Finance 1 – Tutorial 3

6.3 a) and b):

𝟏 ytm
The following table $𝟏𝟎𝟎 𝐭 6.00%
𝐲𝐭𝐦𝐭 = −𝟏
summarizes prices of various 𝐏𝐁
$
default-free, zero-coupon $100 5.00%
𝑦𝑡𝑚$ = − 1 = 0.0394
bonds (expressed as a $96.21
$ 4.00%
percentage of face value): $100 %
Maturity (years) 1 2 3 4 5 𝑦𝑡𝑚% = − 1 = 0.0435
$91.83 3.00%
Price (per $100 $96.21 $91.83 $87.16 $82.51 $77.38 $
face value) $100 &
𝑦𝑡𝑚& = − 1 = 0.0469 2.00%
a) Compute the yield to $87.16
$
maturity for each bond. $100 '
1.00%
𝑦𝑡𝑚' = − 1 = 0.0492
b) Plot the zero-coupon yield $82.51
$
curve (for the first five $100 ( 0.00%
years). 𝑦𝑡𝑚( = − 1 = 0.0526 1 2 3 4 5
$77.38 ytm
c) Is the yield curve upward
sloping, downward
sloping, or flat?
c) The yield curve is upward sloping, the longer the maturity, the
higher the yield
 1 1 𝐹𝑉
𝑃 = 𝐶× 1 − +
6.11 𝑟 1+𝑟 ) 1+𝑟 )

Suppose that Ally Financial Inc. a)

