Answers to End-of-Chapter Questions

2.

You would rather be holding long-term bonds because their price would increase more than the price
of the short-term bonds, giving them a higher return.

Quantitative Problems

1. Calculate the present value of $1,000 zero-coupon bond with 5 years to maturity if the required
annual interest rate is 6%.
Solution: PV = FV/(1 + i)n,
PV = $1000/(1+.06)^5 = $1000/1.338226 = $747.26 (this is what is required on exam)
Try this on the PV Wks by putting 1000 in the 5th year, periods/yr =1 and discount rate = .06
Note that you can calculate the YTM directly by formula because there is only one cash flow. If there
were more than one cash flow, you would need to use a calculator or optimizer in Excel.
On PV Wks, enter YTM = .06, periods/yr = 1 and put a cash flow of $1000 in period 5 to get the
same answer.
On a financial calculator: FV = 1000, i = 0.06, n = 5
PV = 747.25 (per text)
2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the first
payment is made immediately, what is this grand prize really worth? Use a discount rate of 6%.
Formula Solution: There are two important aspects to this. First this is a fixed-term annuity. Second,
since the first payment is due immediately, so this is an annuity due rather than a normal annuity.
Note that since the first payment is due at time zero, there is no discounting applied that payment
(FV=PV since it is immediate). That allows to just value the annuity as though it were a normal
annuity, then just multiply that value by (1+ discount rate). Recall that a fixed-term annuity is
nothing more than a perpetual annuity(perpetuity) with the tail cut off. The tail is a perpetual annuity
that starts when our fixed annuity end, so:
Value of fixed annuity of n periods discount rate of i = value of perpetuity (value of perpetuity)/ (1+i)^n
Value if it were a normal annuity =
$500,000/.06 ($500,000/.06)/(1+.06)^20 = $8,333.333.33-$2,598,372.72 = $5,734,960.61
To convert to a annuity due: $5,734,960.61*1.06 = $6,079,058.25
You could also value the first payment and the remaining payments separately. Note that since the first
payment is due at time zero, there is no discounting applied that payment (FV=PV since it is
immediate). So, PV = first payment + value of 19-year fixed normal annuity.
PV = $500,000 + $500,000/.06 ($500,000/.06)/(1+.06)^19 = $500,000 + $8,333.333.33-$2,754,275.09
=$6,079,058.25

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Next, calculate the value on the PV worksheet. You can easily convert the worksheet to begin mode
just like you can a calculator. To do this, just change cell G5 from 1 to zero. Assuming that your
formulas in cells G6 on down are like =G5 +1, then they will all index down. This reduces every
discounting period by 1, which is what we want for an annuity due. Now just put $500,000 in for
cash flows for the first 20 periods, set the YM to 6% and periods/yr =1 and you should again get
$6,079,058.25. Now, be sure to shift back to end mode by setting G5 to 1 since we almost always will
be using end mode.
Using a financial calculator:
N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode.
Compute PV: PV = $6,079,058.25
Again, shift your calculator back to END mode to avoid future miscalculations.

3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table:
Years to Maturity

Discount Rate

3
3
6
9
9

5
7
7
7
9

Current Price

You can calculate the value of a coupon bond by formula one of two ways. To calculate the PV of each
cash flow and sum for the first example:
PV = $70/(1+.05)^1 + $70/(1+.05)^2 +$1070/(1+.05)^3 = $66.67+$63.49+$924.31 = $1054.47
To calculate the value using the coupon bond formula that we developed in class:
PV of coupon bond = PV of par cash flow + PV of perpetuity of coupon payment PV of tail of perpetuity
PV of par cash flow = $1000/(1+.05)^3 = $863.84
PV of coupon perpetuity = $70.00/.05 = $1400
PV of tail = $1400/(1+.05)^3 = $1,209.37
PV of bond = $863.84 +$1400.00 - $1,209.37 = $1054.47
The entire formula as you might see it in a text: PV = par/(1+r)n + (Coupon/r) x (1-1/(1+r)^n)
Note that the $.01 differences are due to rounding.
You can do this pretty efficiently and accurately on PV Wks. All of these bonds are annual coupon
bonds, so you set the periods/yr to 1 and leave it there. For the first bond, enter payments of $70 each for
years 1&2 and then $1070 for year three, then enter .05 for the YTM. You will get $1,054.46. Just
change the YTM to .07 to get the next answer of $1,000.00. For the 6-year and 9-year bonds, you will
need to change the cash flows.
Try a few of these on your calculator as well to be sure you get the same answers.
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What relationship do you observe between yield to maturity and the current market value?
Solution:
Years to Maturity

