
(1 + ^ r)
8
=
4;500
(1:03)
12
= 3156:21:
Let x denote the initial value of the fund. Using the annuity notation, we must have
3156:21 = 200a
8[^ r
+x = 200(6:5868) +x then x = 1;838:84:
4. B. The amount invested in real assets is given by
I = 6:3m3:9m = 2:4m:
The net present value of the investment is
N = 7:5m6:3m = 1:2m:
Therefore, N I = 1:2m.
5. C. The equivalent rate r for periods of 1=m year (m = 12: monthly rate; m = 6:
53
semiannual rate; etc.) must solve
(1:05)
2
= (1 +r)
m
== r = (1:05)
2=m
1:
Therefore, the present value of a perpetuity paying $123.50 at the end of every such period
is given by
PV =
123:50
r
=
123:50
(1:05)
2=m
1
;
which is equal to 5,000. Solving for m, we obtain m = 4, so that the payments are made
every 3 months.
PART II: Essay Questions
1. (20 points) Recall that the present value of a T-year growing annuity paying C at the
end of the rst year and growing at an annual rate g is given by
C
r g
_
1
_
1 +g
1 +r
_
T
_
;
where r is the annual interest rate. First, let us calculate the real rate of interest R:
R =
1:15
1:05
1 = 9:52381%:
The NPV of this project is given by
NPV =cost of machine +PV (after-tax revenues) PV (after-tax production costs)
+PV (depreciation tax shield) +PV (sale of machine) PV (tax on machine sale:
These PVs are calculated as follows:
PV (after-tax revenues) = (1 0:34)
20 8;000
0:15 0:02
_
1
_
1:02
1:15
_
5
_
= 366;413:08;
PV (after-tax production costs) = (1 0:34)
10 8;000
0:15 0:1
_
1
_
1:1
1:15
_
5
_
= 210;452:24;
PV (depreciation tax shield) = 0:34
100;000
5

1
0:15
_
1
1
(1:15)
5
_
= 22;794:65;
PV (sale of machine) =
5;000
(1 +R)
5
= 3;172:69;
PV (tax on machine sale) =
0:34 (5;000 0)
(1 +R)
5
= 1;078:71:
This gives us NPV = 80;849:47 > 0, so that the project should be undertaken.
54
2. (a) (10 points) The monthly interest rate on the Savings Account is
r =
0:06
12
= 0:005:
The present value of Annas contributions to the Savings Account is
PV =
100(1:005)
0:005
_
1
1
(1:005)
60
_
= $5;198:42:
The future value of her contributions on her 18th birthday will therefore be
FV = PV (1:005)
60
= $7;011:89:
On the other hand, the price of the car will be
P = 16;000(1:02)
5
= $17;665:29;
so that the amount that will need to be nanced is
17;665:29 7;011:89 = $10;653:40:
(b) (10 points) The monthly interest rate charged by the dealer is
r = (1:08)
1=12
1 = 0:00643:
Therefore, the amount (C) of Annas monthly payment will solve
10;653:40 =
C
0:00643
_
1
1
(1:00643)
48
_
= C = $258:69:
3. (15 points) The present value of the cost of plan A is
PV
A
= 50;000 +
_
9;000(1 0:35)
50;000 10;000
20
(0:35)
_
a
20[8%

10;000
(1:08)
20
= 50;000 +
_
9;000(0:65)
40;000
20
(0:35)
_

1
0:08
_
1
1
(1:08)
20
_

10;000
(1:08)
20
= 98;417:98:
Since these costs are incurred over 20 years, the equivalent annual cost EAC
A
must satisfy:
98;417:98 = EAC
A
a
20[8%
= EAC
A
(9:8181474) = EAC
A
= 10;024:09:
55
Similarly, the present value of the cost of plan B is
PV
B
= 120;000 +
_
6;000(1 0:35)
120;000 15;000
35
(0:35)
_
a
35[8%