issued a bond with 10 years until
maturity, a face value of $1000, 1 1 $1,000
𝑃 = 1000 × 6% × 1− +
and a coupon rate of 6% (annual 0.1 1.1$* 1.1$*
payments). The yield to maturity 𝑃 = $368.68 + $385.54 = $754.22
on this bond when it was issued
was 10%. b) Two ways:
a) What was the price of this Method 1:
bond when it was issued?
b) Assuming the yield to
1 1 $1,000
𝑃 = $60 + $60× 1− +
maturity remains constant, 0.1 1.1+ 1.1+
what is the price of the bond 𝑃 = $60 + $345.54 + $424.10 = $829.64
immediately before it makes Method 2:
its first coupon payment?
𝑃 = 𝑃, ×(1 + 𝑟)$ = $754.22 × 1.1 = $829.64
c) Assuming the yield to
maturity remains constant, $ $ $$,***
what is the price of the bond c) 𝑃 = $60×
*.$
1−
$.$!
+
$.$!
= $345.54 + $424.10 = $769.64
immediately after it makes its
first coupon payment?
 6.23 v Derive the yield to maturity curve:
$
Prices of zero-coupon, $1000 $
𝑦𝑡𝑚$ = − 1 = 0.0304
default-free securities with $970.51
face values of $1000 are $
$1000 %
summarized in the following 𝑦𝑡𝑚% = − 1 = 0.0331
table: $936.89
$
Maturity (years)
$1000 &
1 2 3 𝑦𝑡𝑚& = − 1 = 0.0342
$903.92
Price (per $1000 face $970.51 $936.89 $903.92
value) v Calculate the price of 3 year bond with a coupon rate of 10%:
$100 $100 $1100
Suppose you observe that a 𝑃0 = + + = $1185.19
1.0304 1.0331% 1.0342&
three-year, default-free
security with an annual v The market price is too low
coupon rate of 10% and a v Buy the bond/sell the “synthetic” bond
face value of $1000 has a
price today of $1180.79. Is Action 𝒕=𝟎 𝒕=𝟏 𝒕=𝟐 𝒕=𝟑
there an arbitrage Buy 10 3-year Bonds ($11807.9) $1000 $1000 $11000
opportunity? If so, show
Sell 1 1 yr ZC Bond $970.51 ($1000) − −
specifically how you would
take advantage of this Sell 1 2 yr ZC Bond $936.89 − ($1000) −
opportunity. If not, why not? Sell 11 3 yr ZC Bond $9943.12 − − ($11000)
Total (Net Cash Flow) $42.62 − − −
6.30
Andrew Industries is 1 1 𝐹𝑉
contemplating issuing a 30-year 𝑃 = 𝐶× 1− ! + !
𝑟 1+𝑟 1+𝑟
bond with a coupon rate of
9.69% (annual coupon
payments) and a face value of
$1000. Andrew believes it can
get a rating of A from Standard a) When originally issued, the price of the bond was:
and Poor’s. However, due to
1 1 $1,000
recent financial difficulties at the 𝑃 = $96.9× 1− + = $978.98 + $71.53
company, Standard and Poor’s is 𝟎. 𝟎𝟗𝟏𝟗 𝟏. 𝟎𝟗𝟏𝟗&* 𝟏. 𝟎𝟗𝟏𝟗&*
warning that it may downgrade = $1,050.51
Andrew Industries bonds to BBB.
Yields on A-rated, long-term
bonds are currently 9.19%, and
yields on BBB-rated bonds are b) If the bond is downgraded, its price will fall to:
9.59%.
1 1 $1,000
a) What is the price of the bond 𝑃 = $96.9× 1− + = $945.66 + $64.10
if Andrew maintains the A 𝟎. 𝟎𝟗𝟓𝟗 𝟏. 𝟎𝟗𝟓𝟗&* 𝟏. 𝟎𝟗𝟓𝟗&*
rating for the bond issue? = $1,009.76
b) What will the price of the
bond be if it is downgraded?
6.35 vInvestors believe Spanish government bonds are more
likely to default than German government bonds
Suppose the yield on
German government bonds is
1.2%, while the yield on vThis is evidenced by the difference in yields between
Spanish government bonds is the two countries
7%. Both bonds are
denominated in euros. Which vInvestors demand a higher yield to hold Spanish bonds
country do investors believe because they demand to be compensated for holding
is more likely to default? How
can you tell? more default risk
A2
What is the forward rate for
year 3 (the forward rate
quoted today for an
investment that begins in two ! !"# #
1 + 𝑌𝑇𝑀! = 1 + 𝑌𝑇𝑀!"# 1 + 𝑓!
years and matures in three
years)? What can you 1 + 𝑌𝑇𝑀! !
conclude about forward rates ⇒ 𝑓! = !"# −1
when the yield curve is flat?
1 + 𝑌𝑇𝑀!"#
1 + 𝑌𝑇𝑀$ $
𝑓$ = % −1
1 + 𝑌𝑇𝑀%
1 + 5.5% $
𝑓$ = % − 1 = 5.5%
1 + 5.5%
When the yield curve is flat, the forward rate equals the
zero-coupon yield.
7.5
Bill Clinton reportedly was paid 𝐶 1
$15 million to write his book My 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎𝑛 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 1− !
Life. Suppose the book took 𝑟 1+𝑟
three years to write. In the time
he spent writing, Clinton could
have been paid to make
speeches. Given his popularity,
a) NPV without royalties:
assume that he could earn $8
million per year (paid at the end
of the year) speaking instead of 𝑁𝑃𝑉 = 𝑃𝑉 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑉 𝐶𝑜𝑠𝑡𝑠
writing. Assume his cost of 8 1
capital is 10% per year. 𝑁𝑃𝑉 = 15 − × 1− " = −$4.895 𝑚𝑙𝑛
a) What is the NPV of agreeing 0.1 1.1
to write the book (ignoring
any royalty payments)?
7.5
Bill Clinton reportedly was paid b) Timeline:
$15 million to write his book My
Life. Suppose the book took
three years to write. In the time
0 1 2 3 4 5 6
he spent writing, Clinton could
have been paid to make
speeches. Given his popularity,
assume that he could earn $8 15
10 –8 –8 –8 5 5(1 – 0.3) 5(1 – 03)2
million per year (paid at the end
of the year) speaking instead of NPV with royalties (royalties are declining
writing. Assume his cost of
capital is 10% per year.
perpetuity):
b) Assume that, once the book
is finished, it is expected to 𝐶 5
generate royalties of $5 𝑃𝑉#" = = = $12.5 𝑚𝑙𝑛
million in the first year (paid 𝑟 − 𝑔 0.1 − −0.3
at the end of the year) and 12.5
these royalties are expected 𝑁𝑃𝑉 = −4.895 + " = $4.496 𝑚𝑙𝑛
to decrease at a rate of 30% 1.1
per year in perpetuity. What
is the NPV of the book with
the royalty payments?
7.13 vIRR Rule:
Professor Wendy Smith has
been offered the following
§ Calculate monthly IRR:
deal: A law firm would like to
retain her for an upfront 1 1
𝑁𝑃𝑉 = 0 = $54,000 − $4,624× 1− → 𝐼𝑅𝑅1 = 0.0042
payment of $54,000. In 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 $%

