Problem Set 4 FIN 7000

Problem 1: Calculate the annual internal rates of return (IRR) for the following
investments (time t is in years):
a. At t = 0, the cost is $100. The cash flows are $100 at t = 1 and $250
at t = 3.
Solution: 100 = 100/ (1+r) + 250/ (1+r) 3
r=0.78
The IRR is 78%
b. At t = 0, the cost is $150. The cash flows are $100 at t = 1 and $250
at t = 3.
Solution: 150 = 100/(1+r) + 250/(1+r) 3
r=0.45
The IRR is 45%
c. At t = 0, the cost is $100. The cash flows are $100 at t = 1 and $250
at t = 2.
Solution: 100 = 100/(1+r) + 250/(1+r) 2
r = 1.158
The IRR is 115.8%
d. At t = 0, the cost is $100. The cash flows are $250 at t = 1 and $100
at t = 3.
Solution: 100 = 250/(1+r) + 100/(1+r) 3
r=1.64
The IRR is 164%
Which of these investments has the highest IRR? Why?
The fourth one has the highest IRR. This is because the fact we get paid more at the
earliest time.
Problem 2: Consider a 10-year bond that pays a 5 percent coupon semiannually with a face value of $1000.
Since the coupon rate is 5 percent semi-annually hence the Bond pays $25 every
six months.
a. What is the price of this bond if the annualized yield to maturity of 4
percent (i.e., the stated rate is .04 compounded semi-annually)?
Solution: T = 20; C=25; r=0.04/2 =0.02; FV=1000
Using the Formula as below:
PV= (C/r) [1-(1/ (1+r) T)] + [F/ (1+R) T]
PV = $1081.75
b. What is the price of this bond if the annualized yield to maturity of 5
percent (i.e., the stated rate is .05 compounded semi-annually)?
Solution: T = 20; C=25; r=0.05/2 =0.025; FV=1000
Using the Formula as below:
PV= (C/r) [1-(1/ (1+r) T)] + [F/ (1+R) T]

PV = $1000
c. What is the price of this bond if the annualized yield to maturity of 6
percent (i.e., the stated rate is .06 compounded semi-annually)?
Solution: T = 20; C=25; r=0.06/2 =0.03; FV=1000
Using the Formula as below:
PV= (C/r) [1-(1/ (1+r) T)] + [F/ (1+R) T]
PV = $925.613
d. What is the price of this bond if the annualized effective rate is 5
percent?
Solution: rs=m [(1+re)1/m -1] = 0.0489 or 4.89%
T = 20; C=25; r=0.0489/2 =0.0245; FV=1000
Using the Formula as below:
PV= (C/r) [1-(1/ (1+r) T)] + [F/ (1+R) T]
PV = $1007.831
Problem 3: Consider the bond described in Problem 2 above but let the coupon be
paid annually. Answer questions a through c in Problem 2 above for this annual
coupon paying bond.
Solution: if the amount is paid annually then coupon rate is $50.
a. T = 10; C=50; r=0.04; FV=1000
PV = $1081.11
b. T = 10; C=50; r=0.05; FV=1000
PV=$1000
c. T = 10; C=50; r=0.06; FV=1000
PV=$926.40
Problem 4: The price of a 10-year zero-coupon bond is $670 per $1000 in
face value.
a. What is its yield to maturity on this bond?
Using the formula FV=PV (1+r) T
1000=670(1+r) 10
r= 0.0408 or 4.08%
If you buy this 10-year bond today (at t = 0) for $670, hold it for 5
years, and sell it then (when it is a 5-year zero) for $850, what is your
holding period yield? If this happens, will the yield to maturity when
you sell this bond be higher or lower than its current yield to maturity?
Using the formula FV=PV (1+r) T
850=670(1+r) 5
r= 0.0487 or 4.87%
Hence it is higher than current yield to maturity price.
b. What price would this bond current 10-year zero have to sell for in 5
years for the holding period yield to be its current yield to maturity?
Using the formula FV=PV (1+r) T
FV= 670(1+.0408) 5 = $818.30