15;000
(1:08)
35
= 120;000 +
_
6;000(0:65)
105;000
35
(0:35)
_

1
0:08
_
1
1
(1:08)
35
_

15;000
(1:08)
35
= 152;201:00:
Since these costs are incurred over 35 years, the equivalent annual cost EAC
B
must satisfy:
152;201:00 = EAC
B
a
35[8%
= EAC
B
(11:6545682) = EAC
B
= 13;059:34:
Since EAC
A
< EAC
B
, plan A if the better plan.
Note: If you calculated the present values for the dierent types of cash ows separately,
you should have found the following after-tax values:
Plan A Plan B
Cost of system -50,000.00 -120,000.00
Annual maintenance costs -57,436.16 -45,452.82
System resale 2,145.48 1,014.52
Depreciation tax-shield 6,872.70 12,237.30
Total -98,417.98 -152,201.00
4. (a) (6 points) The cash ows for the retirement plan are in the following gure:
65 66 67 68 69 ... 99 100
300,000 30,000 30,000 30,000 30,000 ... 30,000 30,000
PV
The present value PV of these cash ows at age 65 is
PV = 300;000 + 30;000a
35[8%
= 300;000 +
30;000
0:08
_
1
1
(1:08)
35
_
= 649;637:05:
(b) (7 points) The present value of savings needed for the retirement plan is given by
649;637:05=(1:08)
30
= 64;559:20. Let x denote the annual amount saved at the end
of each year. The following gure shows the cash ows for the money saved over the
next 30 years:
56
35 36 37 38 39 ... 64 65
50,000 x x x x ... x x
PV
The present value of these cash ows must be equal to 64,559.20, so that x must
satisfy
64;559:20 = 50;000 +x a
30[8%
= 50;000 +
x
0:08
_
1
1
(1:08)
30
_
:
Solving for x, we get x = 1;293:26.
(c) (7 points) If you did not have any current savings and only started saving an annual
amount y in ve years (at age 41), the cash ows would be as follows:
35 ... 40 41 42 ... 64 65
y y ... y y
PV
Again, the present value of these cash ows must be equal to 64,559.02, so that y
must satisfy
64;559:20 =
1
(1:08)
5
y a
25[8%
=
1
(1:08)
5
y
0:08
_
1
1
(1:08)
25
_
:
Solving for y, we get y = 8;886:24.
57
4 Additional Materials
This section contains some extra handouts that will help you go through some of the material
covered in class and in the problem sets. Also included is a list of formulas that you are welcome
to use to solve problems, and to bring to the placement exam.
58
4.1 Solution to DiMaggios Vow
An annuity growing at rate g per period pays C(1 + g)
t1
at the end of every period t, for
t = 1; : : : ; T:
0 1 2 ::: T T + 1 T + 2 :::
C C(1 +g) C(1 +g)
T1
:::
PV
The cash ows from this growing annuity equal the dierence between the cash ows of two
growing perpetuities, one starting at time 1 and the other starting at time T + 1:
0 1 2 ::: T T + 1 T + 2 :::
PV
1
C C(1 +g) C(1 +g)
T1
C(1 +g)
T
C(1 +g)
T+1
:::
PV
2
C(1 +g)
T
C(1 +g)
T+1
:::
Assuming that the per-period rate of interest is r, the present value of the rst perpetuity
is
PV
1
=
C
r g
;
whereas the present value of the second perpetuity is
PV
2
=
C(1 +g)
T
r g
1
(1 +r)
T
:
The present value of the growing annuity is simply the dierence between the above two present
values:
PV = PV
1
PV
2
=
C
r g
_
1
_
1 +g
1 +r
_
T
_
:
To solve the problem, we rst need to calculate the number of periods T, the equivalent
monthly interest rate ^ r, and the equivalent monthly growth rate ^ g.
There are 52 weeks in each of the 30 years for which DiMaggio is planning to buy owers,
so that
T = 52 30 = 1;560:
The equivalent monthly (per-period) interest rate must satisfy:
(1 + ^ r)
52
= 1:06 = ^ r = (1:06)
1=52
1 = 0:1121%:
59
Similarly, the equivalent monthly (per-period) growth rate must satisfy:
(1 + ^ g)
52
= 1:02 = ^ g = (1:02)
1=52
1 = 0:0381%:
The present value of DiMaggios commitment is therefore
PV =
4
^ r ^ g
_
1
_
1 + ^ g
1 + ^ r
_
T
_
= 3;699:21:
60
4.2 Addition to How Treasury Securities Are Quoted: Example
The Ask yld corresponds to the ask yield of the bond. It assumes simple interest
(no compounding or discounting) and a 365-day year. This yield y can be calculated as
follows:
1 +
135
365
y =
100;000
98;113:75
= y = 5:20%:
Simple interest: you convert y to a 135-day rate by simple multiplication and division to
give y
135
365
. If it were compound interest, we would convert it using (1 +y)
135
365
1
Note that the ask yield is just a notational convention. The yield that we will use in this
course is dierent and involves compound interest. It will be introduced shortly
61
4.3 Solution to BICCs Toad Ranch
We will do the NPV calculations in nominal terms and in real terms. Of course, the results
should be exactly the same.
Nominal Terms:
First, we need to calculate the nominal interest rate r. The relationship between nominal
and real rates is as follows:
1 +R =
1 +r
1 +i
= r = (1 +R)(1 +i) 1 = (1:05)(1:06) 1 = 11:3%:
The nominal cash ows at the end of each of the rst few years are shown in Panel A of the
following table:
Cash Flow at End of Year
1 2 3 4 ...
Panel A: Nominal Terms
Revenues 150,000 150,000(1 + i) 150,000(1 + i)
2
150,000(1 + i)
3
...
Other costs 40,000 40,000(1 + i) 40,000(1 + i)
2
40,000(1 + i)
3
...
Labor costs 80,000 80,000(1.01)(1 + i) 80,000(1.01)
2
(1 + i)
2
80,000(1.01)
3
(1 + i)
3
...
Lease 20,000 20,000 20,000 20,000 ...
Panel B: Real Terms
Revenues
150;000
(1+i)
150;000
(1+i)
150;000
(1+i)
150;000
(1+i)
...
Other costs
40;000
(1+i)
40;000
(1+i)
40;000
(1+i)
40;000
(1+i)
...
Labor costs
80;000
(1+i)
80;000
(1+i)
(1.01)
80;000
(1+i)
(1.01)
2 80;000
(1+i)
(1.01)
3
...
Lease
20;000
(1+i)
20;000
(1+i)
2
20;000
(1+i)
3
20;000
(1+i)
4
...
Using the present value formulas for perpetuities derived in section I.1, we can calculate the
following present values of the nominal cash ows (discounting at r):
PV (Revenues) =
150;000
r i
=
150;000
0:113 0:06
= 2;830;188:68;
PV (Other costs) =
40;000
r i
=
40;000
0:113 0:06
= 754;716:98;
