Assignment 1 for SEEM3590 Investment Science Due Date: 16 Sep. 2011, 5.

00pm
1. (The 72 rule) The number of years n required for an investment at interest rate r to double in value must satisfy (1 + r ) n = 2 . Using ln 2 = 0.69 and the approximation ln(1 + r ) r valid for small r, show that n 69 / i , where i is the interest rate percentage (that is, i=100r). Using the better approximation ln(1 + r ) r 1/ 2r 2 , show that for r 0.08 there holds n 72 / i .
2. (Effective rates) Find the corresponding effective rates for (a) 3% compounded semiannually (b) 18% compounded monthly (c) 18% compounded continuously

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(A prize) A major lottery advertises that it pays the winner $10 million. However, this prize money is paid at the rate of $500,000 each year (with the first payment being immediate) for a total of 20 payments. What is the present value of this prize at 10% interest rate? (Sunk cost) 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%. (An appraisal) You are considering the purchase of a nice home. It is in every way perfect for you and in excellent condition, except for the roof. The roof has only 5 years of life remaining. A new roof would last 20 years, but would cost $20,000. The house is expected to last forever. Assuming that costs will remain constant and that the interest rate is 5%, what value would you assign to the existing roof? (Domination) Suppose two competing projects have cash flows of the form ( A1 , B1 , B1 , , B1 ) and ( A2 , B2 , B2 , , B2 ) , both with the same length and A1 , A2 , B1 , B2 all positive. Suppose B1 / A1 > B2 / A2 . Show that project 1 will have a higher IRR than project 2.

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