Assignment 1 for SEEM3590 Investment Science Due Date: 27th Sep.

, 2010
1. Find the corresponding effective rates for (a) 3% compounded semiannually (b) 18% compounded monthly (c) 18% compounded continuously A young couple has made a nonrefundable deposit of the first months rent (equal to $1,000) on a 6-month apartment lease. The next day they find a different apartment that they like just as well, but its monthly rent is only $900. They plan to be in the apartment only 6 months. Should they switch to the new apartment? What if they plan to stay 1 year? Assume an interest rate of 12%. A copy machine is available. It has useful lives of 5 years and can be either leased or purchased. We have two options: A (leasing) and B (purchasing). The details are shown in the following table. (The first years maintenance is included in the initial cost. There are four additional maintenance payments, occurring at the beginning of each year, followed by revenues from resale.) Suppose the external interest rate is 10%. A B 6000 30000 8000 2000 0 10000

2.

3.

Initial outlay Yearly expense Resale value

It is not possible to compute the IRR for any of these alternatives, because all cash flows are negative (except for the resale values). However, it is possible to calculate the IRR on an incremental basis. Find the IRR corresponding to a change from A to B (Using Newtons Method). Is a change from A to B justified on the basis of the IRR?

Appendix Newtons method

The IRR is generally calculated using an iterative procedure. Suppose that we define f ( ) = a0 + a1 + a2 2 + + an n , where all ai s are positive and n > 1 . of estimates that conveNewtons method generates a sequence 0 , 1 , k

rges to the root > 0 , solving f ( ) = 0 .

Step 1: Choose any 0 > 0 close to the solution and a small > 0 ; Step 2: Assuming k has been calculated, evaluate

f ( ) = a1 + 2a2 k + 3a3k2 + + nan kn 1 and define f (k ) k +1 = k ; f (k )

Step 3: When | k +1 k | , we stop and let k +1 . If not, we return to step 2.