PV (Labor costs) =
80;000
r g
=
80;000
0:113 0:0706
= 1;886;792:45;
PV (Lease) =
20;000
r
=
20;000
0:113
= 176;991:15:
The growth rate g for the labor costs is calculated as follows:
(1 +g) = (1:01)(1 +i) = g = (1:01)(1:06) 1 = 7:06%:
62
The NPV of the project is then easily calculated:
NPV = PV (Revenues) PV (Other Costs) PV (Labor Costs) PV (Lease)
= 2;830;188:68 754;716:98 1;886;792:45 176;991:15
= 11;688:09:
Since this NPV is greater than zero, the project should be undertaken.
Real Terms:
Panel B of the above table shows the real cash ows for this project. Not surprisingly, the
nominal year-t cash ows (CF
n
t
) of Panel A and the real year-t cash ows (CF
r
t
) of Panel B
satisfy the following equation:
CF
n
t
= CF
r
t
(1 +i)
t
:
Again, using the present value formulas for perpetuities derived in section I.1, we can calculate
the present values for the dierent categories of cash ows (notice that we now discount at R):
PV (Revenues) =
150;000=(1 +i)
R
=
150;000=(1:06)
0:05
= 2;830;188:68;
PV (Other Costs) =
40;000=(1 +i)
R
=
40;000=(1:06)
0:05
= 754;716:98;
PV (Labor Costs) =
80;000=(1 +i)
R 0:01
=
80;000=(1:06)
0:05 0:01
= 1;886;792:45;
PV (Lease) =
20;000=(1 +i)
R g
=
20;000=(1:06)
0:05 (0:0566038)
= 176;991:15:
The growth rate g for the present value of the lease is calculated as follows:
1
(1 +g) =
1
1 +i
= g =
1
1:06
1 = 5:66038%:
As expected, the present values are exactly the same as before, so the NPV of the project is
again 11,688.09.
1
The negative growth rate only reects the fact that the cash ows are decreasing through time. The same
formulas as usual can still be applied.
63
4.4 Capital Budgeting Under Resource Constraints: A More Elab-
orate Technique
The appropriate way of dealing with capital budgeting in the presence of resource constraints
is to look at it as a constrained maximization problem. Suppose that a $10 million budget limit
applies to the cash ows at times 0 and 1 (now and in one year), and the company faces the
following investment opportunities.
Cash Flows (millions) NPV
Project C
0
C
1
C
2
at 10%
A 10 30 5 21
B 5 5 20 16
C 5 5 15 12
D 0 40 60 13
Assume rst that it is possible to accept fractional investments. Then the capital budgeting
problem can be written as
Maximize 21x
A
+ 16x
B
+ 12x
C
+ 13x
D
subject to 10x
A
+ 5x
B
+ 5x
C
+ 0x
D
_ 10
30x
A
5x
B
5x
C
+ 40x
D
_ 10;
0 _ x
A
_ 1, 0 _ x
B
_ 1, ...
where x
A
denotes the proportion accepted of project A, and so on.
Computers equipped to handle linear programming can easily solve the above problem.
When fractional projects are not feasible, integer programming should be used instead to ac-
count for the additional constraint that x
A
; : : : ; x
D
should all be either 0 or 1. However, linear
programming models are not widely used for a number of reasons. First, they are often expen-
sive to use. Second, since obtaining accurate long-term data is often problematic in the rst
place, applying such sophisticated models may be overkill. Third, the NPV rule assumes that
markets are perfect; in particular, it assumes that capital constraints are non-existent. The
mere presence of these constraints suggests that (constrained) NPV maximization may not be
the right objective.
64
4.5 Short Sales: An Overview
This handout is a reproduction of section 2.4.2 (pages 25-30) of
Sharpe, William F., and Gordon J. Alexander, 1990, Investments, Prentice-Hall, New Jersey.
Introduction
An old adage from Wall Street is to buy low, sell high. Most investors hope to do just
that by buying securities rst and selling them later.
2
However, with a short sale this process
is reversed. The investor sells a security rst and buys it back later. In this case the old adage
about investor aspirations might be reworded as sell high, buy low.
Short sales are accomplished by borrowing stock certicates for use in the initial trade and
then repaying the loan with certicates obtained in a later trade. Note that the loan here
involves certicates, not dollars and cents (although it is true that the certicates at any point
in time have a certain monetary value). This means the borrower must repay the lender by
returning certicates, not dollars and cents (although it is true than an equivalent monetary
value, determined on the date the loan is repaid, can be remitted instead). It also means that
there are no interest payments to be made by the borrower.
Rules Governing Short Sales
Any order for a short sale must be identied as such. The Securities and Exchange Com-
mission has ruled that short sales may not be made when the market price for the security is
falling, on the assumption that the short seller would exacerbate the situation, cause a panic,
and prot therefrom an assumption inappropriate for an ecient market with astute, alert
traders. The precise rule is that a short sales must be made on an up-tick (for a price higher
than that of the previous trade) or on a zero-plus tick (for a price equal to that of the previous
trade but higher than that of the last trade at a dierent price).
Within ve business days after a short sale has been made, the short-sellers broker must
borrow and deliver the appropriate securities to the purchaser. The borrowed securities may
come from the inventory of securities owned by the brokerage rm itself or the inventory of
another brokerage rm. However, they are more likely to come from the inventory of securities
held in street name by the brokerage rm for investors that have margin accounts with the rm.
The life of the loan is indenite, meaning there is no time limit on it.
3
If the lender wants to
sell the securities, then the short seller will not have to repay the loan if the brokerage rm can
