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Group Homework Assignment #1 – Review

FINA4120 – Spring 2020

1. a) All loans require a 20% down payment. Since the base sticker price is $10,000 the down
payment is $2,000. After the down payment, there is a $8,000 loan to be financed (the loan is the
difference between the base price and the down payment). All loans are for 48 months (n = 48).
i. Chrysler offers no concession. After the $2,000 down payment, there is an $8,000 loan to be
financed at market rate (16.5% A.P.R. compounded monthly). Thus, the monthly interest rate
16.5%
is rmonthly = = 1.375% and the monthly payments can be calculated using the PV
12
formula for annuities (for n=48, r=1.375%, and the present value being equal to the principal
of the loan at t=0, $8,000):
é1 1 ù
PV = X ´ ê - nú
ë r r (1 + r ) û
é 1 1 ù
$8,000 = X ´ ê - 48 ú
= X ´ 34.969
ë 0.01375 0.01375(1 + 0.01375) û
$8,000
X= = $228.78
34.969
The WSJ article then computes the total payments as the (undiscounted) sum of monthly
payments and down payment 48∗$228.78+$2,000=$12,981.44.

ii. Ford offers a 6 percent rebate that reduces the down payment. The down payment is therefore
$2,000-$600=$1,400. The loan is still a $8,000 loan at market rate. Hence, the monthly
payments will be the same as for the offer by Chrysler. The WSJ article then again computes
the total payments as the (undiscounted) sum of monthly payments and reduced down
payment of $1,400
48∗$228.78+$1400=$12,381.44

iii. GM offers a loan at 12.8% A.P.R. compounded monthly. The monthly interest rate is
12.8%
rmonthly = = 1.067%
12
The down payment is again 20% ($2,000). The monthly payments on the $8,000 loan will
then be (for r=1.067% and n=48):
é1 1 ù
PV = X ´ ê - nú
ë r r (1 + r ) û
é 1 1 ù
$8,000 = X ´ ê - 48 ú
= X ´ 37.411
ë 0.01067 0.01067(1 + 0.01067) û
$8,000
X= = $213.84
37.411
The WSJ article then computes the total payments as the (undiscounted) sum of monthly
payments and down payment of $2,000
48∗$213.84+$2,000=$12,264.32

b) The problem with the analysis in the WSJ article is that it does not take into account the time value
of money. It compares the offers based on the total payments that are computed as the undiscounted
sum of the monthly payments and the down payment. However, the down payment occurs now (t=0)
while the monthly loan payments occur in the future. Using undiscounted sums of payments is
incorrect because it doesn't account for the timing of payouts.

c) The correct way of comparing the three offers is by computing the present value of the payments
required under each offer. The appropriate discount rate is the market rate for car loans (16.5% A.P.R.
or r = 16.5%/12 =1.375% per month).

i. Chrysler offers a market loan. Since the discount rate equals the contractual interest rate, the present
value of the loan payments equals the principal of the loan. You can double check that by discounting
the monthly payments:
é 1 1 ù
PV = $228.78 ´ ê - 48 ú
= $8,000
ë 0.01375 0.01375(1 + 0.01375) û
In addition to the monthly payments the buyer also needs to make the current down payment of $2,000
at t=0. Adding this to the present value of monthly payments yield the present value of total payments
PVChrysler = $2,000 + $8,000 = $10,000

ii. Ford also offers exactly the same loan as Chrysler. Again, the present value of monthly payments
is $8,000. The down payment is $1,400. Hence, the present value of total payments is
PVFord = $1, 400 + $8,000 = $9, 400

iii. The present value of the monthly payments of the loan offered by GM is
é 1 1 ù
PV = $213.84 ´ ê - 48 ú
= $7, 477.77
ë 0.01375 0.01375(1 + 0.01375) û
The down payment is $2,000. Hence, the present value of total payments is
PVGM = $2,00 + $7, 477.77 = $9, 477.77
Hence, Ford's offer is the best deal.

2. So, the mortgage requires n=15∗12=180 monthly payments.


The monthly interest rate is r = 0.09/12 = 0.75%.
i. $200,000 must equal the present value of the annuity of monthly payments where the monthly
interest rate is 0.75%. The first payment is due at the end of the first month. Using the formula
for the present value of annuities we can solve for the monthly payment. Let X be the monthly
payment, then
é1 1 ù
$200,000 = X ´ ê - nú
ë r r (1 + r ) û
for n=180 and r = 0.0075.
X = $200,000/98.493 = $2,028.53
The monthly payments on the mortgage are $2,028.53.

