Question 1 Would a dollar tomorrow be worth

Question 1 and Answer Would a dollar tomorrow be worth more to you today when the interest rate is 20% or 10%? PV = CF/(1 + i) Less. It would be worth 1/(1 + 0. 20) = $0. 83 when the interest rate is 20%, rather than 1/(1 + 0. 10) =$0. 91 when the interest rate is 10%. Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -2

Question 2: What is the yield to maturity on a $1, 000 Face-value discount

Question 3 Which $1, 000 bond has the higher yield to maturity, a 20 year bond selling for $800 with a current yield of 15% or a 1 year bond selling for $800 with a current yield of 5%? Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -5

Question 3 and Answer Which $1, 000 bond has the higher yield to maturity, a 20 year bond selling for $800 with a current yield of 15% or a 1 year bond selling for $800 with a current yield of 5%? If the one-year bond did not have a coupon payment, its yield to maturity would be ($1, 000 − $800)/$800 − $200/$800 = 0. 25 = 25%. Because it does have a coupon payment, its yield to maturity must be greater than 25%. However, because the current yield is a good approximation of the yield to maturity for a twenty-year bond, we know that the yield to maturity on this bond is approximately 15%. Therefore, the one-year bond has a higher yield to maturity. Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -6

Question 4 You have just won $10 million in the lottery, which promises to pay you $1 million every year for the next 10 years. Have you really won $10 million? Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -7

Question 4 and Answer You have just won $10 million in the lottery, which promises to pay you $1 million every year for the next 10 years. Have you really won $10 million? Assuming a 5% interest rate the present value would make payment only worth a little over $7 million. On excel: =PV(rate-. 05, # of payments-9, payment amount-$1, 000, future value-0) = $7, 107, 821. 68 Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -8

Question 5 • Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -9

Question 5 and Answer • Copyright © 2007 Pearson Addison. Wesley. All rights reserved.

Question 6 If mortgage rates rise from 5% to 10% but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses? Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -11

Calculating Interest Rates (Cont. ) p. 61 • Nominal Versus Real Interest Rates • Nominal Interest Rates—Money amount of interest received • Real Interest Rates—Purchasing power of interest received • Real interest rate is the nominal interest adjusted for inflation Real interest rate = Nominal rate – Inflation rate Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4 -12

Question 6 and Answer If mortgage rates rise from 5% to 10% but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses? People are more likely to buy houses because the real interest rate when purchasing a house has fallen 3 percent (5 percent − 2 percent) to 1 percent (10 percent − 9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. Copyright © 2007 Pearson Addison. Wesley. All rights reserved. 4 -13