UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

MGT337Y PROBLEM SET #2 Nov. 10, 2006

SOLUTIONS

1. (a) The implied forward rate for the third year is given by f3 = (1+ r3 )3 /(1+r2 )2 − 1 =
(1.15)3 /(1.14)2 − 1 = 17.03%.
(b) Denote Y (C; T ) the yield to maturity of a coupon bond with coupon rate C% and
maturity T . Then Y (C; T ) is given by the solution to the following equation:
T T
X C 100 X C 100
t
+ = +
t=1 (1 + rt ) (1 + rT )T t=1 (1 + Y (C; T ))
t (1 + Y (C; T ))T

Solving this for C = 5 and T = 5, we obtain Y (5; 5) = 15.57% and for C = 10 and
T = 5, we have Y (10; 5) = 15.47%. Obviously, the yield to maturity of the 5% coupon
bond is higher than the yield to maturity of the 10% coupon bond. A 5% coupon
bond has a higher percentage of its cashflows coming at maturity than a 10% coupon
bond, so the effective (or weighted average) maturity of the cashflows of the 5% coupon
bond is longer than that of the 10% coupon bond. When we face an increasing term
structure of spot rates, a long term bond is going to earn a higher interest rate than
a short term bond. Therefore, the longer effective maturity of the 5% coupon bond is
the reason why it earns a higher yield over its life.

2. (a) To find the term structure, we start with the equations for bond prices:
1080
1018.772 = ,
1 + r1
1000
907.029 = ,
(1 + r2 )2
50 50 50
136.967 = + 2
+ .
1 + r1 (1 + r2 ) (1 + r3 )3
Note that the one-year coupon bond only has one more cash flow before maturity, so
we price it as we would a zero coupon bond.
We can solve the system of equations above to get r1 = 6.01%, r2 = 5%, and r3 = 4%.
(b) Note that f1 = r1 = 6.01%. We can apply the formula we learnt in class to get
f2 = (1 + r2 )2 /(1 + r1 ) − 1 = 4% and f3 = (1 + r3 )3 /(1 + r2 )2 − 1 = 2.03%.

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 (c) Under the expectations theory, our best forecast of the 1-year rate next year, 1 r2 ,
is the forward rate over year 2, or f2 :
E[1 r2 ] = f2 = 4%.
Thus, the expected price of the zero-coupon bond in a year is
1000 1000
 
E[P1 ] = E ≈ = 961.538.
1 + 1 r2 1 + E[1 r2 ]

(d) The forward rate is the same as the implied rate we computed in part (b). Thus,
there is no mispricing. Arbitrage is not possible here and we cannot eat a free lunch.
(e) Note that the rate offered by Bank of Montreal is different from the forward rate
implied by the spot interest rates. Thus, there is an arbitrage opportunity here!
We begin by identifying the mispriced security. Obviously, it is the forward over the
second year.
To create a replicating portfolio for that forward, we need to trade the three bonds.
Suppose that you invest in x1 units of the 1 year bond, x2 units of the second one, and
x3 units of the third one. The cash flows of your portfolio will be:

t 1 2 3
Cashflow 1080x1 + 0x2 + 50x3 1000x2 + 50x3 50x3

We need to make sure that the cash flows of the replicating portfolio are the same as
the cash flows of the forward loan. You want to get $10,000 at the end of year 2 and
repay it with interest at the end of year 3. That is, the cash flows need to satisfy:
0 = 1080x1 + 0x2 + 50x3
10000 = 1000x2 + 50x3
−10000(1 + 0.03) = 50x3
Solving the system of equations we get x1 = 9.537, x2 = 20.3, and x3 = −206. If you
hold 9.537 units of the coupon bond, 20.3 units of the zero-coupon bond, and -206
units of the annuity, you will exactly replicate the payoffs of the forward loan: you will
get zero cash flow at the end of year 1, $10,000 at the end of year 2, and you will need
to pay $10, 000 × (1 + 0.03) = $10, 300 at the end of year 3. The value of this portfolio
is:
1018.772x1 + 907.029x2 + 136.967x3 = −86.447.
The value is negative. It means that if you want to get these cash flows (receive $10,000
in two years and pay $10,300 in three years) investors will gladly give them to you and
even compensate you by paying you $86.447 to make sure that you break even.1
1
You can check that if the forward rate is correctly priced (i.e., it is equal to 2.03%) then the value of the
replicating portfolio is equal to 0.

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 We construct the arbitrage strategy by “buying low and selling high.” We want to buy
the underpriced security, or the replicating portfolio. We want to sell the overpriced
one, or the forward contract from Bank of Montreal (to do that, we will invest the
money with the Bank to earn the forward rate interest). Our payoffs will be as follows:

t 1 2 3
Buy low 86.447 10,000 −10,300
Sell high 0 −10,000 10,300
Total 86.447 0 0

