Chapter 3 Financial Decision Making and the Law of One Price

3-2. You are an international shrimp trader. A food producer in the Czech Republic offers to
pay you 2.9 million Czech koruna today in exchange for a year’s supply of frozen shrimp.
Your Thai supplier will provide you with the same supply for 2.2 million Thai baht today.
If the current competitive market exchange rates are 24.24 koruna per dollar and 37.74
baht per dollar, what is the value of this deal?

Czech buyer’s offer = 2,900,000 CZK / (24.24 CZK/USD) = 119,636.96 USD.

Thai supplier’s offer = 2,200,000 THB / (37.74 THB/USD) = 58,293.59 USD.

The value of the deal is $119,636.96 – $58,293.59 = $61,343.37 today (i.e. it is a good deal and
should be accepted).

3-7. You have an investment opportunity in Japan. It requires an investment of $0.98 million
today and will produce a cash flow of ¥107 million in one year with no risk. Suppose the
risk-free interest rate in the United States is 3.9%, the risk-free interest rate in Japan is
2.3%, and the current competitive exchange rate is ¥110 per $1. What is the NPV of this
investment? Is it a good opportunity?

Cost = $0.98 million today

Benefit = (¥1107 million) / (1.023¥1/¥0) / (110¥0/$0) = $00.951 million
[Note: For easy reading, we use a currency’s subscript to denote the period.]
NPV = $0.951 – $0.98 = –$0.029 million.

The NPV is negative, so it is not a good investment opportunity.

3-8. Your firm has a risk-free investment opportunity where it can invest $163,000 today
and receive $179,000 in one year. For what level of interest rates is this project
attractive?

You are indifferent if r = 179,000/163,000 – 1 = 9.816%

Thus, the project is attractive if r < 9.816% (indifferent if =)

3-12. Suppose Bank One offers a risk-free interest rate of 9% on both savings and loans, and
Bank Enn offers a risk-free interest rate of 9.5% on both savings and loans.

a. What arbitrage opportunity is available?

b. Which bank would experience a surge in the demand for loans? Which bank would
receive a surge in deposits?

c. What would you expect to happen to the interest rates the two banks are offering?

a. Take a loan from Bank One at 9% and save the money in Bank Enn at 9.5%.
 b. Bank One would experience a surge in the demand for loans, while Bank Enn would receive
a surge in deposits.

c. Bank One would increase the interest rate, and/or Bank Enn would decrease its rate, such
that neither bank offers a savings rate that is higher than either bank’s loan rates.

3-16. An Exchange-Traded Fund (ETF) is a security that represents a portfolio of individual

stocks. Consider an ETF for which each share represents a portfolio of two shares of
Hewlett-Packard (HPQ), three shares of Sears (SHLD), and three shares of General
Electric (GE). Suppose the current stock prices of each individual stock are as shown
here:

Stock Current Market Price

HPQ $28

SHLD $38

GE $17

a. What is the price per share of the ETF in a normal market?

b. If the ETF currently trades for $203, what arbitrage opportunity is available? What
trades would you make?

c. If the ETF currently trades for $233, what arbitrage opportunity is available? What
trades would you make?

a. We can value the portfolio by summing the value of the securities in it:

Price per share of ETF = 2 × $28 + 3 × $38 + 3 × $17 = $221

b. If the ETF currently trades for $203, an arbitrage opportunity is available. To take advantage of
it, one should buy the ETF for $203, sell two shares of HPQ for $28, sell three shares of SHLD
for $38 each, and sell three shares of GE for $17 each. Total profit for such transaction is $221
– $203 = $18.

c. If the ETF trades for $233, an arbitrage opportunity is also available. To take advantage of it,
one should sell the ETF for $233, buy two shares of HPQ for $28, buy three shares of SHLD
for $38 each, and buy three shares of GE for $17 each. Total profit for such transaction is $233
– $221 = $12.
Chapter 4 The Time Value of Money
4-6. Consider the following alternatives:

i. $150 received in one year

ii. $220 received in five years

iii. $330 received in ten years

a. Rank the alternatives from most valuable to least valuable if the interest rate is 11%
per year.

b. What is your ranking if the interest rate is only 4% per year?

c. What is your ranking if the interest rate is 15% per year?

$150
a. 𝑃𝑉 = = $135.14
1.111

$220
𝑃𝑉 = = $130.56
1.115
$330
𝑃𝑉 = = $116.22
1.1110
Option i. > option ii. > option iii.