borrow shares elsewhere, thereby transferring the loan from one source to another. However, if
the brokerage rm cannot nd a place to borrow the shares, then the short seller will have to
2
After purchasing a security, an investor is said to have established a long position in the security.
3
The New York Stock Exchange, the American Stock Exchange, and NASDAQ publish monthly list of the
short interest in their stocks (short interest refers to the number of shares of a given company that have been
sold short where, as of a given date, the loan remains outstanding). To be on the NYSE or AMEX list, either
the total short interest must be equal to or greater than 100,000 shares or the change in the short interest from
the previous month must be equal to or greater than 50,000 shares. The respective gures for NASDAQ are
50,000 and 25,000.
65
repay the loan immediately. Interestingly, the identities of the borrower and lender are known
only to the brokerage rm that is, the lender does not know who the borrower is and the
borrower does not know who the lender is.
An Example
An example of a short sale is indicated in the diagrams below. At the start of the day, Mr.
Lane owns 100 shares of the XYZ Company, which are being held for him in a street name by
Brock, Inc., his broker. During this particular day, Ms. Smith places an order with her broker
at Brock to short sell 100 shares of XYZ (Mr. Lane believes that the price of XYZ will rise in
the future, whereas Ms. Smith believes it is going to fall). In this situation, Brock takes the
100 shares of XYZ that they are holding in street name for Mr. Lane and sells them for Ms.
Smith to some other investor, in this case Mr. Jones. At this point XYZ will receive notice that
the ownership of 100 shares of its stock has changed hands, going from Brock (remember that
Mr. Lane held his stock in a street name) to Mr. Jones. At some later date, Ms. Smith will tell
her broker at Brock to purchase 100 shares of XYZ (perhaps from a Ms. Poole) and use these
shares to pay o her debt to Mr. Lane. At this point, XYZ will receive another notice that the
ownership of 100 shares has changed hands, going from Ms. Poole to Brock, restoring Brock to
their original position.
66
What happens when XYZ declares and subsequently pays a cash dividend to it stockholders?
Before the short sale, Brock would receive a check for cash dividends on 100 shares of stock.
After depositing this check in their own account at a bank, Brock would write a check for an
identical amount and give it to Mr. Lane. Thus, neither Brock or Mr. Lane has been worse
o by having his shares held in the street name. After the short sales, XYZ will see that the
owner of those 100 shares is not Brock any more but is now Mr. Jones. Thus, XYZ will now
mail the dividend check to Mr. Jones, not Brock. However, Mr. Lane will still be expecting his
dividend check from Brock. Indeed, if there was a risk that he would not receive it, he would
have agreed to have his securities held in street name. Brock would like to mail him a check
for the same amount of dividends that Mr. Jones received from XYZ that is, for the amount
of dividends Mr. Lane would have received from XYZ had he held his stock in his own name.
If Brock does this, they will be losing an amount of cash equal to the amount of the dividends
paid. In order to prevent themselves from experiencing this loss, they make Ms. Smith, the
short seller, give them a check for an equivalent amount!
Consider all the parties involved in the short sale now. Mr. Lane is content, since he has
received his dividend check from his broker. Brock is content, since he has received his dividend
check from his broker. Brock is content since their net cash outow is still zero, just as it was
67
before the short sale. Mr. Jones is content, since he received his dividend check directly from
XYZ. What about Ms. Smith? She should not be upset with having to reimburse Brock for
the dividend check given by them to Mr. Lane, since the price of XYZs common stock can be
expected to fall by an amount roughly equal to the amount of cash dividend, thereby reducing
the dollar value of her loan from Brock by an equivalent amount.
What about annual reports and voting rights? Before the short sale, these were sent to
Brock, who then forwarded them to Mr. Lane. After the short sale, Brock no longer received
them, so what happened? Annual reports are easily procured by brokerage rms free of charge,
so Brock probably got copies of them from XYZ and mailed a copy to Mr. Lane. However,
voting rights are dierent. These are limited to the registered stockholders (in this case, Mr.
Jones) and cannot be replicated in the manner of cash dividends by Ms. Smith, the short seller.
Thus, when voting rights are issued, the brokerage rm (Brock, Inc.) will try to nd voting
rights to give to Mr. Lane (perhaps Brock owns shares or manages a portfolio that owns shares
of XYZ and will give these voting rights to Mr. Lane). Unless he is insistent, however, there
is a chance he will not get his voting rights once his shares have been borrowed and used in a
short sale. In all other matters, he will be treated just as if he were holding the shares of XYZ
in his own name.
As previously mentioned, a short sale involves a loan. Thus, there is a risk that the borrower
(in the example, Ms. Smith) will not repay the loan. In this situation the broker would be left
without the 100 shares that the short seller, Ms. Smith, owes him or her. Either the brokerage
rm, Brock, is going to lose money or else the lender, Mr. Lane, is going to lose money. To
