Answers to Problem Set 7 1. (a) The equation is -65+30 δ + 84 δ 2-10 δ 3- 12 δ 4 = 0 (b) Only δ=.77 makes sense here which in turn gives i*=.2864. (c ) The balance in the “project account” (see handout) has to be zero at the end of the project. In year 0 the balance is Fo=-65 Since Fo is negative, the borrowing rate i’ will be used to calculate the interest plus principal which is (1+i’ )(-65). But at the end of year 1 there is a deposit (positive amount) of 30, therefore the balance at the end of year 1 will be F 1 = (1+i’ )(-65)+30 Even at a borrowing rate of 0%, F 1 will be negative and thus the rate i’ should be used again to calculate the next period’s balance:
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