Bridge program, Summer 2005

Finance module, Solutions to assignment 2

Solutions to assignment 2: NPV Analysis

1. Details on the solutions in assign2sol.xls. (a) Find the value of a 6%-coupon bond with a face value of $100,000, which matures in May 2048. Assume coupons are paid annually. This bond pays $6,000 in May 2045, May 2046, and May 2047, and $106,000 (principal plus coupon) on May 2048. We can simply discount these cash ows using the rates from assignment one to get V = 6 6 6 106 + + + = $105.983 1.0299 1.0681 1.1248 1.1883

Note that I have used the total holding returns to discount the above cash ows. I could have equivalently used the annualized rates (and raise these to the time at which the payments occur), or even simpler just multiply the cash ows by the discount factor (which is the bond price divided by 100). You will get the same answer either way. (b) Find the value of a 8%-coupon bond with a face value of $500,000, which matures in February 2049. Assume the coupons are paid semi-annually, i.e. the bond pays coupons of $20,000 (4% of $500,000) every February and August until maturity. The calculations for this bond are similar. The bond has 9 coupon payments of $20,000 each, plus a payment of principal and the last coupon, amounting to $520,000. Discounting each of the payments by the appropriate rates should yield the value V = $583838. Finally note that in both (a) and (b) the value of the bond is higher than its face value. This is simply due to the fact that their coupon rates are higher than the current term structure. (c) Imagine you want to issue a coupon bond with face value of $300,000, which matures in May 2047, and which pays an annual coupon of x%. For what coupon x would the bond sell at par (i.e. its price would equal its face value)? Fixing x, this bond has cash ows of 300000x in May 2045 and May 2046, and of 300000(1 + x) in May 2047. Using the discount rates from assignment one we have that the value of such a bond should therefore be given by 300x 300x 300(1 + x) + + = 300; 1.0299 1.0681 1.1248 where the equality in the above equation comes from the fact that we would like to set the coupon x such that the value of the bond (the left-hand side of the above expression), equals its face value of $300000. One can solve the above equation analytically or numerically to nd a coupon of x = 0.03967, i.e. around 3.97%. This number is a (complicated) weighted average of the spot rates during the life of the bond.

Tuck School of Business at Dartmouth

Pr. Diego Garc a

Bridge program, Summer 2005

Finance module, Solutions to assignment 2

2. Consider a mortgage for a $350,000 house, with 20 year maturity, for which the owners plan to nance $300,000. The bank quotes an interest rate on this loan of 6%. What monthly payments will the buyers face? Break down the interest and principal payments for the rst two-years (on a monthly basis). What can you say about the after-tax monthly payments by the new owners of the house? First we convert the annual rate into a monthly rate: rm = 0.06/12 = 0.5%. Using the annuity formula we can nd the payment by solving 300000 = 1 C 1 0.005 (1 + 0.005)240 = 139.58C; C = 2149.29

In order to nd how much principal and interest each payment represents, we can construct a spreadsheet such that: (i) the rst column records the amount outstanding in the loan (starts at 300000); (ii) the second column records the interest due that period, simply equal to 0.005 times column one; (iii) the third column calculates the amount of principal repaid (equal to the payment minus the interest); (iv) the fourth column records the principal amount owed to the bank after each payment (which becomes the rst column in the next row). See the table below for the calculations for the rst 4 months (the spreadsheet includes the rest). Month 1 2 3 4 Balance (before payment) 300,000.00 299,350.71 298,698.17 298,042.36 Interest 1,500.00 1,496.75 1,493.49 1,490.21 Principal 649.29 652.54 655.80 659.08 Balance (after payment) 299,350.71 298,698.17 298,042.36 297,383.28

In terms of the after-tax payments, it should be noted that they will be less than the $2149.29, since every year the new owners will be able to deduct part of these payments (the interest portion) from their income tax. In other words, by taking on this mortgage loan, the new owners will have to pay $2149.29 to the bank, but at the same time they will receive a tax break each year (which depends on the actual interest expense). The actual after-tax amount will depend on their marginal tax rate, and can be easily computed using the calculations outlined above once this tax rate is known. As an illustration, take a marginal tax rate of 30%. Then by deducting $1500 from the rst payment of the loan, the owners will save (0.3)1500 = 450 in taxes next year. Therefore we can approximate the after tax payment on the loan that month to be 2149 450 = 1699.

Tuck School of Business at Dartmouth

Pr. Diego Garc a