prevent this from happening, the cash proceeds from the short sale, paid by Mr. Jones are not
given to the short seller, Ms. Smith. Instead, they are held in her account with Brock until
she repays her loan. Unfortunately this will not assure the brokerage rm that the loan will be
repaid.
In the example, assume the 100 shares of XYZ were sold at a price of $100 per share. In
this case, the proceeds from the short sale of $10,000 are held in Ms. Smiths account, but she
is prohibited from withdrawing it until the loan is repaid. Now imagine that at some date after
the short sale, XYZ stock rises by $20 per share. In this situation, Ms. Smith owes Brock 100
shares of XYZ with a current market value of 100 shares $120 per share = $12,000 but has
only $10,000 in her account. If she skips town, Brock will have collateral of $10,000 (in cash)
but a loan of $12,000, resulting in a loss of $2,000. However, Brock can use margin requirements
to protect itself from experiencing losses from short sellers who do not repay their loans. In
this example, Ms. Smith must not only leave the short-sale proceeds with her broker, but she
must also give he broker initial margin applied to the amount of the short sale. Assuming the
initial margin requirement is 60%, she must give her broker 0.6 $10,000 = $6,000 in cash.
In this example, XYZ stock would have to rise in value to a price above $160 per share in
order for Brock to be in jeopardy of not being paid. Thus, initial margin provides the brokerage
68
rm with a certain degree of protection. However, this protection is not complete, since it is
not unheard of for stock to rise in value by more than 60%. It is the maintenance margin that
protects the brokerage rm from losing money in such situations. In order to examine the use
of maintenance margin in short sales, the actual margin in a short sale is dened as:
Actual Margin =
Market Value of Assets - Loan
Loan
:
In this example, if XYZ stock rises to $130 per share, the actual margin in Ms. Smiths
account will be
($100 100)(1 + 0:6) ($130 100)
$130 100
= 23%:
Assuming the maintenance margin requirement is 30%, the account is undermargined, and Ms.
Smith will receive a margin call. Just as in margin calls on margin purchases, she will be asked
to put up more margin, meaning she will be asked to add cash or securities to her account.
If, instead of rising, the stock price falls, then the short seller can take a bit more than the
drop in the price of the account in the form of cash, since in this case the actual margin has
risen above the initial margin requirement and the account is thus unrestricted.
4
Having discussed the cases for short sales where the stock price either (1) fell and the
account was thereby unrestricted or (2) went up to such a degree that the maintenance margin
requirement was violated and the account was thereby undermargined, there is one more case
left to be considered. That is the case where the stock price goes up but not to such a degree
that the maintenance margin is violated. In this case, the initial margin requirement has been
violated, which means that the account is restricted. Here, restricted has a meaning similar
to its meaning for margin purchases. That is, any transaction that has the eect of further
decreasing the actual margin in the account will be prohibited.
An interesting question is: what happens to the cash in the short sellers account? When
the loan is repaid, the short seller will have access to the cash (actually, the cash is used to repay
the loan). Before the loan is repaid, however, it may be that the short seller can earn interest
on the portion of the cash balance that represents margin (some brokerage rms will accept
certain securities, such as Treasury bills, in lieu of cash for meeting margin requirements). In
regard to the cash proceeds from the short sale, sometimes the securities may be lent only
on the payment of a premium by the short seller, meaning the short seller not only does not
earn interest on the cash proceeds but must pay a fee for the loan. At other times the lender
may pay the short seller interest on the cash proceeds. Usually, however, securities are loaned
at the brokerage rm keeps the cash proceeds from the short sale and enjoys the use of this
money, and neither the short seller nor the investor who lent the securities receives any direct
compensation. In this case, the brokerage rm makes money not only from the commission
4
Alternatively, the short seller could short sell a second security and not have to put up all (or perhaps any)
of the initial margin.
69
paid by the short seller but also on the cash proceeds from the sale (they may, for example,
earn interest by purchasing Treasury bills with these proceeds.)
70
4.6 Mathematics and Statistics: A Reminder
Problems:
1. The only logarithm that we will use in this course (and in all other nance courses as
a matter of fact) is the natural logarithm. We will denote the natural logarithm of a
positive number x by log x. The objective of this exercise is to remind you of some simple
logarithm manipulations.
(a) Are the following statements true of false.
i. If y = log x, then x = e
y
.
ii. log(x +y) = log x + log y.
iii. log(xy) = log x + log y.
iv. log(x=y) =
log x
log y
.
v. log(x
y
) = y log x.
(b) Solve y
x
= z for x (using natural logarithms only).
(c) What is log (log e
e
)?
2. In this course, we will sometimes be faced with quadratic equations of the form ax
2
+
bx +c = 0.
(a) What is the formula that gives the two roots (zeros) of this equation in terms of a,
b, and c?
(b) Solve
1
x
+ 1 =
2
x
2
for x.
3. To simplify long equations, we will also make use of summation signs.
(a) Calculate

