Investments

Fall 2024
Problem Set - Weeks 1 & 2

1. Your company purchased the logging rights for a forest for the next 2 years by $3M.
If the area is logged, your company will receive $2M in 1 year and $2.5M in 2 years.
What is the NPV of the project? Consider a 6% discount rate.

2. Consider the following projects and the respective cash flows:

Project Y0 Y1 Y2 Y3 Y4 Y5
A -1300 1000 500 400 300 200
B -1500 600 400 400 300 200
C -1000 2000 -100 -1300 300 50

a. Calculate the NPV of each project with a discount rate equal to:
i. 10%
ii. 20%
iii. 35%
b. Which projects would you invest in assuming you had no capital restriction,
considering a 20% discount rate? Why?
3. The following is a list of prices for zero-coupon bonds of various maturities. Calculate
the yields to maturity of each bond and the implied sequence of forward rates.

Maturity (years) Price of Bond

1 $955.00

2 $901.47

3 $838.62

4 $779.89

4. Consider the following spot and forward rates.

1y Spot 4%

One-year forward rate one year from today 5.5%

One-year forward rate two years from today 8.5%

What is the price of a 3-year bond that has a 5% coupon rate paid annually and a face
value of $1000?

5. Consider a 9% coupon bond selling today for $964.8, with 3 years until maturity
making annual coupon payments.
a. Calculate the yield to maturity.
b. After reaching maturity, you look back to the bond that you bought 3 years
ago and are interested in knowing how well it performed. During this 3-year
period, the observed 1-year interest rates were: r1=6%, r2=8%, and r3=9%,
where r1 corresponds to the rate observed at beginning of year 0 (for the period
0-1y), r2 in the beginning of year 1 (for the period 1-2y) and r3 in the
beginning of year 2y (for the period 2-3y). Calculate the realized compound
return of the bond (i.e. assuming you reinvested the coupons).
6. Assume you have a one-year investment horizon and are trying to choose among three
bonds. All the bonds have the same degree of default risk and mature in 8 years. The
first is a zero-coupon bond that pays €1000 at maturity. The second has an 7% coupon
rate and pays €70 coupon once per year. The third has a 8% coupon rate and pays €80
coupon once per year.
a. If all three bonds are now priced at yield to maturity of 6%, what are their
prices?
b. If you expect their yields to maturity to be 10% at the beginning of next year,
what will their prices be then? Assume you are computing the prices after
coupons have been paid.
c. What is your holding period return on each bond if the investment horizon is
1 year?
d. Decompose the holding period return, over the first year, into return coming
from the coupon (current yield) and price changes (capital gain).

7. A coupon bond pays annual interest, has a par value of $1,000, matures in 5 years,
has a coupon rate of 10% and has a YTM of 11%. What is the current yield of this
bond? Note: A bond's current yield is defined as the ratio between the investment's
annual income (including interest payments and, if any, dividends payments) and the
current price of the security.

8. Ceteris paribus, the price and yield on a bond are:

a. Positively related
b. Negatively related
c. Sometimes positively and sometimes negatively related
d. Not related
e. Indefinitely related
9. A coupon bond that pays interest annually is selling at par of $1,000, matures in 5
years and has a coupon rate of 10%. The YTM on this bond is:
a. 8.0%
b. 8.3%
c. 9.0%
d. 10.0%
e. None of the options above

Use the information in the table to answer questions 10. and 11.

Years 1 2 3 4 5
Strip Price 99 96 94 91 88

10. What is the yield to maturity (YTM) of a 5-year coupon bond with a coupon rate of
5% paid annually?

11. The yield to maturity is not the same as the expected return in each year over the life
of a bond except when one holds a zero-coupon bond until maturity. Expected return
depends on yield of bonds with shorter maturities, which for coupon bonds means the
rate at which coupons can be reinvested. We explore this in the following set of
questions. Assume the expectations hypothesis of the term structure is correct.
a. Compute the spot rates from the strip prices.
b. What is the no-arbitrage price of a 5-year coupon bond paying 5% annually
with a par value of €1000?
c. Compute the expected return if you purchase the coupon bond at the no-
arbitrage price and expect to hold it for one year. In other words, what is the
expected return after the 1st year?
d. Repeat c for the 2nd, 3rd, 4th and 5th years if you similarly buy at the beginning
of the year and expect to hold the bond for only one year.
e. What is the expected return if you buy the bond at time 0 and plan to sell in 3
years’ time?
12. Your company is considering investing in a new renewable energy project that
involves setting up a wind farm. The initial investment required is $5 million, which
will cover the purchase of land, equipment, and installation. The project is expected
to generate the following cash flows over the next 5 years:

• Year 1: $1.2 million

• Year 2: $1.5 million
• Year 3: $1.8 million
• Year 4: $2.1 million
• Year 5: $2.4 million

Assume the required rate of return (discount rate) for this type of project is 8%.

a. Calculate the Net Present Value (NPV) of the project. Should the company undertake
the project based on the NPV rule?

b. Assume that in addition to the initial cash flows, there is a 30% chance that a major
technological breakthrough will occur in Year 3, which will increase the cash flows by
50% for Years 4 and 5. Recalculate the expected NPV considering this new
information.

c. The company is considering an alternative project with similar characteristics to the

first project described at the start of exercise 12 but involves higher risk. The expected
cash flows are 20% higher in each year, but the required rate of return increases to 12%
due to the higher risk.

• Calculate the NPV of the alternative project.

• Discuss which project the company should choose based on both NPV and risk
considerations.