$150
b. 𝑃𝑉 = = $144.23
1.04 1

$220
𝑃𝑉 = = $180.82
1.04 5

$330
𝑃𝑉 = = $222.94
1.04 10

Option iii. > option ii. > option i.

$150
c. 𝑃𝑉 = = $130.43
1.151
$220
𝑃𝑉 = = $109.38
1.155
$330
𝑃𝑉 = = $81.57
1.1510
Option i. > option ii. > option iii.

4-8. Your daughter is currently 11 years old. You anticipate that she will be going to college in
seven years. You would like to have $108,000 in a savings account to fund her education
at that time. If the account promises to pay a fixed interest rate of 6% per year, how much
money do you need to put into the account today to ensure that you will have $108,000 in
seven years?

Timeline:
0 1 2 3 7

PV = ? $108,000
 $108,000
𝑃𝑉 = = $71,826.17
1.067

4-11. Suppose you receive $100 at the end of each year for the next three years.

a. If the interest rate is 7%, what is the present value of these cash flows?

b. What is the future value in three years of the present value you computed in (a)?

c. Suppose you deposit the cash flows in a bank account that pays 7% interest per year.
What is the balance in the account at the end of each of the next three years (after
your deposit is made)? How does the final bank balance compare with your answer in
(b)?

$100 $100 $100

a. 𝑃𝑉 = + + = $93.46 + $87.34 + $81.63 = $262.43
1.071 1.072 1.073

b. 𝐹𝑉 = $262.43 × 1.073 = $321.49

c. Year 1: $100

Year 2: 100 × 1.07 + 100 = $207

Year 3: 100 × 1.072 + 100 × 1.07 + 100 = $321.49

4-16. Your buddy in mechanical engineering has invented a money machine. The main
drawback of the machine is that it is slow. It takes one year to manufacture $100. However,
once built, the machine will last forever and will require no maintenance. The machine
can be built immediately, but it will cost $1000 to build. Your buddy wants to know if he
should invest the money to construct it. If the interest rate is 9.5% per year, what should
your buddy do?

Timeline:

0 1 2 3

–1,000 100 100 100

To decide whether to build the machine you need to calculate the NPV. The cash flows the
machine generates are a perpetuity, so by the PV of a perpetuity formula:
 100
PV = = 1, 052.63.
0.095

So the NPV = 1, 052.63 − 1, 000 = 52.63 . He should build it.

4-18. The British government has a consol bond outstanding paying £300 per year forever.
Assume the current interest rate is 4% per year.

a. What is the value of the bond immediately after a payment is made?

b. What is the value of the bond immediately before a payment is made?

Timeline:
0 1 2 3

£300 £300 £300

a. The value of the bond is equal to the present value of the cash flows. By the perpetuity
formula:

£300
= £7,500
0,04

b. The value of the bond is equal to the present value of the cash flows. The cash flows are
the perpetuity plus the payment that will be received immediately.

PV = 100/0.04 + 100 = £2,600

4-22. You are 23 years old and decide to start saving for your retirement. You plan to save $5000
at the end of each year (so the first deposit will be one year from now), and will make the
last deposit when you retire at age 68. Suppose you earn 9% per year on your retirement
savings.

a. How much will you have saved for retirement?

b. How much will you have saved if you wait until age 32 to start saving (again, with
your first deposit at the end of the year)?
a. Timeline:

23 24 25 26 68
0 1 2 3 45

$5,000 $5,000 $5,000 $5,000

 1
𝐹𝑉 = $5,000 × ((1 + 0.09)45 − 1) = $2,629,293.67
0.09

b. Timeline:

32 33 34 35 68
0 1 2 3 36

$5,000 $5,000 $5,000 $5,000

1
𝐹𝑉 = $5,000 × ((1 + 0.09)36 − 1) = $1,180,623.61
0.09

4-26. You work for a pharmaceutical company that has developed a new drug. The patent on
the drug will last 17 years. You expect that the drug’s profits will be $1 million in its first
year and that this amount will grow at a rate of 5% per year for the next 17 years. Once
the patent expires, other pharmaceutical companies will be able to produce the same drug
and competition will likely drive profits to zero. What is the present value of the new drug
if the interest rate is 10% per year?

Timeline:
0 1 2 3 17

$1 $1(1.05) 1 $1(1.05)2 $1(1.05)16

This is a 17-year growing annuity. By the growing annuity formula we have

1 1 + 0.05 17
𝑃𝑉 = $1,000,000 × (1 − ( ) )
0.1 − 0.05 1 + 0.1

𝑃𝑉 = $1,000,000 × 10.9307279 = $10,930,727.9