Question

Noi Piana Corporation needs $168,000,000 twenty years from now to replace three assembly lines in their Torino plants. Noi Piana Corporation plans to make equal payments, starting today, into an investment account. It can buy bonds, which mature in twenty years, or bonds, which mature in one year. Both types of bonds currently sell to yield 10 percent. Noi Piana Corporation’s best estimate of the future interest rates is that they will stay at current levels, they may go up or they may go down, but the expected interest rate is the current interest rate.

There is some chance that the assembly lines will wear out in less than twenty years, in which case Noi Piana Corporation will need to cash out its investment before twenty years. If that occurs, Noi Piana Corporation will desperately need the money that has been accumulated—this money could save the corporation for bankruptcy and going out of business.

a) How much should Noi Piana Corporation plan to invest each year in the investment account to accumulate enough money to replace the assembly lines?

b) If Noi Piana Corporation decides to invest enough money right now to accumulate the needed $168,000,000 at the end of twenty year, how much must it invest?

c) What type of risk is generally relevant to 1-year bonds and what time risk is generally relevant to twenty-year bonds?

d) Can you suggest any type of bond, which might be beneficial for Noi Piana Corporation’s purposes? Defend your position.

Answer 1

a) $ 2933,217

FV= 168,000,000

Nper= 20

Rate= 10%

Using PMT function as =PMT(10%,20,,-168000000) = 2933,217

b) $24,972,130

Using PV function as =PV(10%,20,,168000000), we get the present value of investment which will yield 168 milllion in 20 years.

c) 20 years bonds are subject to interest risk. Higher the maturity, higher is the risk of flctuation in price due to interest changes.A longer-term bond carries greater risk that higher inflation could reduce the value of payments, as well as greater risk that higher overall interest rates could cause the bond's price to fall.

A one year bond on the hand will yield lower returns.

d) For Noi Piana Corporation, the 20 year bond is better. This is because there is a sureity of return from this bond which will be enough to provide it with enough amount to replace the machinery.