Week 5 – Homework Answers
Suppose that a 30-year U.S. Treasury bond offers a 4% coupon rate, paid semiannually. The market price of the bond is $1,000, equal to its par value. a.
What is the payback period for this bond?
With such a long payback period, is the bond a bad investment? c.
What is the discounted payback period for the bond assuming its 4% coupon rate is the required return? What general principle does this example illustrate regarding a project’s life, its discounted payback period, and its NPV?
Payback on this bond is 25 years. You pay $1,000. You receive $40 a year for 25 years, a total of $1,000.
b The bond is not necessarily a bad investment. Payback does not take time value of money into account, nor does it account for cash flows received after the payback period. It is more appropriate to calculate the NPV of an investment. Given the risk level of the bond, is 4% a fair return? If the answer is yes, then the bond may be a good investment.
c The discounted payback, using a 4% discount rate, is 30 years. This shows that unless the acceptable payback period is decreased when discounted payback is used, vs. regular payback, then projects which return money late in the life of the investment are even more disadvantaged under discounted payback than under regular payback. NPV is a more appropriate method to use to determine the value of an investment project.
Calculate the net present value (NPV) for the following 20-year projects. Comment on the acceptability of each. Assume that the firm has an opportunity cost of 14%. a.
Initial cash outlay is $15,000; cash inflows are $13,000 per year. b.
Initial cash outlay is $32,000; cash inflows are $4,000 per year. c.
Initial cash outlay is $50,000; cash inflows are $8,500 per year.
Project A has CF0 = −$15,000, and 20 inflows of $13,000. At a 14% discount rate, its NPV is $71,100.70. This is positive NPV and an acceptable project.
Project B has...
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