Intermedia Finance

Summer 2016                0472-371                 Assignment #1 Solution

1.C        Certainty equivalent factor is time sensitive given by αt = PVIF(RADR, t)/PVIF(RF, t) where PVIF denotes present value interest factor.  Actually, it represents the present value of $1 discounted at the risk-adjusted discount rate for t periods. Use financial calculator with inputs: N = t = 2, I/Y = RADR = 14, PMT = 0, FV = -1, to compute PV = 0.7694.  Similarly, PVIF(6%, 2) = 0.89.  Therefore, α2 = 0.7694/0.89 = 0.8645.  The corresponding certainty cash flow = (0.8645)(350) = $302.57.

2.C        Follow the same procedure to find the other certainty equivalent factors for year 1 and year 3 and convert those uncertainty cash flows into certainty cash flows.  Since all uncertainty has been removed, we need to use the risk-free rate to discount all certainty cash flows to keep the consistency.

Finally, NPV@6% = $52.46.  Alternatively, NPV@14% = 300/(1.14)1 + 350/(1.14)2 + 400/(1.14)3 – 750 = $52.46.  Two answers are the same.

3.A        With an initial investment of $1,000, $700 = $400 + $300 is recovered by the end of year 2.  Taking 2.5 years to break even requires the company to make up the remaining $300 in an half year.  That implies year 3 must have a cash flow of $600.  NPV@15% = 400/(1.15)1 + 300/(1.15)2 + 600/(1.15)3 + 200/(1.15)4 -1,000 = $83.53    

4.D        Yield-to-maturity (YTM) is the market interest rate).  To find it on a financial calculator, input the current price (PV = -3,500), the interest payment (PMT = 1,500), the face value (FV = 0) and the number of interest payments (n = 3), then solve for YTM (I/Y = 13.8).