4
n=1
2
n
.
(b) Calculate

3
n=1

3
m=n
mn.
4. Random variables are crucial to the study of nance. This course will often require
calculations of the expected value and the variance of a random variable, as well as
the covariance between two random variables. Suppose that the joint distribution (i.e.
Pr ~ x = x; ~ y = y) of two random variables ~ x and ~ y is given by:
x
0 1
y 1 0.2 0.4
2 0.3 0.1
Calculate the following:
71
(a) Pr ~ x = 0 and Pr ~ x = 1.
(b) Pr ~ y = 1 and Pr ~ y = 2.
(c) Pr(~ x) and Pr(~ y).
(d) Pr(~ x) and Pr(~ y).
(e) Pr(~ x; ~ y).
Solutions:
1. (a) i. True.
ii. False.
iii. True.
iv. False.
v. True.
(b) Take the (natural) logarithm on both sides of y
x
= z to obtain:
log y
x
= log z:
Since the left-hand side of this last expression simplies to x log y using one of the
rules from part (a), we have
x =
log z
log y
:
(c) The (natural) logarithm of e
e
is simply e, and the (natural) logarithm of e is 1. So
log (log e
e
) = log(e) = 1:
(d) The two roots (if they both exist) are given by
x =
b
_
b
2
4ac
2a
:
(e) First multiply both sides of the equation by x
2
to obtain
x +x
2
= 2;
which we can rewrite as
x
2
+x 2 = 0:
We can now use the above formula to get
x =
1
_
(1)
2
4(1)(2)
2(1)
= 1 or 2:
72
(f)

4
n=1
2
n
= 2
1
+ 2
2
+ 2
3
+ 2
4
= 2 + 4 + 8 + 16 = 30.
(g) This one can be calculated step by step:
3

n=1
3

m=n
mn =
_
3

m=1
m(1)
_
+
_
3

m=2
m(2)
_
+
_
3

m=3
m(3)
_
= [1(1) + 2(1) + 3(1)] + [2(2) + 3(2)] + [3(3)]
= 6 + 10 + 9 :=: 25:
(h) Pr ~ x = 0 = 0:2 + 0:3 = 0:5, and
Pr ~ x = 1 = 0:4 + 0:1 = 0:5
(i) Pr ~ y = 1 = 0:2 + 0:4 = 0:6, and
Pr ~ y = 2 = 0:3 + 0:1 = 0:4
(j) E(~ x) = 0 Pr ~ x = 0 + 1 Pr ~ x = 1 = 0:5.
E(~ y) = 1 Pr ~ y = 1 + 2 Pr ~ y = 2 = 1:4.
(k) V ar(~ x) = (0 0:5)
2
Pr ~ x = 0 + (1 0:5)
2
Pr ~ x = 1 = 0:25.
V ar(~ y) = (1 1:4)
2
Pr ~ y = 1 + (2 1:4)
2
Pr ~ y = 2 = 0:24.
(l) Let us solve this one in more details:
Cov(~ x; ~ y) =