return, for the next year the

firm would have access to 8
hours of her time every § Convert to annual IRR:
month. Smith’s rate is $578
per hour and her opportunity
cost of capital is 15% (EAR). 𝐼𝑅𝑅! = 1.0042"# − 1 = 0.05158 = 5.158%
What does the IRR rule
advise regarding this
§ The IRR is smaller than the cost of capital → Turn down the offer.
opportunity? What about the
NPV rule?
7.13 vNPV Rule:
Professor Wendy Smith has
been offered the following
§ Calculate monthly effective rate:
deal: A law firm would like to
retain her for an upfront "
payment of $54,000. In 𝑟$ = 1.15"# − 1 = 0.01171 = 1.171%
return, for the next year the
firm would have access to 8
hours of her time every § Calculate NPV:
month. Smith’s rate is $578
per hour and her opportunity 1 1
cost of capital is 15% (EAR). 𝑁𝑃𝑉 = $54,000 − $4,624× 1− $%
= $2,514.44
0.01171 1.01171
What does the IRR rule
advise regarding this
opportunity? What about the v The NPV is positive→ Take the offer.
NPV rule?
7.21 v Payback period – the number of periods it takes to return
You are a real estate agent the initial investment.
thinking of placing a sign
advertising your services at a
$7,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = = 6.25 𝑚𝑜𝑛𝑡ℎ𝑠
local bus stop. The sign will $1,120
cost $7,000 and will be
posted for one year. You
expect that it will generate
additional revenue of $1,120
per month. What is the
payback period?
7.24
You have just started your summer Proposal IRR Year 0 Year 1 Year 2 Year 3
internship, and your boss asks you to
review a recent analysis that was
done to compare three alternative A 60.0% -100 30 153 88
proposals to enhance the firm’s
manufacturing facility. You find that B 50.8% ? 0 206 95
the prior analysis ranked the
proposals according to their IRR, and C 55.8% -100 37 0 204 +?
recommended the highest IRR
option, Proposal A.
You are concerned and decide to redo
the analysis using NPV to determine
whether this recommendation was
appropriate. But while you are
confident the IRRs were computed v Finding missing data – Project B (IRR Rule):
correctly, it seems that some of the
underlying data regarding the cash
flows that were estimated for each $206 $95
proposal was not included in the 𝑁𝑃𝑉! = 0 = −𝑥 + 0 + + → 𝑥 = −$118.29
report. For Proposal B, you cannot
find information regarding the total
1.508" 1.508#
initial investment that was required in
year 0. And for Proposal C, you
cannot find the data regarding v Finding missing data – Project C:
additional salvage value that will be
recovered in year 3. Here is the
information you have:
Suppose the appropriate cost of $37 $204 + 𝑦
capital for each alternative is 10%. 𝑁𝑃𝑉$ = 0 = −$100 + % + 0 + # → 𝑦 = $84.36
Using this information, determine the 1.558 1.558
NPV of each project. Which project
should the firm choose?
7.24
You have just started your summer Proposal IRR Year 0 Year 1 Year 2 Year 3
internship, and your boss asks you to
review a recent analysis that was
done to compare three alternative A 60.0% -100 30 153 88
proposals to enhance the firm’s
manufacturing facility. You find that B 50.8% ? 0 206 95
the prior analysis ranked the
proposals according to their IRR, and C 55.8% -100 37 0 204 +?
recommended the highest IRR
option, Proposal A.
You are concerned and decide to
redo the analysis using NPV to v NPV of the projects:
determine whether this
recommendation was appropriate. But $30 $153 $88
while you are confident the IRRs were 𝑁𝑃𝑉& = −$100 + + " + # = $119.84
computed correctly, it seems that 1.10 1.10 1.10
some of the underlying data regarding
the cash flows that were estimated for
each proposal was not included in the
report. For Proposal B, you cannot
$206 $95
𝑁𝑃𝑉! = −$118.29 + + = $123.33
find information regarding the total
initial investment that was required in
1.10" 1.10#
year 0. And for Proposal C, you
cannot find the data regarding
additional salvage value that will be $37 $288.36
recovered in year 3. Here is the 𝑁𝑃𝑉$ = −$100 + + $0 + = $150.29
information you have: 1.10 1.10#
Suppose the appropriate cost of
capital for each alternative is 10%.
Using this information, determine the
NPV of each project. Which project v Comparing projects by using their IRR is not valid since this measure
should the firm choose? doesn’t take into account the scale of the project and the pattern of
its cash flows over time
7.34
Orchid Biotech Company is
evaluating several development
projects for experimental drugs. v Define:
Although the cash flows are difficult 𝑁𝑃𝑉
to forecast, the company has come 𝑃𝐼(𝑁𝑃𝑉 𝑝𝑒𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) =
up with the following estimates of 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
the initial capital requirements and 𝑁𝑃𝑉 𝑁𝑃𝑉
=
NPVs for the projects. Given a wide 𝐻𝑒𝑎𝑑𝑐𝑜𝑢𝑛𝑡 # 𝑜𝑓 𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ 𝑆𝑐𝑖𝑒𝑛𝑡𝑖𝑠𝑡
variety of staffing needs, the
Project Initial # of NPV PI NPV/Headc
company has also estimated the Capital Scientists ount
number of research scientists
required for each development I $10 2 $10.1 1.01 5.1
project (all cost values are given in
millions of dollars). II $15 3 $19.0 1.27 6.3

