UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

RSM332 PROBLEM SET #1

SOLUTIONS

1. (a) The net output of corn at date 1 = 400 50,000 = 89,442.72.

(b) We know from the transformation formula that W1 = 400 I0 . Thus to harvest

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 2
W1
W1 at date 1, we need to plant I0 = 400 . In order to harvest 100,000 bushels at

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100,000 2
 

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date 1, we must plant 400
= 62,500 bushels at date 0.

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(c) In this case, we maximize our utility by maximizing the minimum of consumption

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at date 0 and date 1. In order to do this, we want to have the same consumption at
rs e
both date 0 and date 1.
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Consumption at date 0 is 22,500I0 and consumption at date 1 is 400 I0 . To maximize
utility, we set:
o
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q
vi y re

22,500 I0 = 400 I0
q
I0 + 400 I0 22,500 = 0.
ed d

Solving the quadratic equation, we have:

ar stu

q
q 400 + 4002 4(22,500)
I0 = = 50.
2
sh is

Therefore, I0 = (50)2 = 2,500, and the optimal

consumption at dates 0 and 1 are
C0 = 22,500 2,500 = 20,000 and C1 = 400 2,500 = 20,000, respectively.
Th

W1 400 2,500
Average rate of return on investment = I0
1= 2,500
1 = 700%.
dW1
Rate of return on the marginal investment = dI0
1 = 200
I0
1 = 20050
1 = 300%.

400 22,500
(d) Average rate of return on investment = 22,500
1 = 166 23 %.
200 200
Rate of return on the marginal investment =
I0
1= 150
1 = 33 13 %.
(e) The optimal investment will be such that the marginal rate of return will equal the
interest rate. So from (d), it can be seen that the optimal investment is 22,500.

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 (f) Optimal consumption plan: again you want the consumption in both periods to be
the same. So we have:
C0 = C1 .
But this consumption plan must fulfill the budget constraint:
C1 W1
C0 + = I0 +
1+r 1+r
C1 60,000
C0 + 1 = 22,500 +
13 1 31
C1
C0 + 1 = 22,500.
13

Solving the two equations, we have C0 = C1 = 12,857.14. The value of your equity in

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the farm is simply its net present value and it is equal to 22,500 bushels of corn.

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The sources and uses of the funds at date 0 and date 1 are:

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Sources Uses

o.
Date 0
rs e Borrowing 35,357.14 Plant 22,500
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Consume 12,857.14
Date 1
Receive corn 60,000 Repayment of Loan 47,142.86
o

Consume 12,857.14
aC s
vi y re

(g) Yes, loan the farm for a period at 23,100. Equity in the farm was shown to be
22,500 in (f).
Again, you wish to consume equal amounts in both periods. Similar to (e), we solve
ed d
ar stu

C0 = C1

and
C1
= 23,100.
C0 +
sh is

1+r
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Solving the equations, we get C0 = C1 = 13,200. Now the residual amount in date 0
is lent at 33 31 %.

2. (a) To maximize todays consumption, you need to borrow. Therefore, the relevant
interest rate is the borrowing rate. The optimal investment will be such that the
marginal rate of return is equal to the

borrowing rate. The marginal rate of return of
the given production function is dI 1 = 20I 1. Setting it equal to 33 13 %, we have
d40 I


I = 225. As a result, the maximum feasible consumption today is (Y0 I ) + 401+ I1 =
3
725.

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 (b) To maximize tomorrows consumption, you need to lend.1 Therefore, the relevant
interest rate is the lending rate. The optimal investment will be such that the marginal
rate of return is equal to the lending rate. Setting it equal to 25%, we have I = 256. As
a result, the maximum feasible consumption tomorrow is (Y0 I )1.25+40 I = 945.
(c) From the diagram below, it is obvious that the investor which maximizes U (C0 , C1 ) =
min(C0 , C1 ) is a net borrower. Therefore, we solve,

C0 = C1

But this consumption plan must fulfill the budget constraint:

C1
C0 + = 725
1+r
C1
C0 + 1 = 725

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13

er as
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Solving the two equations, we have C0 = C1 = 414.29.

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Optimal Consumption and Investment Decisions

o.
1000

rs e (0,945)
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900

800 C0 = C1
o

700
(244,640)
aC s

600 (275,600)
vi y re
C1

500
(414.3,414.3)
400
ed d
ar stu

300

200
sh is

100
(725,0)
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0
0 200 400 600 800 1000
C0

(d) Fisher separation theorem states that investment decision and consumption deci-
sion can be considered separately in a perfect capital market. It is not valid here because
1
Depending on your initial endowment, you may be better off just investing and not lending. In that case,
if you solve the above problem, you will find Y0 < I (negative lending) and the solution is infeasible. The

optimal investment plan should then be I = Y0 (invest everything) and the maximum feasible consumption
tomorrow will be given by 40 Y0 .

