Homework #2 Fall 2009

1.

You are looking into buying a new condo in the Hamptons. Currently, you have $400,000 in the bank saved for the condo, and you have access to another $2,000,000 in debt from the bank. The condo you are looking at costs $2,400,000 total, and you want to put down all $400,000 as a down payment on the home. The loan that is being offered is a 30 year mortgage, and it offers an interest rate of 12%. Payments are to be made semiannually.

A.

How much of the principal of this loan will be paid off by the beginning of the 14th year?

P/Y = 2 PV = -2,000,000 I/Y = 12% N = 60 PMT = 123,751.443

2nd AMORT P1 = 1 P2 = 26 Principal Paid = 221,921.68 B. What if you intend to pay off this 30 year mortgage early? Your plan is to increase your payment by $4000 at each semiannual payment date. If you follow through with this plan, how long will it take you to pay off the mortgage? P/Y = 2 PMT = 127,751.443 PV = -2,000,000 I/Y = 12% N = 48.091 C. Suppose that 10 years after the purchase of the condo the value of real estate in the Hamptons plummets. In response to this, the government has cut interest rates significantly and started buying 30 year U.S. Treasuries. Because of this, you have the option of refinancing your mortgage at an interest rate of 6%. Suppose also, that you are still doing well at your job and want to continue making a semiannual

Homework #2 Fall 2009 payment of $127,751.443. How long will it take you to pay off the mortgage under this new structure? P/Y = 2 PV = -2,000,000 N = 60 I/Y = 12 PMT = 123,751.44 2nd Amort P1 = 1 P2 = 20 Principal Paid = 137,998.98 Principal Outstanding = 2,000,000 - 137,998.98= 1,862,001.02 P/Y = 2 PV = -1,862,001.02 PMT = 127,751.443 I/Y = 6% N = 19.4504 + 20 = 39.4504 Periods or about 20 Years in total or an additional 9.73 years from when the loan is refinanced

2.

You intend to buy a $600,000 house in Hawaii. Your local lender offers you a $550,000 mortgage. The entire mortgage is financed over 40 years using an adjustable rate mortgage. The ARM is set at 8.75%. The adjustment to the ARM is indexed to the t-bill rate and is made once a year; not exceeding 3% in any one year or 7% over the life of the loan. The exact adjustment formula is T-bill rate + 2.65%. A. What is your monthly payment in the first year? 2nd P/Y 12 PV = -550,000 I/Y = 8.75 N = 40*12 = 480 CPT PMT PMT = 4,136.94

B. After 1 year, the T-bill rate is at 8%. What is the new rate of the ARM? What will be your new monthly payment? ARM = T bill rate + 2.65% = 8% + 2.65% = 10.65%

Homework #2 Fall 2009

2nd P/Y 12 PV = -550,000 I/Y = 8.75 N 480 CPT PMT PMT = 4,136.94 2nd Amort: P1 = 1 and P2 = 12 Balance = $548,419.34 Then, 2nd P/Y 12 PV = -548,419.34 I/Y = 10.65% N = 468 CPT PMT PMT = 4,946.3626 3. Your uncle Leo just sold his famous invention to Microsoft for a large sum of money. If the interest rate is 15%, which one of the following would you advise him to take? Please show the value of each alternative. A. $300,000 now 300,000 B. $450,000 at the end of 5 years FV = 450,000, N = 5, I/Y = 15, P/Y = 1, CPT PV = 223,729.5309 C. $36,000 a year forever starting next year. 36,000/0.15 = $240,000 D. $25,000 for each of the next 15 years, starting next year. N = 15, I = 15, PMT = 25,000, PV = 146,184.25 E. $9,900 next year and increasing thereafter by 10% per year forever. 9,900/(0.15-0.10)=$198,000 F. $50,000 a year forever, with the first payment received at the end of 5 years.

Homework #2 Fall 2009

50000/.15=333333.33 N = 4, I = 15, FV = 333333.33, PV = 190,584.42

4.

You are currently saving for a lavish retirement, which you hope to spend on a tropical island. In order to be able to purchase your dream home, a boat, a seaplane, and a parrot, you estimate that you need to have $12,092,439 saved by the time you reach retirement. At present, you are 20 years old and plan to work for another 30 years. Your current salary is $1,000,000, and you know you can earn a risk free 4% on your savings.

A. Given the above information, how much money will you have to save from your annual paycheck to reach your goal?

FV = 12,092,439 I/Y = 4% N = 30 PMT = 215,609.3861

B. What if, after 10 years of diligent savings, a financial crisis strikes and the interest you can earn on your money decreases from 4% to 2%. What is the new payment required to fulfill your goal?

