Problem Set 4

15/379328/EK/20388

1. Problem 2
a. The future value of an investment project in 4 years is $15 million (given). To
calculate the present value of the investment at different interest rate and compare
each with the cost of the project to determine whether the firm would undertake
the project or not.
It can be calculated by using the formula:

Where:
PV = present value
FV = future value
r = interest rate
N = number of years

When interest rate (r) = 11%, the PV of investment is:

Because the PV of the payoff is $9.88 million which is less than the cost
$10 million, the firm should not undertake the project.

- The PV of $15 million to be received in 4 years at an interest rate of 10%

= $10.25 million.
 Because the PV of the payoff is greater than the cost, the project
should be undertaken.
- The PV of $15 million to be received in 4 years at an interest rate of 9% =
$10.63 million.
Because the PV of the payoff is greater than the cost, the project
should be undertaken.
- The PV of $15 million to be received in 4 years at an interest rate of 8% =
$11.03 million.
Because the PV of the payoff is greater than the cost, the project
should be undertaken.
b. The cut off interest rate is between 10 and 11 percent. To find the exact number
we need to find what interest rate R makes the PV equal to $10 million.

$10

2. Problem 3
a. The interest rate (r) = 3.5%
PV of bond is given by:

Bond A pays 8,000 in 20 years. The PV of bond A is:

Bond B pays 8,000 in 40 years. The PV of bond B is:

Thus, on comparing the PV of bond A and bond B, bond A is worth more today.
b. The interest rate (r) is now 7%
Using the rule of 70, when the interest rate is 7 percent the value of the bond will
double in approximately . Therefore, the value today of Bond A, which
 matures in 20 years, is approximately $2,000 because its value will
double twice in 20 years. Today's value of Bond B, which matures in 40 years, is
approximately $500 because its value will double 4 times in 40 years.
The percentage change in value for Bond A:

The percentage change in value for Bond B:

c. The value of a bond falls when the interest rate increases, and bonds with a longer
time to maturity are more sensitive to changes in the interest rate.
3. Problem 4
The value of the stock is equal to the PV of its dividends and its final sale price. This
is equal to:

Since this is lower than the initial selling price of $110, XYZ stock is not a good
investment.
4. Problem 5
Kinds of insurance Moral hazard Adverse selection
a. Health insurance You are more likely to use People with chronic
health care – even if you illnesses have more
don’t need it. incentive to buy health
insurance (provided it
covers their treatment)
than other people.

b. Car insurance A driver with an auto If a person who lives in a

insurance policy that
provides full coverage,
accident forgiveness, and
no deductible may
exercise less care while
driving than someone with
high crime area does not
disclose this information
or lies on his insurance
application about his
address.
 no insurance or a less
generous policy because
the first driver knows the
insurance company, not
him, pays 100% of the
costs if he has an accident
c. Life insurance An employer’s A smoker who
indifference to health and successfully manages to
safety regulations obtain insurance coverage
increases the chances of as a nonsmoker
claims