a) Suppose that Orchid has a total III $15 4 $22.0 1.47 5.5
capital budget of $60 million.
How should it prioritize these IV $20 3 $25.0 1.25 8.3
projects ?
V $30 12 $60.2 2.01 5.0

a) Prioritize using the PI – V, III, II. These are also the optimal projects to
undertake (as the budget is used up fully taking the projects in order).
𝑇𝑜𝑡𝑎𝑙 𝑁𝑃𝑉 = $101.2
7.34
Orchid Biotech Company is Project Initial # of NPV PI NPV/Headc
evaluating several development Capital Scientists ount
projects for experimental drugs.
Although the cash flows are difficult I $10 2 $10.1 1.01 5.1
to forecast, the company has come
up with the following estimates of II $15 3 $19.0 1.27 6.3
the initial capital requirements and
NPVs for the projects. Given a wide
III $15 4 $22.0 1.47 5.5
variety of staffing needs, the
company has also estimated the
number of research scientists IV $20 3 $25.0 1.25 8.3
required for each development
project (all cost values are given in V $30 12 $60.2 2.01 5.0
millions of dollars).
b) Suppose in addition that Orchid
currently has only 12 research
scientists and does not
anticipate being able to hire b) Prioritize using the NPV/Head# - IV, II, III, I. Both budgets are
any more in the near future. exhausted.
How should Orchid prioritize
these projects? 𝑇𝑜𝑡𝑎𝑙 𝑁𝑃𝑉 = $76.1
c) If instead, Orchid had 15
research scientists available,
explain why the profitability c) The rule cannot be utilized anymore since the ranking doesn’t
index ranking cannot be used exhaust the budget. Choose projects V and IV instead.
to prioritize projects. Which
projects should it choose now?
𝑇𝑜𝑡𝑎𝑙 𝑁𝑃𝑉 = $85.2