Question:
a) Kayak Plc is closing down its factory which will make all the workers redundant. Kayak's CEO is enraged to learn that the firm must continue to pay for workers' health insurance for 4 years. The cost per worker next year will be £2,400. The inflation rate is expected to be 4% per year and the health costs are expected to increase 3 percentage points faster than inflation. The nominal discount rate is 10%. What is the present value of this obligation?
b) You are to receive cash payments of £1,000 at the end of each of the next three years. Assuming a nominal discount rate of 7 percent, what is the present value of these cash flows? If the rate of inflation is 2 percent in years one and two and 3 percent in year 3, what are the values of these cash flows in real terms and what are the real discount rates for years one, two, and three? Show that discounting real cash flows using real discount rates gives the same present value as discounting nominal cash flows at a nominal discount rate.
c) A two-year and a five-year bond both have coupon rates of 7%. Both bonds are currently selling at par. How much does the price of each bond change if the interest rates fall to 5%? Explain the difference in the price change for these bonds?