ii. The outstanding principal of the mortgage (or any other loan) is the present value of the
remaining payments discounted at the contractual rate. In this case the contractual rate is 9%
A.P.R. or r = 0.75% per month. At the end of year 5, there are 120 (10 years, 12 payments
per year) monthly payments of $2,028.53 each remaining under the old mortgage. Thus, we
can calculate the outstanding principal at the end of the fifth year as the present value of 120
equal payments of $2,028.53 with r=0.75%.
é 1 1 ù
outstanding principal = $2,028.53 ´ ê - 120 ú
ë 0.0075 0.0075(1 + 0.0075) û
= $160,135.59

After you have made monthly payments of $2,028.53 for 5 years, the outstanding principal of
your mortgage is $160,135.59.

iii. Since you want to borrow the refinancing fees of $1,500 as part of your new mortgage, the
new mortgage has to cover both the outstanding principal of the old mortgage ($160,135.59)
and the refinancing fees ($1,500). Therefore, the principal of the new mortgage is

Principalnew = $160,135.59 + $1,500 = $161,635.59

The new mortgage is a 10 year-mortgage. Hence, there are 120 monthly payments. The
contractual rate is 8% A.P.R. or r = 8%/12 = 0.667% per month. Using the formula for the
present value of annuities we can solve for the monthly payment. Let Xnew be the monthly
payment of the new mortgage, then
é1 1 ù
$161,635.59 = X new ´ ê - nú
ë r r (1 + r ) û
for n=120 and r=0.00667.
$161,635.59 = X∗82.421
X = $1,961.09
iv. After the end of year 5, the number of payments you need to make is the same, whether you
refinance or not (10 years of 12 payments per year). If you do not refinance, the monthly
payment will be the monthly payment of the old mortgage ($2,028.53), while if you refinance,
the monthly payment will be the monthly payment of the new mortgage ($1,961.09).
Therefore, if you refinance, you will save

$2,028.53-$1,961.09=$67.44 per month.


Clearly, you are better off refinancing. We can calculate the present value of this savings at
the time when you are making the refinancing decision as
é 1 1 ù
PVsavings = $67.44 ´ ê - 120 ú
= $67.44 ´ 82.421 = $5,558.50
ë 0.667% 0.667%(1 + 0.667%) û

3. a. Let's figure out the life expectancy for which the deal is a zero NPV project. For a donation of
$100,000 the annuity is $6,500 per year. The donation is zero NPV for each party when:
1 é 1 ù
$100,000 = $6,500 ´ 1-
0.05 ë 1.05 n úû
ê
Using the NPV equality above implies that
1
1- n
= 0.7692 Û 1.05 n = 4.333
1.05
Taking natural logs of both sides of this equality, and rearranging, we get that:
ln 4.333
n= = 30.05
ln 1.05
If the donor lives longer than an additional 30.05 years (i.e., to an age greater than 80.05) the
NPV is positive for the donor and negative for the Art Institute.

b. The true value is $1,000,000 minus the present value of the annuity paid to the donor. For
a life expectancy of 25 years the annuity is worth:
1 é 1 ù
$69,000 ´ ê1 - 25 ú = $626,315.76
0.1 ë 1.1 û
Therefore, the true donation is $373,684.24 = $1,000,000 - $626,315.76.

4. a. Effective annual rate on the zero-coupon bond:


100,000 4
( ) – 1 = 1.024124 – 1 = .10 or 10%
97,645
b. Effective annual interest rate on coupon bond paying 5% semiannually
(Since the bond is selling at par, BEY = C = 10%):
(1.05)2 – 1 = .1025 or 10.25%
Therefore, b has a higher effective annual interest rate
5. PV=500,000, N=360, I/Y=4, P/Y=C/Y=12, CPT PMT à $2,387.08. This is the monthly
mortgage payment if you purchase the house at the end of 2015.

Now change PV = 525,000, I/Y=5, CPT PMT à $2,818.31. This is the monthly mortgage
payment if you purchase the house at the end of 2016. This represents an increase of 18%
(=2818.31/2387.08-1). So failure to launch is costlyJ

6. a) The floating rate note pays a coupon that adjusts to market levels. Therefore, it will not
experience dramatic price changes as market yields fluctuate. The fixed rate note therefore will
have a greater price range.

b) Floating rate notes may not sell at par for any of several reasons:
• The yield spread between 1-year Treasury bills and other money market instruments of
comparable maturity could be wider (or narrower) than when the bond was issued.
• The credit standing of the firm may have eroded (or improved) relative to Treasury
securities which have no credit risk. Therefore, the 2% premium would become
insufficient to sustain the issue at par.
• The coupon increases are implemented with a lag, i.e., once every year. During a period
of changing interest rates, even this brief lag will be reflected in the price of the security.

