Chapter 7 Interest Rates and Bond Valuation

If you assume returns follow a normal distribution, which investment would give a better chance of getting at least $40 million return?

Free cash flows of the project for next five years can be calculated by adding depreciation values and subtracting changes in working capital from net income. In 2010, there will be a cash outflow of $2.2 million as capital expenditure. In 2011, there will be an additional one time cash outflow of $300,000 as an advertising expense. Using net free cash flow values for next five years and discount rate for discounting, NPV for the project comes out to be $2907, 100. The rate of return at which net present value becomes zero i.e.

e. If we evaluated at the same effective rate, the earlier payments would give the semiannual bond the higher value.

The third scenario was ignoring the option to invest in the second-generation project and selling the equipment in year 2. We evaluated this option as a put option. First, we calculated the probabilities for going up and down based on the assumption of a risk neutral word. As a result, the probability of going upward is calculated as 0.3375 and downward probability is 0.6625. In order to determine the present value of all the sequence cash flow at the end of year 2, we calculated the upside change rate and downside change rate as 64.87% and -39.35%, respectfully. The next step is to analyze the option value by using the “Binomial Tree” method. In order to determine the present value of all the subsequence cash flow at the end of year 2, we calculated the cash flow at each node on the tree, until 2006. We discounted all the cash flow at the risk free rate at 10%. The End of Year NPV of all the subsequence cash flow at Year 2 is calculated as $7,571,752, and the selling price of the equipment at end of 2 is $4,000,000, which is the salvage value. We found the NPV of selling the machine at end of Year 2 to be -$2,951,861 as of Year 0, which is negative. The APV of the project after adding the option turned out to be -$6,321,932. This negative APV suggest that the

a) Assuming the opportunity interest rate is 6%, what is the present value of the second alternative?

B. The present value of an annuity is unaffected by the number of the annuity payments.

a) In the first set of calculations, the staff used a discount rate of 20%, a five-year time horizon, and ignored taxes and terminal value. What is the relative attractiveness of these three alternatives?

1a. You get the same prize but the choice changes to $5,000 now or $5,250 in three years. What do you do?

The interest rate of a term deposit is at 5.2% per annum. Available investment fund is $200,000. Term Deposit will yield $10,400 p.a. by using $200,000 multiply by 5.2%. However, for compounded interest rate, 5 years investment will be $257,697 (ROI = $57,697). And 10 years investment will be $332,038 (ROI = $132,038), assume that the interest rate is constant within 10 years period. The risk is considered minimal.

If there is no capital rationing, project B should be accepted because it has a larger net present value. If there is a capital constraint, the problem then focuses on what can be done with the additional $1,005,000 freed up if project A is chosen. If Caledonia can earn more on project A, plus the project financed with the additional $1,005,000, than it can on project B, then project A and the marginal project should be

b. What happens to the value of the option if you change it to 30%?

If you invest in the project after five years you will get $ 463,188.77 which is $ 13,188.77 more.

later in the project life. With a NPV of less than -$810,000, Scenario 6 is the project with the

1. Compute the Free Cash Flows for the years 2010 to 2020 for both projects

(5 points) $100 invested for 10 years at 12% interest is worth more in FV terms than $200 invested for 10 years at 4% interest.