x

y
[x E(~ x)] [y E(~ y)] Pr ~ x = x; ~ y = y
= [0 0:5][1 1:4](0:2) + [0 0:5][2 1:4](0:3)
+[1 0:5][1 1:4](0:4) + [1 0:5][2 1:4](0:1)
= 0:04 0:09 0:08 + 0:03 :=: 0:1
73
4.7 Linear Algebra: Simple Methods
As seen in section I.2 of my lecture notes, knowing how to solve a system of linear equations
can often be useful in this course. In this handout, I will try to show you three approaches
for solving systems of linear equations. My goal is not to give you a rigorous exposition of
linear algebra, but rather to give you a few simple methods that (I hope) will help you in your
homeworks and exams.
Lets start with a concrete example: suppose you want to solve the following system of
linear equations, i.e. you want to solve for x; y; z in
2x + y + z = 9 (10)
x + y + 4z = 19 (11)
4x + 3y + z = 15 (12)
First Method: Substitution
The idea of this rst method is to substitute one equation into the others in order to reduce
the 3 3 (3 equations and 3 unknowns) system to a 2 2 system rst, and eventually to a
single equation with one unknown.
For example, lets substitute equation (10) into equations (11) and (12), using the y variable.
5
By this, I mean that we rst write an expression for y in terms of x and z using equation (10):
y = 9 2x z: (13)
Then we use this equation to replace y in each of equations (11) and (12):
x + (9 2x z) + 4z = 19 == x + 3z = 10 (14)
4x + 3(9 2x z) + z = 15 == 2x 2z = 12 (15)
Observe that we have reduced our original 3 3 system of equations to a 2 2 system of
equations given by (14) and (15). We can now repeat the same strategy to reduce this system
to a single equation with a single unknown. For example, lets substitute equation (14) into
equation (15) using the variable x. From (14), we have
x = 3z 10: (16)
5
Note that we could use any of the three equations and any of the three variables.
74
Replacing x with this expression in (15), we get
2(3z 10) 2z = 12 == 6z + 20 2z = 12
== 8z = 32
== z = 4:
Now that we have found z, we can use it in (16) to obtain x:
x = 3(4) 10 = 2:
Finally, we can use the values of x and z in (13) to obtain y:
y = 9 2(2) 4 = 1:
So the solution to the system of equations (10)-(12) is given by x = 2; y = 1; z = 4. In fact,
you can plug these values in (10), (11), (12), and verify that these values of x; y; z do indeed
solve the equations.
Second Method: Diagonal Reduction
This second method requires a little more time to get used to than the rst method. However,
with a little practice, it becomes much faster than the rst method.
To use this method, we rst need to rewrite our original system of equations (10)-(12) in
matrix form. This is done by writing in the rst column the coecients of x in the three
equations. Similarly, the second and third column contain the y and z coecients. Finally, the
last column, which should be separated from the other three, contains the right-hand sides of
each equation. So in this example, we write:
_

_
2 1 1
1 1 4
4 3 1

9
19
15
_

_
In order to solve our problem, we are allowed three kinds of operations on this matrix:
We can multiply (divide) any line by any nonzero constant.
We can interchange any two lines.
We can add (subtract) any multiple of a line to any other line.
75
Suppose for example that we want to interchange line 1 and line 2 above. Then we write
6
_

_
2 1 1
1 1 4
4 3 1

9
19
15
_

_
L
1
L
2
~
_

_
1 1 4
2 1 1
4 3 1

19
9
15
_

_
Suppose that we now want to subtract 2 times line 1 to line 2 of this last matrix. We then
write
7
_

_
1 1 4
2 1 1
4 3 1

19
9
15
_

_
L
2
2L
1
L
2
~
_

_
1 1 4
0 1 7
4 3 1

19
29
15
_

_
The general goal of this method is to eventually obtain an identity matrix,
_

_
1 0 0
0 1 0
0 0 1
_

_
;
in the 3 3 part of the matrix. The rightmost column will then give us the values of x; y; z
that solve our system of equations. This can be achieved by the following steps:
1. Reduce the numbers below the diagonal to zeros.
2. Reduce the numbers above the diagonal to zeros.
6
The symbol ~ means that the two systems are equivalent. The left-right arrow means that we
interchange two lines.
7
The right arrow means that the expression on the left-hand side will replace the line on the right-hand
side.
76
The complete solution to our example is then
8
_

_
2 1 1
1 1 4
4 3 1

9
19
15
_

_
L
1
L
2
~
_

_
1 1 4
2 1 1
4 3 1

19
9
15
_

_
L
2
2L
1
L
2
~
_

_
1 1 4
0 1 7
4 3 1

19
29
15
_

_
L
3
4L
1
L
3
~
_

_
1 1 4
0 1 7
0 1 15

19
29
61
_

_
L
2
L
2
~
_

_
1 1 4
0 1 7
0 1 15

19
29
61
_

_
L
3
L
3
~
_

_
1 1 4
0 1 7
0 1 15

19
29
61
_

_
L
3
L
2
L
3
~
_

_
1 1 4
0 1 7
0 0 8

19
29
32
_

_
1
8
L
3
L
3
~
_

_
1 1 4
0 1 7
0 0 1

19
29
4
_

_
L
1
4L
3
L
1
~
_

_
1 1 0
0 1 7
0 0 1

3
29
4
_

_
L
2
7L
3
L
2
~
_

_
1 1 0
0 1 0
0 0 1

3
1
4
_

_
L
1
L
2
L
1
~
_

_
1 0 0
0 1 0
0 0 1

2
1
4
_

_
The solution to our original system of equations (10)-(12) is therefore given by x = 2; y =
1; z = 4.
Third Method: Matrix Inversion
This method is the quickest of the three methods presented in this handout. However, it
requires a computer or a calculator that performs matrix inversions and multiplications.
9
Also,
I will only present an outline of the method since this method requires more knowledge of linear
algebra.
The systems of equations (10)-(12) can be written in matrix form as
_