N = 10 I/Y = 4% PMT = 215,609.3861 FV = 2,588,629.386

PV = 2,588,629.386 I/Y = 2%

Homework #2 Fall 2009 N = 20 FV = 3,846,567.09 So we need an additional: 12,092,439-3,846,567.09=8,245,871.91 FV: 8,245,871.09 I/Y: 2 20 N PMT = $ 339,373.03 5. Michael Williams Jewelers recently issued a $1,000 face, 20-year zero-coupon bond for $225. The initial public offering sold in January 2006. A. What is the yield to maturity on this bond at issuance? P/Y = 1 PV = -225 FV = 1000 N = 20 CPT I/Y = 7.7434% B. What is the current yield on this bond? The bond doesnt have a current yield because it doesnt pay interest payments. C. What is the implicit interest earned for this bond in year 2? Find PV at 19 years to maturity: FV = 1000 I/Y = 7.7434 N = 19 CPT PV = 242.4249 Find the PV at 18 years to maturity: FV = 1000 I/Y = 7.7434 N = 18 CPT PV = 261.1968 Interest = 261.1968 242.4249 = 18.7719

Homework #2 Fall 2009 *We had to add the for $225 it was left out in the coursepack copies. We will post an announcement on angel and Mrs. Booth will announce it in class. 6. Letts Industries is a publicly traded company that has been very successful. They have been paying a dividend for 8 years, but they want to find another way to return money to their shareholders. They decide to explore the possibility of a share repurchase. The firm currently has 100 million shares outstanding, and they plan on earnings of $350 million in year 1. Additionally, the market believes these earnings will grow at 3% per year forever, and they believe the proper discount rate for the firm is 10%. Of the revenues, the firm plans to pay out 20% as a dividend and use 20% to repurchase shares. Assume that the firm keeps this payout policy constant. Please use the payout model to solve this problem A. What is the present value of the total dividend payment that will be made to shareholders? P0 = P1/r-g = (350*.2)/(.1-.03) = 1000 = 1B B. What is the present value of the total share repurchases that will be made in the future? P0 = Repo1/(r-g) = (350*.2)/(.1-.03) = 1000 = 1B C. What is the present value of one share of this firm? Total Payout Method = P0 = PV(Future Div and Repo)/shares outstanding Dividend PV = (350*.2)/(.1-.03) = 1000 Repo PV = (350*.2) / (1-.03) = 1000 PV(Div and Repo) = 2000 1000/# of shares = 2000 / 100 = $20 / share 7. You are given two bonds. Bond A has a 6% coupon rate paid semi-annually, a 20-year maturity, and is currently selling at $1,000. Bond B has a 6% coupon rate paid semiannually, a 10-year maturity, and is currently selling at $1,000. If interest rates rise over the next year, what will happen to the prices of these two bonds, all else held constant? Which bond, if either, will depreciate most rapidly? Explain. First, there is an inverse relationship b/w present values and the interest rate. Therefore, if interest rates rise, the value of both bonds will fall. Second, both bonds pay the same coupon rate, but Bond A has a longer maturity. Holding all else constant, the longer the time to maturity, the greater the interest rate risk. Therefore, Bond As price will fall by a larger amount than Bond Bs price. 8. You are a financial analyst at Highbridge Capital Management, and you are looking into the bonds of General Electric for a potential investment. The bonds are currently selling

Homework #2 Fall 2009 for a price of $1,086.32 per $1000 bond, and they currently have a yield to maturity of 8%. The bonds are set to mature in 10 years, and they make coupon payments semiannually.

A. What is the coupon rate of these bonds?

P/Y = 2 PV = 1086.32 FV = 1000 I/Y = 8% N = 20 PMT = 46.3516

46.3516*2 = 92.7032/1000 = 9.27%

B. What is the current yield on this bond?

Yearly PMT = 92.7032 Current Price = 1086.32 Current Yield = 8.53%

C. Suppose investors believe that the overall market has become less risky, and they begin requiring a lower return for the given risks they are taking. This shift in sentiment causes the market rate to decrease from 8% to 6%. What is the new price of the GE bond?

P/Y = 2

Homework #2 Fall 2009 FV = 1000 PMT = 46.3516 N = 20 I/Y = 6% PV = 1,243.2705

9.

You just read an investing book that recommended diversifying your portfolio in order to decrease risk and increase return. You previously were fully invested in Bear Stearns equity, but you have decided to take the books advice and move some of this money. You have decided to evaluate Walmart, because you think it will do well, even in a recession. The stock currently is trading at $43.06, and it has just recently paid its dividend of 1.43/share, and the investors discount this stock at a rate of 10%. A. What is the current assumed growth rate that is priced into this stock?

P = D1/(r-g) D0 = 1.43/share P = D0*(1+g)/(r-g) 43.06 = 1.43*(1+g)/(.1-g) 4.306-43.06g = 1.43 + 1.43g 2.876 = 44.49g G = .0646 = 6.46%

B. Suppose the growth rate is changed to 8%. What is the new price of the stock?

G = 8% D = 10% D1 = 1.43*1.08 = 1.5444

Homework #2 Fall 2009 P0 = 1.5444/.1-.08 P0 = 77.22 10. Internet Question