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Homework 1 Questions

This document provides the instructions for Homework 1. Students can work in groups of up to 4 but must submit individual write-ups. There are 5 questions to be handed in from the provided sources. Additional practice problems are included but not to be handed in, with answers provided. Students are advised to choose between 4 investment options for $2 million based on calculating their net present values. Higher rent-to-price ratios in some cities compared to others provide information about future rent growth in those cities.

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Derek Chui
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81 views2 pages

Homework 1 Questions

This document provides the instructions for Homework 1. Students can work in groups of up to 4 but must submit individual write-ups. There are 5 questions to be handed in from the provided sources. Additional practice problems are included but not to be handed in, with answers provided. Students are advised to choose between 4 investment options for $2 million based on calculating their net present values. Higher rent-to-price ratios in some cities compared to others provide information about future rent growth in those cities.

Uploaded by

Derek Chui
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Corporate Finance

Master of Finance
LEE

Due in class: Monday Mar 10

Homework 1

You may collaborate on the homework assignments in groups of up to 4 students, however each
person must submit a separate write-up. If you elect to work with a group, please list the
members of the group on your submission.

Format of homework: First, I give problems to be handed in. Second, I give practice problems
not to be handed, along with answers. There are also additional practice problems and answers
assigned in some of the lectures.

I. Problems to be handed in
[3 questions from BMA + 2 Lamont questions = 5 total]

BMA Chapter 2, Question 32


BMA Chapter 2, Question 38
BMA Chapter 3, Question 31 (hint: start by finding the spot rate for each year = interest rate on
zero-coupon bond)

LEE Hand-in Question 1) Personal Financing Decision:

You decide to buy a Bonda Discord Lx automobile. You have $4,000 in cash. If you purchase
the car (at a price of $16,000), you will spend all your cash in making a down payment. You can
borrow the remaining at an interest rate of 10.5% on the outstanding balance.

(i) Assume (for simplicity) that loan repayments have to be made annually and you pay $2000
every year. How long will it be before you pay off your loan?

(ii) Suppose Bonda offers you a rate of 2.9% on your outstanding balance. How long would it
take for you to repay the loan if you repaid $2000 every year? What is the net present value of
the loan to you? As far as possible, try to avoid using a spreadsheet to answer this question – in
an exam situation you would need to know how to apply the relevant formulas.

(iii) Bonda offers to lease the Discord at $199 a month with no down payment. The car reverts to
Bonda at the end of four years. Its resale value at that point is $9500.
Are you better off leasing or buying the car and financing at 2.9%? How would your answer
change if you estimate the resale value to be $7500.

1
LEE Hand-in Question 2) NPV

Norman Gerrymander has just received a $2 million bequest. How should he invest it?

There are four immediate alternatives.


a. Investment in one-year U.S. government securities yielding 5 percent.
b. A loan to Norman’s nephew Gerald, who has for years aspired to open a big
Cajun restaurant in Duluth. Gerald had arranged a one-year bank loan for $900,000, at
10 percent, but asks for a loan from Norman at 7 percent.
c. Investment in the stock market. The expected rate of return is 12 percent.
d. Investment in local real estate, which Norman judges is about as risky as the
stock market. The opportunity at hand would cost $1 million and is forecasted to be
worth $1.1 million after one year.

Which of these investments have positive NPVs? Which would you advise Norman to
take?

II) Practice problems (don't hand these in; answers given here)

BMA Chapter 2: 27, 30, 35


BMA Chapter 3: 14, 26, 27

Practice Problem 1) Let’s do an alternate derivation of the value of a stock that pays
dividend D forever, with a fixed discount rate of r. For this stock, show that the fact
that the stock earns a rate of return r every period implies that P=D/r.

Practice Problem 2) Suppose now that we consider a stock that every period pays
dividend D with probability q, and pays zero with probability 1-q. As before we have a
constant discount rate r. Find a mathematical expression for P in terms of q, D, and r.

Practice Problem 3) This question is a follow-up from a practice problem at the end of
lecture 3. See that question (along with answers provided) if you are confused.

Suppose the nominal interest rate is r, the rate of growth of rent is g, annual rent is
currently C, and the price of a house is P. Derive an expression for the rent-to-price
ratio, C/P, as a function of g and r. Now suppose g can vary across cities, but r does not.
If Boston has a higher rent-to- price ratio than Chicago (but the interest rate/rate of return
on houses is the same for the two cities), what does that say about future rents in Boston?
Does it say anything about future prices?

Homework 1 – Questions - Page 2

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