Assignment 1

Group members:
Aw Yong Yu Heng (30501164)
Choong Pik Yee (30856574)
Lee Kar Kei (31083145)
Pang Yee Ling (30148626)
Wong Hon Mun (27953580)

Question 1
Consider a debt instrument issued by Government that pays $5,000 every quarter for the next
8 quarters starting in three months. This is a 2-year instrument with quarterly payments and
there are 8 payments. In other words, it pays $5,000 in 3, 6, 9, 12, 15, 18, 21 and 24 months.
Suppose that the effective 3-month risk-free interest rate is 1.5%. Find the fair value of the
security. The Government is considering increasing the interest rate to 2% from 1.5% to cool
the overheated economy. What will be the fair value of the instrument if the Government
implements the higher interest rate policy?

Solution

When effective 3-month interest rate = 1.5%,

𝑐 𝑐 𝑐 𝑐 𝑐 𝑐 𝑐 𝑐
V0 = (1+𝑟) + (1+𝑟)2 + (1+𝑟)3 + (1+𝑟)4 + (1+𝑟)5 + (1+𝑟)6 + (1+𝑟)7 + (1+𝑟)8
5000 5000 5000 5000 5000 5000 5000
= + (1+0.015)2 + (1+0.015)3 + (1+0.015)4 + (1+0.015)5 + (1+0.015)6 + (1+0.015)7 +
(1+0.015)
5000
(1+0.015)8
5000 5000 5000 5000 5000 5000 5000 5000
= (1.015)
+ (1.015)2 + (1.015)3 + (1.015)4 + (1.015)5 + (1.015)6 + (1.015)7 + (1.015)8

= $4,629.10834 + $4,853.308743 + $4,781.584969 + $4,710.921151 + $4,641.301627 +

$4,572.710963 + $4,505.133953 + $4,438.555619
= $37,429.62
When effective 3-month interest rate = 2%,
𝑐 𝑐 𝑐 𝑐 𝑐 𝑐 𝑐 𝑐
V0 = (1+𝑟) + (1+𝑟)2 + (1+𝑟)3 + (1+𝑟)4 + (1+𝑟)5 + (1+𝑟)6 + (1+𝑟)7 + (1+𝑟)8
5000 5000 5000 5000 5000 5000 5000 5000
= + (1+0.02)2 + (1+0.02)3 + (1+0.02)4 + (1+0.02)5 + (1+0.02)6 + (1+0.02)7 + (1+0.02)8
(1+0.02)
5000 5000 5000 5000 5000 5000 5000 5000
= + (1.02)2 + (1.02)3 + (1.02)4 + (1.02)5 + (1.02)6 + (1.02)7 + (1.02)8
(1.02)

= $4,901.960784 + $4,805.443906 + $4,711.611673 + $4,619.22713 + $4,528.654049 +

$4,439.856911 + $4,352.800893 + $4,267.451856
= $36,627.40
Question 2
Consider security that pays annual dividends. It just paid $2.50 dividends per share and the
next dividend will be paid in 1 year. The dividend is expected to grow at a rate of 6% per
annum for the next four years. After the fourth year, the dividend is expected to grow at a
terminal rate of 1% per year forever. Find the fair value for the security if the annual cost-of-
capital is 14%.

Solution:
𝑐 𝑐(1+𝑔) 𝑐(1+𝑔)2 𝑐(1+𝑔)3 𝑐(1+𝑔)4 𝑐(1+𝑔)5
V0 = (1+𝑟) + (1+𝑟)2 + + + +
(1+𝑟)3 (1+𝑟)4 (1+𝑟)5 (𝑟−𝑔)

2.50 2.50(1+0.06) 2.50(1+0.06)2 2.50(1+0.06)3 2.50(1+0.06)4 2.50(1+0.06)5

= (1+0.14) + + + + +
(1+0.14)2 (1+0.14)3 (1+0.14)4 (1+0.14)5 (0.14−0.01)

2.50 2.50(1.06) 2.50(1.06)2 2.50(1.06)3 2.50(1.06)4 2.50(1.06)5

= + + + + +
(1.14) (1.14)2 (1.14)3 (1.14)4 (1.14)5 (0.13)

= $2.192982456 + $2.03908895 + $1.895994989 + $1.762942709 + $1.639227431 +

$25.73510726
= $35.26

Question 3
Suppose that the covariance of return on Delta Technology located in the USA and the
market portfolio is 0.1254. The expected return on the market portfolio is 12.54% and the
volatility of the market portfolio is 16.5%. The effective annual riskfree rate is 3%. Find the
cost-of-capital of Delta Technology. Find the cost-of-capital of Delta Technology given the
news that the US Fed has just reduced the risk-free interest rate to 2.75% from 3% due to
slowing US economy caused by COVID-19, i.e., the risk-free rate decreases by 25 basis
point.

Solution:
k = rf + β (µm − rf )
𝐶𝑜𝑣 (𝑅˜𝑚,𝑅˜)
= rf + (µm − rf )
𝑉𝑎𝑟 (𝑅˜𝑚)
0.1254
= 0.03 + ( 0.1254 - 0.03)
(0.165)2
= 0.4694
= 46.94%

k = rf + β (µm − rf )
𝐶𝑜𝑣 (𝑅˜𝑚,𝑅˜)
= rf + 𝑉𝑎𝑟 (𝑅˜𝑚)
(µm − rf )
0.1254
= 0.0275 + ( 0.1254 - 0.0275)
(0.165)2
= 0.4784
= 47.84%