Homework Solution: Investment Science

Solution Problem 5.2: The Road

Project # or 4 are carried out B# B% "

Project ' or ( are carried out B' B( "

Add constraint:
B# B% " B' B( !
Observe:
B# B % " B ' B ( "
Hence, if projects # or % are carried out, either project ' or ( must also be
carried out.

EMSE 6992 : Investment Science - Leunberger Page 1

Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr
Homework Solution: Investment Science

Cost NPV Optimal

($1,000) ($1,000) x-values Cost NPV Goals
Road between Augen and Burger
1 Concrete, 2 lanes 2,000 4,000 0 0 0
2 Concrete, 4 lanes 3,000 5,000 0 0 0
3 Asphalt, 2 lanes 1,500 3,000 0 0 0
4 Asphalt, 4 lanes 2,200 4,300 1 2,200 4,300 1
Bridge at Cay Road
5 Repair Exisiting 500 1,000 0 0 0
6 Add Lane 1,500 1,500 1 1,500 1,500
7 New Structure 2,500 2,000 0 0 0 1
Traffic Control in Downsburg
8 Traffic lights 100 300 0 0 0
9 Turn lanes 600 1,000 0 0 0
10 Underpass 1,000 2,000 1 1,000 2,000 1
At most one project can be selected for each major objective Totals 4,700 7,800

EMSE 6992 : Investment Science - Leunberger Page 2

Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr
Homework Solution: Investment Science
Solution Problem 5.11: Growing Annuity

W "1

"15" " 5"

"<5
"< "<5
5" 5#

"15"
5#
" "1
"< "< "<
5#

"1
5"
" "1
"< "< "<5
5"

" "1 "1 "

"< "< W W" "< "<

<1 " "

W "< "< W <1

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Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr
Homework Solution: Investment Science
Solution Problem 5.12: Two-Stage Growth
It is common practice in security analysis to modify the basic dividend
growth model by allowing more than one stage of growth, with the growth
factor being different in different stages. As an example, consider company
^ , which currently distributed dividend of $"!Q annually. The dividends
are expected to grow at a rate of "!% for the next & years and at a rate of
&% thereafter.

+ Using a dividend discount approach with an interest rate of "&%

what is the approximate value of the company?

Approximate Value: $"#(*"Q (See spreadsheet)

, Find a general formula for the value of a company satisfying a

two-stage growth model. Assume a growth rate of K for 5 years,
followed by a growth rate of 1 thereafter, and an initial dividend
of H! .

EMSE 6992 : Investment Science - Leunberger Page 4

Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr
Homework Solution: Investment Science

R T Z H!
5
" K3 H! " K5 " 13
3
5 3
"
3"
" < " < 3"
" <

For the first term in " we have

5 5 5
" K3 "K 3 3 "K
B where B
3"
" <3 3"
"< 3"
"<

Utilizing B3
8
BB8"
"B one obtains
3"

"< "K
"<
5 +1 5

"K "K
5
" K3 "< "
3
"K
" K #
3"
" < " "<
<K

EMSE 6992 : Investment Science - Leunberger Page 5

Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr
Homework Solution: Investment Science
For the second term in # we have

" 13 "1 3
" < 3 " <
3" 3"

Utilizing B3

B
"B one obtains
3"

"1
" 13 "< "1 " "
3
"1
"1
" 1 $
3"
" < " "< " < " "< <1

Finally, substitution of # and $ in " yields:

EMSE 6992 : Investment Science - Leunberger Page 6

Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr
Homework Solution: Investment Science

"<
5
"K
" H! " K5 "
R T Z H! " K " 1 "
<K " <5 <1
Substitution of < !"& K !" 1 !!&, H! "! and 5 & yields:

R T Z $"#(*#Q

EMSE 6992 : Investment Science - Leunberger Page 7

Chapter 5 : The Term Structure of Interest Rates Notes by J. Rene van Dorp
www.seas.gwu.edu/~dorpjr