Tarun Singh

Worked with Cliff Beltzer and Rohan Parsad

Ec 1745 Problem Set 2

1. a) NPV=C0+(C1/(1+r))+…+(Ct/((1+r)t))
NPV(Red Pig)=-400+(250/(1.09))+(300/(1.092))=$81.86
NPV(Caffeine Delight)=-200+(140/(1.09))+(179/(1.092))=$79.10
Following the NPV rule, Coca Cola should produce Red Pig
b) The IRR rule tells us that the project with the higher IRR can stand a higher
cost of capital and still be a positive NPV project and that we should invest in
a project if the IRR > cost of capital. However, in this case both projects have
an IRR that is greater than the cost of capital (9%), so we can’t simply use
this rule to tell us which project to invest in. What we can do is create another
synthetic project that measures the differences between the two projects and
then calculate the IRR for this synthetic project to see if one should invest in
it, if one should, then the result is the same as part a).
Project Synthetic Payoffs:
Year 0 Year 1 Year 2
-400-(-200)=-200 250-140=110 300-179=121
NPV=-200+(110/(1+r))+(121/(1+r)2)=0
r=.1 so IRR=10%
Since the IRR for the synthetic project is greater than the cost of capital, you
should take on both the synthetic project and the Caffeine Delight project,
which is the same thing as taking on the Red Pig Project. Thus, by using this
method we achieve the same result as in part a).

2. Let F=Face Value Let C=Coupon Rate Let M= value at maturity

n n
Price=PV=(FC)((1-(1/(1+r) ))/r)+(M/((1+r) ))
PV=(1000(.10))((1-(1/(1.08)20))/.08)+(1000/((1.08)20)) =$ 1196.36 when C=.1
and r=.08
PV=(1000(.04))((1-(1/(1.08)20))/.08)+(1000/((1.08)20))=$607.27 when C=.04 and
r=.08
PV=(1000(.1))((1-(1/(1.12)20))/.12)+(1000/((1.12)20))=$850.61 when C=.1 and
r=.12
PV=(1000(.04))((1-(1/(1.12)20))/.12)+(1000/((1.12)20))=$402.45 when C=.04 and
r=.12
The price of the bond increases as the coupon rate increases.
The price of the bond decreases as interest rate in the economy increases.

3. Let F=Face Value Let C=Coupon Rate Let M= value at maturity

Let F=1000
PV=(FC/r)(1-(1/((1+r)5)))+(F/((1+r)5))
PV=((1000(.06))/.04)(1-(1/((1.04)5)))+(1000/((1.04)5))=$1089.04 when C=.06
and r=.04
 Semiannual coupon payments r=4%: effective rate=((1.04)(1/2))-1=1.98%:
PV=((1000(.06))/.0198)(1-(1/((1.0198)(5x2))))+(1000/((1.0198)(5x2)))=$1361.44
when C=.06 and r=.04
PV=((1000(.06))/.03)(1-(1/((1.03)5)))+(1000/((1.03)5))=$1137.39 when C=.06
and r=.03
Semiannual coupon payments=((1.03)(1/2))-1=1.49%
PV=((1000(.06))/.0149)(1-(1/((1.0149)(5x2))))+(1000/((1.0149)(5x2)))=$1416.14
when C=.06 and r=.03
The bond value would increase if the interest rate fell from 4% to 3%.

4. a) ((dP/P)/(dr/(1+r)) → (dP/dr)((1+r)/P) = (-(C1/((1+r)2))-( 2C2/((1+r)3))-… -

(tCt/((1+r)(t+1))))((1+r)/P)
= (-1/(1+r))((1+r)/P)((C1/(1+r))+( 2C2/((1+r)2))+…
+(tCt/((1+r)t)))
=-(1/P)((C1/(1+r))+( 2C2/((1+r)2))+… +(tCt/((1+r)t)))
=-D
This shows that the Macaulay duration is the negative of the discount-rate
elasticity of the bond price

b) Part a) shows that the Macaulay Duration= -((dP/P)/(dr/(1+r))= -D

Price volatility of the bond= -(dP/P)
-(dP/P)= -D(dr/(1+r))= -dr(D/(1+r))
The Macaulay Duration discounted by an additional time period and then
multiplied by the negative change in the discount rate is equal to the price
volatility of the bond.