_
2 1 1
1 1 4
4 3 1
_

_
_

_
x
y
z
_

_
=
_

_
9
19
15
_

_
:
The solution is then given by
_

_
x
y
z
_

_
=
_

_
2 1 1
1 1 4
4 3 1
_

_
1
_

_
9
19
15
_

_
:
Therefore, the solution to our system of equations can be found by applying the following
8
Note that, once you get used to this method, you dont really need to write anything above ~ at every
step. However, it is a good idea to do so at the beginning so that you can trace back your mistakes.
9
It is possible to perform matrix inversions and multiplications by hand, but it is tedious and not very
important for this course. In any case, I show in the next section how to use a spreadsheet software to perform
such calculations.
77
two steps:
1. Find the (matrix) inverse of
_

_
2 1 1
1 1 4
4 3 1
_

_
.
2. (Matrix) Multiply that inverse by
_

_
9
19
15
_

_
.
Using either a computer (see next section) or a calculator, we rst nd that
_

_
2 1 1
1 1 4
4 3 1
_

_
1
=
_

_
11
8

1
4

3
8

15
8
1
4
7
8
1
8
1
4

1
8
_

_
:
Finally, by (matrix) multiplying this inverse by
_

_
9
19
15
_

_
, we obtain the solution to our system
of equations:
_

_
x
y
z
_

_
=
_

_
11
8

1
4

3
8

15
8
1
4
7
8
1
8
1
4

1
8
_

_
_

_
9
19
15
_

_
=
_

_
2
1
4
_

_
:
Matrix Manipulations Using a Spreadsheet Software
In this section, I show how to use Microsoft Excel to manipulate matrices. The steps to
perform the same manipulations on other spreadsheet software should be similar. The table
below shows the spreadsheet on which I did my calculations.
First in A1:C3, I enter the matrix I want to invert. Then I position the cursor in cell A5,
highlight the range A5:C7, type
= MINVERSE(A1 : C3)
and press Ctrl-Shift-Enter.
10
The inverted matrix appears in A5:C7.
To perform the matrix multiplication, I rst need to enter my second matrix; this is what I
do in E5:E7. Then I position the cursor in cell G5, highlight the range G5:G7, type
= MMULT(A5 : C7; E5 : E7)
and press Ctrl-Shift-Enter. The solution to my system of linear equations then appears in
G5:G7.
10
If you only press Enter, only the top-left cell (cell A5) will appear. The Ctrl-Shift-Enter tells Excel that
you want a matrix as a result.
78
A Few Additional Problems
For practice, you can solve the following systems of linear equations using each of the three
methods. The solutions are also provided so that you can check your answers.
System 1:
x + y = 1
2x + 4y z = 6
y + 2z = 2 Solution : x = 1; y = 2; z = 0:
System 2:
x y z = 0
2x + 4z = 2
2y + 2z = 1 Solution : x =
1
2
; y =
1
4
; z =
1
4
:
79
4.8 Formulas
Mathematics
ax
2
+bx +c = 0 x =
b
_
b
2
4ac
2a
Quadratic Equation
z = e
x
== x = log z Natural Logarithm
z = y
x
== x =
log z
log y
log(x
y
) = y log x
log(xy) = log x + log y
log(x/y) = log(x) - log y
Compounding and Discounting
FV
t
= C(1 +
r
m
)
mt
Compounding m times a year
FV
t
= Ce
rt
Continuous compounding
DF
t
=
1
(1+rt)
t
Discount factor
PV =

T
t=1
Ct
(1+rt)
t
=

T
t=1
C
t
:DF
t
Present value formula
NPV = C
0
+

T
t=1
Ct
(1+rt)
t
=

T
t=0
Ct
(1+rt)
t
Net present value
PV =
C
r
Perpetuity
PV =
C
rg
Growing perpetuity (1st payment: C at 1)
PV =
C
r
[1
1
(1+r)
T
] T-year annuity
PV =
C
rg
[1 (
1+g
1+r
)
T
] T-year growing annuity (1st payment: C at 1)
Note: In these last four formulas, the payments are made at the end of every year. If instead
the payments are made at the beginning of every year, multiply these present values by (1+r).
Bond Prices and the Term Structure
P =

T
t=1
Ct
(1+rt)
t
+
F
(1+r
T
)
T
Bond prices
P =

T
t=1
Ct
(1+y)
t
+
F
(1+y)
T
Bond yields
f
t
=
(1+rt)
t
(1+r
t1
)
t1
1 =
DF
t1
DFt
1 Forward rates
(1+R
t
)
t
=
(1+rt)
t
(1+it)
t
Real interest rates
Capital Budgeting Under Certainty
PI =
PV
C
0
=
C
0
NPV
C
0
Protability Index
0 =

T
t=0
Ct
(1+IRR)
t
Internal Rate of Return
80