c) The risk of call is low. Because the bond will almost surely not sell for much above par value
(given its adjustable coupon rate), it is unlikely that the bond will ever be called.

d) The fixed-rate note currently sells at only 88% of the call price. Call risk is currently low, since
yields would need to fall substantially for the firm to use its option to call the bond.

e) The 9% coupon notes currently have a remaining maturity of 15 years and sell at a yield to
maturity of 9.9%. This is the coupon rate that would be needed for a newly-issued 15-year
maturity bond to sell at par.

f) Because the floating rate note consists of a variable stream of interest payments to maturity, the
effective maturity for comparative purposes with other debt securities is closer to next coupon
reset date than the final maturity date. Therefore, yield-to-maturity is an indeterminable
calculation for a floating rate note.

7. a) The yield on the par bond equals its coupon rate, 8.75%. All else equal, the 4% coupon bond
would be more attractive because its coupon rate is far below current market yields, and its price
is far below the call price. Therefore, if yields do fall, capital gains on the bond will not be limited
by the call price. In contrast, the 8 ¾% coupon bond can increase in value to at most $1050,
offering a maximum possible gain of only 0.5%. The disadvantage of the 8 ¾% coupon bond in
terms of vulnerability to being called shows up in its higher promised yield to maturity.

b) If an investor expects yields to fall substantially, the 4% bond will offer a greater expected
return.

c) Implicit call protection is offered in the sense that any likely fall in yields would not be nearly
enough to make the firm consider calling the bond. In this sense, the call feature is almost
irrelevant.

8. The price of the coupon bond, based on its yield to maturity, is:
$120 / (1.058) + $1,120 / 1.0582 = $1,113.99.

If the coupons were stripped and sold separately as zeros, then, based on the yield to maturity of
zeros with maturities of one and two years, respectively, the coupon payments could be sold
separately for: $120 / (1.05) + $1,120 / 1.062 = $1,111.08.
Recall, we always want to Buy LOW and Sell HIGH. The arbitrage strategy is to buy zeros with
face values of $120 and $1,120 and respective maturities of one year and two years, and
simultaneously sell the coupon bond. The profit equals $2.91. The cash flows are:

T=0 T=1 T=2


Buy 1yr zero with a face value of $120 -$114.286 $120 -
Buy 2yr zero with a face value of $1120 -$996.796 - $1120
Sell the 2yr coupon bond $1113.99 -$120 -$1120
Net cash flow $2.91 - -
Cumulative net cash flow $2.91 $2.91 $2.91

9. The cash flows you will receive if you buy the bond today are $50 at t=1, t=2, and t=3 (those are
coupon payments) and $1050 at t=4 (coupon + principal payment). Hence, the fair price of the
bond today is
B B B B
P = 50 1 + 50 2 + 50 3 + 1050 4
100 100 100 100
= $1,035.52

!""#$%%$&'∗)"" )" ,$%%$&'


10. a) Deposit = 100 Million ∗ 500 − !.")!
= 50 Billion − !.")!
Asset = 8 billion
Net CF = (100 Million * 100 * 5)-40 Billion = 10 Billion
" !
)" !"-!./ 0 1
".$!
Firm value = 50 − !.")! + 8 + ".")
= 62.12 𝐵𝑖𝑙𝑙𝑖𝑜𝑛
" "$
)" !"-!./ 0 1
".$!
b) Firm value = 50 − !.")"$ + 8 + ".")
= 104.52 𝐵𝑖𝑙𝑙𝑖𝑜𝑛

11. a) Two buyers (Buyer 1 and Buyer 2) will choose to buy the bond.

b) Given Buyer 1 chooses to buy, Buyer 2 can infer that Buyer 1 observes a G signal.
Therefore, if Buyer 2 obverses a B signal, then he chooses not to buy. If Buyer 2 observes a G
signal, then he chooses to buy.

c) Given Buyer1 and Buyer 2 choose to buy, Buyer 3 can infer that Buyer 1 and Buyer 2 observe
a G signal respectively.
Therefore, Buyer 3 will choose to buy no matter which signal he observes.

d) Based on b) and c), we know that first three buyers (Buyer 1, Buyer 2, and Buyer 3) will choose
to buy.
For Buyer 4, the decision of Buyer 3 is not informative. Buyer 4 cannot infer which signal Buyer
3 observes. While given both Buyer1 and Buyer 2 choose to buy, Buyer 4 can infer that Buyer 1
and Buyer 2 observe a G signal respectively. Therefore, Buyer 4 will choose to buy since 2G>1B.
By the same token, Buyer 5 will choose to buy as well. Overall, all five buyers will choose to buy.

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