Investment Projects

This is a diagnostic test to find out what you already know and what your analytical skills are. Answer to the best of your abilities. Answer questions 1 – 7 in class. Then, take the questions home and revise or change your answers. You should hand in revised answers at the beginning of class tomorrow. Answer question 8 and, before class tomorrow, send the Excel file as an email attachment to .

  1. U.S. Treasury Securities carry virtually no default risk. Given this, how do you explain the observation that the yields on short-term to maturity treasuries are lower than the yields on longer-term maturity treasuries? Do you expect this relationship to be unique to the U.S., or will it be a general observation for short-term vs. longer-term bonds with equal default risk profiles in other countries as well?
  1. You need to Borrow $100,000 (pesos). The lender offers you two different repayment options:
  2. You can repay $133,820 in a single lump sum in 5 years or
  3. You can repay $26,380 per year (starting in one year) for 5 years.

A friend tells you to choose option b since the total you will repay is 5 x $26,380 = $131,900, which is less than the $133,820 you will repay if you do option a. Which is the better repayment plan? Explain your reasons for making your choice.

  1. What does the real rate of interest measure? What is the relationship between the real rate of interest and the nominal rate of interest? Is your answer the same for Mexico and the U.S. as it is for Venezuela?
  1. You own a durable asset (for example, a building) in a city that is far away. You receive a financial report that takes you by surprise: the value of your asset has fallen suddenly. Having taken economics and finance courses, you know that there are two possible explanations:
  2. The expected future values generated by the asset have fallen unexpectedly, or
  3. The interest rate has increased.
    To find out which explanation is correct, you look at the bond market and learn that bonds increased in value while your asset was decreasing in value. How does this information allow you to decide whether explanation (a) or (b) is correct?
  1. Two machines that produce identical outputs are available for purchase. One costs more to buy but less to operate as shown below. Both are expected to last 10 years with zero salvage value at the end of 10 years.

Machine A Machine B

Purchase Price:$84,000$70,000
Annual Operating
Cost (in each year):$10,000$12,000

Which is the cheaper source of production over a ten-year period? Is there additional information you need to have to answer this question? If you could not obtain that information (e.g., your internet connection is totally down), how would you answer the question as completely as possible?

  1. The current exchange rate between two countries is 1A = 1.5B where A is the currency in country A and B is the currency in country B. If the 3 month interest rate is less in country A than the equivalent interest rate in country B, what can you expect the 90-day forward exchange rate to look like (i.e., will it be greater, equal to, or less than the 1:1.5 ratio in the spot market)?
  1. What is the difference between an option and a futures contract? (Define them and show the differences.)
  2. Use Excel to provide an answer to this question;

A friend of your wishes to borrow $800,000 to refurbish a business. It is estimated that it will take 3 months to do the remodeling so the business will be closed and not be generating any revenue during that time. Therefore, your friend is talking to a banker about obtaining a loan that will allow no payments for the first 3 months. But, even after the business reopens, your friend is not sure that the cash flows will allow full amortization payments on the loan. So, for the next 12 months, the payments will be interest only. Thereafter, your friend wishes to pay off the loan in equal monthly payments of $7000. The problem is that the bank will only allow this type of loan to have a term of at most 8 years, so at the end of the 8 years, your friend will be faced with a balloon payment that will have to be refinanced or paid off. Build the amortization table that shows the monthly payments and balances for this loan if the annual interest rate is 9.85% and calculate the size of the balloon payment that will be due 96 months after the loan is taken out.