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E120

Homework 5
Due 10/10/2014

1. Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6%.
You hold the bond for five years before selling it.
(a) If the bonds yield to maturity is 6% when you sell it, what is the internal rate of
return of your investment?
(b) If the bonds yield to maturity is 7% when you sell it, what is the internal rate of
return of your investment?
(c) If the bonds yield to maturity is 5% when you sell it, what is the internal rate of
return of your investment?
(d) Even if a bond has no chance of default, is your investment risk free if you plan
to sell it before it matures? Explain.


Pnew
Porig

1/t

Note: The internal rate of return is defined as


1. Here, Pnew is the price
at which you sold the bond; Porig is the price at which you purchased the bond; and t
is the time elapsed between the time you purchased the bond and the time you sold it.
2. You are considering investing in a new gold mine in South Africa. Gold in South Africa
is buried very deep, so the mine require an initial investment of $250 million. Once
this investment is made, the mine is expected to produce revenues of $ 30 million per
year for the next 20 years. It will cost $ 10 million per year to operate the mine. After
20 years, the gold will be depleted. the mine must then be stabilized on an ongoing
basis, which will cost $ 5 million per year in perpetuity. Plot the PV of the cash flow
of this investment as a function of the interest rate r and then calculate the IRR of
this investment.
Note: You are welcome to use any software to plot the graph and do the computation.
Attach the plot with your code (if any) to your submission.
3. Professor Wendy Smith has been offered the following deal: A law firm would like to
retain her for an upfront payment of $50,000. In return, for the next year the firm
would have to access to 8 hours of her time every month. Smiths rate is $550 per hour
and her opportunity cost of capital is 15% (EAR). What does the IRR rule advise
regarding this opportunity? What about the PV rule?
4. Assume an annual coupon bond with face value FV, coupon rate c (i.e. each coupon
is of the amount c F V ), yield to maturity y, and time to maturity of n years. Show:

(a) If the bonds coupon rate c is larger than its yield to maturity y, then the bonds
price is larger than its face value FV.
(b) If the bonds price is larger than its face value FV, then the bonds coupon rate
c is larger than its yield to maturity y.
Note: This problem presents a quick way check as to whether a bond is being sold at
a premium, discount, or at par.
5. Please indicate whether each of the following statements is true or false. If it is true,
explain/prove why it is true. If it is false, explain why or provide a counterexample.
Credit will not be given unless an explanation is provided.
(a) Given an APR of 12% compounded semiannually, the effective monthly rate is
1%.
(b) Bond A is a 10-year, semi-annual coupon bond with face value $1000 and coupon
payment of $50. Bond B is a 20-year, annual coupon bond with face value $4000
and coupon payment of $200. Given the yield to maturity of both bonds are the
same, and are 15%, the true price of bond A is less than the true price of
bond B.
(c) An n-year, annual-coupon bond with coupon rate 10% is priced at half of its face
value. In order for this bond to have a yield to maturity of 8%, n must be at least
30.
(d) Suppose you have two cash flows (0,2,2,2,...) and (0,1,3,1,3,...), then for any
interest rate the PV of the first cash flow is greater than or equal to the PV of
the second cash flow.
(e) Your little sister proposes the following game to you. On day 1, you will give her
$1. On day 2, she will give you $2. And in general, you will give her $i on day i if
i is odd, and she will give you $i on day i if i is even (so that the cash flow from
your point of view is (0,-1,2,-3,4,-5,6,...)). Living in a hypothetical world where
interest rate per day is 10%, should you take up her offer?