This pattern of cash-flows proves that we have an arbitrage opportunity here: you get
something today without any obligations in the future.
3. (a) There are four factors that could affect the P/E ratio of a stock: (i) the discount
rate (which is itself related to the risk of the stock), (ii) unexpected earnings (i.e.,
a stock could have unusually high or low earnings in the past year and as a result
the realized earnings are different from the expected normal earnings), (iii) accounting
methods (e.g., the choice of LIFO versus FIFO), and (iv) the net present value of
growth opportunities. In this case, we believe that Planet Hollywood is more risky
than McDonald’s, so risk is not an explanation why Planet Hollywood has a higher
P/E ratio than McDonald’s. It is also not possible that Planet Hollywood had an
unusually low earnings in the previous year. Otherwise, they would not had gone to
the markets for an initial public offering. In addition, since both Planet Hollywood and
McDonald’s have to conform to GAAP in the U.S., it is unlikely that the differences
in the accounting methods that they adopt could explain the huge difference in their
P/E ratios. That leaves the growth rate as the only plausible explanation that Planet
Hollywood and McDonald’s have such a big difference in their P/E ratios. Obviously,
investors believe that the earnings of Planet Hollywood will grow at a much faster rate
than the earnings of McDonald’s. Whether this expectation of high growth rate for
Planet Hollywood can be justified by fundamentals or not is another issue.
As stocks can have higher P/E ratios because of lower risk or higher growth rate, it
is not entirely clear whether stocks with low P/E ratios are better buy than stocks
with high P/E ratios. It is only when the pricing of stocks cannot be supported by the
fundamentals that we can say one stock is better buy than another stock. However,
mispricing can occur in both high P/E stocks and low P/E stocks, so P/E alone cannot
be used as an indicator of mispricing.
(b) From the valuation formula, we have
EPS
P = + NPVGO.
r
Dividing this equation by P and rearranging the terms, we get
NPVGO 1
=1− .
P r(P/EPS)

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 Under different assumptions of capitalization rate r, the following table presents the
values of NPVGO/P for Google.

r 5% 10% 15% 20%

NPVGO/P 0.7143 0.8571 0.9048 0.9286

This table shows that the implied NPVGO in the price of Google depends crucially on
the assumption of the discount rate (i.e., the return that you expect to earn by holding
Google). If you are only willing to hold Google when it offers you an expected return
of 20%/year (maybe because you think it is a risky stock), then you are implicitly
assuming that there is a lot of future growth opportunities with Google such that they
account for 92.86% of its current stock price.

A way to provide a reality check to your assumption is to use the expected return to
compute the expected market capitalization in a few years. If you assume r = 20%,
then you expect the equity of Google will be worth $146b. × (1.2)5 = $363.3b. in five
years’ time (which is about the same as the current market value of General Electric,
which is $367.6b.). Is this realistic? If not, then you may want to lower your assumption
of r, but then you have to ask yourself are you willing to hold Google by earning an
expected return of say only 5%? The following table provides the expected market
value of Google five years from now under different assumptions of r.

r 5% 10% 15% 20%

Google $186.3b. $235.1b. $293.7b. $363.3b.

This suggests that in order to justify the current high valuation of Google and Yahoo,
one must be able to justify a substantially higher valuation for them in five years’ time.

4. The NPV of project A is given by

4000 2000 1000

NPVA = −5000 + + 2
+ .
1 + r (1 + r) (1 + r)3

The NPV of project B is given by

1000 2000 5000

NPVB = −5000 + + 2
+ .
1 + r (1 + r) (1 + r)3

Setting NPV = 0 and solving for r, we have IRRA = 0.2486 and IRRB = 0.2115.
Therefore, project A should be accepted when r < 0.2486 and rejected when r >
0.2486. Similarly, project B should be accepted when r < 0.2115 and rejected when
r > 0.2115. It remains to find out at what discount rates that we will prefer Project
B to A. Consider the incremental cashflows from going to project A to B. They are

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 given by C0 = $0, C1 = −$3000, C2 = $0, C3 = $4000. The incremental IRR of going
from project A to project B is the solution to

3000 4000
0 = NPVB−A = − + .
(1 + IRRB−A ) (1 + IRRB−A )3

Solving the equation, we have IRRB−A = 0.1547. Therefore, we would prefer project
B to project A when r < 0.1547 and vice versa when r > 0.1547. The following graph
plots the NPV of the two projects as a function of the discount rate. In summary,
if 0 < r < 0.1547, we prefer project B to project A, but we would accept both. If
0.1547 < r0.2115, we prefer project A to project B, but we would accept both. If
0.2115 < r < 0.2486, we would accept project A and reject project B. If r > 0.2486,
then we would reject both projects.

3000

2500
NPVB
2000
Net Present Value

NPVA
1500

1000

500

−500

−1000
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount rate

5. The following table gives the cashflows (in 000’s) of the project other than the CCA
tax shield.

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 0 1 2 3 4 5
NWC 585 1,510.5 1,852.5 2,166 2,451 0
Sales 5,035 6,175 7,220 8,170 4,370
Fixed Costs 25 25 25 25 25
Variable Costs 3,180 3,900 4,560 5,160 2,760
Net Operating Income 1,830 2,250 2,635 2,985 1,585
Taxes (40%) 732 900 1,054 1,194 634
After-tax NOI 1,098 1,350 1,581 1,791 951
Changes in NWC −585 −925.5 −342 −313.5 −285 2,451
Cost −6,500
Salvage Value 1,950
Total −7,085 172.5 1,008 1,267.5 1,506 5,352

The present value of CCA tax shield is given by

PV(CCA Tax Shield)

CdT 1 + k2
! n
Sn dT 1

= −
d+k 1+k d+k 1+k
6,500,000 × 0.2 × 0.4 1.1 1,950,000 × 0.2 × 0.4 1 5
   
= −
0.2 + 0.2 1.2 0.2 + 0.2 1.2
= 1,034,934.

The NPV of the project is therefore given by

172,500 1,008,000 1,267,500 1,506,000 5,352,000
NPV = −7,085,000 + + + + +
1.2 (1.2)2 (1.2)3 (1.2)4 (1.2)5
+ 1,034,934
= −1,595,687.