Question

1. A beach town in Maine is being attacked by a great white shark. The local municipal council has offered to reward to anyone who can kill this fish. An eccentric local fisherman has offered to catch and kill the shark and demands an immediate payment of $8,000. He also demands to be paid $1,000 every six months for the next three years (beginning six months from today). His final demand is a one-time lump sum payment to his daughter in exactly 5 years of $6,000. The council hires this fisherman. Compute the present value of the demand under the following market conditions: (assume the fisherman is successful and is not eaten like in the movie). Real risk-free rate: 2.26% Default risk premium: 2.08% Liquidity premium: 0.85% Maturity risk premium: 1.01% Inflation premium: 1.62%

Answer 1

Nominal rate = Real risk free rate + Inflation
Nominal rate = 2.26% + 1.62%
Nominal rate	3.88%
Immediate payment	8000
Semi annual payment	1000
Period (3*2)	6
Excel formula for finding present value	Present value of $1000 semi annual payment
=PV(3.88%/2,6,-1000,0,0)	5,612.79
Lump sum amount	6000
Rate	3.88%
Period years	5
Excel formula for finding present value	Present value of lump sum $6000
=PV(3.88%,5,0,-6000,0)	4,960.11
* assuming annual compounding
Total present value = Initial payment + PV of semi annual payment + PV of Lump sum payment
Total present value = 8000 + 5612.79 + 4960.11
Total present value = 18,572.90