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 net borrower and net lender has different required rate of return. Hence, the optimal
investment decision can not be made independent of the consumption decision. There-
fore, investment and consumption decision now have to be considered together and in
general they could depend on the individuals utility function and his endowments.
3. (a) Let y = 1/(1 + r)n , we have:
200y + 100y 2 = 200
y 2 + 2y 2 = 0

y = 1 3.
Since y has to be positive, we drop the negative root and therefore

y = 31
! !
1 3+1
(1 + r)n =

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31 3+1
!1

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3+1 n

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r = 1.
2

o.
rs e
(b) Let S be the price of the security, we have
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1 2 n
S= + 2
+ + + (1)
1 + r (1 + r) (1 + r)n
o

Multiply both sides of (1) by (1 + r), we obtain

aC s

2 n
(1 + r)S = 1 + + + + (2)
vi y re

1+r (1 + r)n1
Subtract (1) from (2)
1 1 1
ed d

rS = 1 ++ 2
+ + +
1 + r (1 + r) (1 + r)n
ar stu

1
rS = 1 +
r
1+r
S= 2 .
sh is

r
The second equality follows because the expression on the right hand side is $1 plus a
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perpetuity of $1 (which has a present value of 1/r). Putting r = 0.1, we have S = $110.
(c) Let r be the continuously compounded interest rate and T the time it takes to
double the money, we have
erT = 2
rT = ln(2)
T = 0.693/r
T = 69.3/(100r).

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 Therefore, you only need to divide 69.3 by the continuously compounded interest rate
(in percentage) to find out the time to double your money. Similarly, to triple your
money, you need

erT = 3
rT = ln(3)
T = 1.099/r
T = 109.9/(100r).

so the rule of thumb is to divide 110 by the continuously compounded interest rate (in
percentage).
In reality, interest rate is seldom expressed in continuously compounded form. However,
for a stated annual interest rate that is compounded on a monthly basis, the difference

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between the stated annual interest rate and the continuously compounded interest rate

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is not material and the rule of 69 is still a good working approximation. For stated

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interest rate that is compounded on an annual basis, the rule of 69 does not apply and
we can get better approximation by using the rule of 72 for reasonable interest rates.

o.
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4. We first figure out the effective monthly interest rate, rm . Since (1 + rm )12 = 1.12, we
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have
1
rm = (1.12) 12 1 = 0.0094888.
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There are many ways to compute the present value of the rental payments. We demon-
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strate one of the approaches here that makes use of the growing annuity formula. In-
vi y re

stead of computing the present value of the monthly payments, we convert them into
annual payments with the same present value. Let C1 be the annual payment at the
end of year 1 such that it has the same present value as that of the monthly payments
ed d

from month 0 to 11, we have

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C1
= $1000A12
rm (1 + rm )
1.12 " #
1.12 $1000(1 + rm ) 1
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C1 = 1
rm (1 + rm )12
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C1 = $12766.50.

Similarly, let Ct be the equivalent annual payment at the end of year t that has the
same present value of the monthly payments for year t. We have Ct = C1 (1 + g)t1 ,
where g = 0.05. Therefore, C1 to C30 is a growing annuity and its present value is
given by
" 30 # " 30 #
C1 1+g $12766.50 1.05
 
PV = 1 = 1 = $156069.10.
rg 1+r 0.12 0.05 1.12

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 5. (a) Since the mortgage interest rate in Canada is a semi-annually compounded rate,
the monthly interest rate is given by
1
0.05

6
rm = 1 + 1 = 0.004124.
2
We plan to repay the mortgage using 20 12 = 240 monthly payments. Therefore, the
monthly mortgage payment is
200000 200000rm
C= = = 1314.25.
240
Arm 1 (1+r1m )240

(b) After the 60th payment, you still owe the bank 180 payments, so the outstanding
balance is " #
C 1

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180
CArm = 1 = 166756.80.

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rm (1 + rm )180

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(c) At the beginning of month t, you still owe the bank 241 t payments, so the
outstanding balance is

o.
rs e C
"
1
#
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CA241t
rm = 1 .
rm (1 + rm )241t
It follows that the interest payment for month t is
o

" #
1
aC s

CAr241t rm =C 1 ,
vi y re

m
(1 + rm )241t
and the principal repayment for month t is
C
ed d

C CAr241t rm = .
m
(1 + rm )241t
ar stu

Therefore, the interest payment for the 24th month is

" #
1
sh is

C 1 = 776.19
(1 + rm )24124
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and the principal repayment for the 24th month is

C
= 538.06.
(1 + rm )24124

(d) From part (c), the present value of the principal repayment for month t is
1 C C
t 241t
= = 487.46,
(1 + rm ) (1 + rm ) (1 + rm )241

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 which is independent of t. Since the present value of the interest payment for each
month is equal to the difference between the present values of the mortgage payment
and the principal repayment, the present value of the interest portion of the first 60
payments is
CA60
rm 60 487.46 = 40482.45,

where the first term is the present value of the first 60 mortgage payments, and the
second term is the present value of the principal repayments in the first 60 months.

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aC s
vi y re
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