Yield to Maturity

Current Price

3
3
6
9
9

5
7
7
5
9

$1,054.46
$1,000.00
$1,000.00
$1,142.16
$ 880.10

When yield to maturity is above the coupon rate, the bands current price is below its face
value. The opposite holds true when yield to maturity is below the coupon rate. For a given
maturity, the bonds current price falls as yield to maturity rises. For a given yield to
maturity, a bonds value rises as its maturity increases. When yield to maturity equals the
coupon rate, a bonds current price equals its face value regardless of years to maturity.
4. Consider a coupon bond that has a $1,000 per value and a coupon rate of 10%. The bond is currently
selling for $1,150 and has 8 years to maturity. What is the bonds yield to maturity?
To calculate the bonds yield to maturity using a financial calculator:
N = 8; PMT = 1000 0.10 = 100; FV = 1000; PV = 1150
Compute I : I = 7.44
On PV Wks, enter cash flows of $100 each for the first seven periods and $1100 for period 8 (make
sure you knwo why). Set periods/yr =1. Set cell C14 to $1,150 as the target price. Then
run Solver with the following setings:
Max C3
By Changing Cells C3
Constraint: C6=C14
You will 7.44%
Solver is changing the discount rate to find the discount rate that causes the addition of the PVs of
each cash flwo to add up to $1,150.
You cannot calculate the YTM for this bond directly by formula because there are more than one
cash flow.
5. You are willing to pay $15,625 now to purchase a perpetuity which will pay you and your heirs
$1,250 each year, forever, starting at the end of this year. If your required rate of return does not
change, how much would you be willing to pay if this were a 20-year, annual payment, ordinary
annuity instead of a perpetuity?
This is easy to calculate manually.
For a perpetuity, PV = CF/i
So, lets find our discount rate. $15,625 = $1250/i, so i = $1250/$15,625 = 8%.
For a fixed-term normal annuity: PV = CF/i (CF/i)/(1+i)^n
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PV = $1250/.08 ($1250/.08)/(1+.08)^20 = $15625 - $3,352.32 = $12, 272.68

Using a financial calculator, to find your yield to maturity, Perpetuity value = PMT/I.
So, 15625 = 1250/I. I = 0.08
The answer to the final part, using a financial calculator:
N = 20; I = 8; PMT = 1250; FV = 0
Compute PV : PV = 12,272.69
6. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just
bought a $100,000 home, what is the PV of all the future property tax payments? Assume that the
house remains worth $100,000 forever, property tax rates never change, and that a 9% discount rate
is used for discounting.
Solution: The taxes on a $100,000 home are roughly 100,000 0.0266 = 2,660.
The PV of all future payments = 2,660/0.09 = $29,555.55 (a perpetuity).
Add-On Problem: Lets take look at what happens if taxes go up over time due to inflation. Lets
assume that the $2660 is the tax amount for the next year. Further lets assume that
inflation will be a steady 4%. Okay, before we start on that, confirm the above calculation
on the worksheet. We wont make our worksheet truly perpetual as that would require an
infinite number of rows. Lets limit it to 200 years. Right now, the worksheet is only set
up to calculate up to 40 periods, so we need more rows. Highlight all at once cells F44
through J44. Now, with them still highlighted, put your cursor in the lower right corner of
cell J44 and drag it down to J204. If you go over a few, it is no big deal. You now have
formulas for 200 periods.
Now, enter $2660 in cell E5 and copy that down to E204. Set periods/yr = 1. Set YTM = .09. You
will get a PV of $29,555.55
Now, lets add growth (inflation) of the tax payment. Leave cell E5 set to $2660. Now set cell E6 to
=1.04*E5 and copy that formula down E204.
Now, your PV is $53,195.56. What you have just done is prove the Dividend Doscount Model. That
model says that PV = CF/(i-g) where the CF is the first year dividend and g = growth rate.
For us, the growth is the 4% inflation, PV = $2660/(.09-.04)
$2660/.05 = $53,200.00. The difference of $4.44 is due to our 200 year cutoff. The payments from
year 201 through infinity have a PV of $4.44.
Why is the answer right on when we assume no inflation, but not when we assume inflation? Bring
your thoughts to class.
7. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2% and
inflation is expected to be 6% over the next year. What nominal interest rate would you require from
the bank over the next year? How much money will you have at the end of one year? If you are
saving to buy a stereo that currently sells for $1,050, will you have enough to buy it?

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Solution: The required nominal rate would be:

i = ir + e
= 2% + 6% = 8%.
At this rate, you would expect to have $1,000 1.08, or $1,080 at the end of the year.
Can you afford the stereo? In theory, the price of the stereo will increase with the rate of
inflation. So, one year later, the stereo will cost $1,050 1.06, or $1,113. You will be
short by $33.
The new price would be $980.20. Using a discounted cash flow approach, the price is
980.23only $.03 different.
Year
Payments
PV of payments

60.00
56.21

60.00
52.65

1060.00
871.3

14

Sum
980.23