FINANCE 2360 ASSIGNMENT #2

Please make sure to show all your work! Final answers without supporting work will receive a 0 mark.

Total Marks: 55

Chapter 6 Cash Flow Valuations

Problem 1 (8 marks)

You are considering between 2 investments: A and B.   Investment A will pay you $100 per year forever with the first cash flow occurring 11 years from today.  Investment B will pay you $90 per year forever with the first cash flow also occurring 11 years from today; however, the cash flow amounts are expected to grow at 1% forever.  Assume interest rates are expected to be 6.125% every year forever;

1. What is Investment A worth today? (3 marks)
2. What is Investment B worth today? (4 marks)
3. Which investment would you choose? (1 mark)

Problem 2 (10 marks)

You would like to buy a big boat.  You do your research and find the boat you want in Portugal.  The price of the boat is $300,000 and it will cost $20,000 to have the boat delivered to Halifax.  You go to the bank to borrow the entire amount of the purchase and the bank offers you a loan with a 20-year amortization at 5% (monthly compounding) with a 5-year term.  You plan on making monthly payment on this loan.

1. Calculate your monthly payments. (3 marks)

1. At the end of the 5^th year, you will need to negotiate a new interest rate and a new payment schedule. The loan contract allows you to pay down 10 percent of the original loan amount with no penalty. You have saved the 10 percent so you will pay down the amount you owe to the bank.  How much do you still owe the bank before you pay down the loan amount? (2 marks)

4. When you go to the bank to re-negotiate your loan with the bank. Interest rates are now 4.75 percent (monthly compounding).  If you make the payment to reduce the loan balance for the remaining amortization period, what are your new loan payments? (3 marks)

1. If this loan had been to purchase a summer home, explain what changes would be made for your calculations in the previous parts of this question? No calculations required. (2 marks)

Question 3. (10 marks)

You have saved $50,000 to use as a down payment for some property and to build a home. The home is in a prime building location that has trees and a stream running through the property.  The clearing of the land and the building of the house will cost a total $650,000.

1. How much money will you need to borrow through a loan for your home? (2 marks)

4. The bank offers to finance your purchase with a 25-year amortized loan with a 5-year term at 4.125%. You want to make monthly payments on this loan, how much are the monthly payments? (3 marks)

4. At the end of the 5-year term, the loan terms allow you pay down an additional 10% of the original loan amount and the terms allow you to change the remaining amortization period. You have saved the additional money to pay down the amount of the loan and you what to shorten the remaining amortization by 5 years. The bank will fund your loan at 4.50% for a 5 year term. If you are to make monthly, what are your new monthly payments for the loan after the renegotiation? (5 marks)

Chapter 7 Interest Rates and Bond Valuation

Question 4 (4 marks)

1. How does a bond issuer decide on the appropriate coupon rate to set on its bonds if the company wants to issue a bond at par value? (2 marks)

1. Explain the difference between the coupon rate and the required rate of return and the impact of the required rate of return on the market value of the bond? (2 marks)

Question 5 (11 marks)

Bond P is a 12 percent coupon bond that is selling at a premium. Bond D is a 6 percent coupon bond currently selling at a discount. Both bonds make semi-annual payments, have a YTM of 9 percent and have 5 years to maturity.

1. What is the current yield for bond P? (3 marks)
2. What is the current yield for bond D? (2 marks)
3. Assume the YTM (yield to maturity) decreases to 8%. Which bond is more sensitive to changes in the market interest rate making the bond riskier? Show your work! (6 marks)

Question 6 (3 marks)

Any regular coupon bond of any maturity will sell for its face value if the coupon rate is the same as the market rate of interest. TRUE or FALSE? Explain and provide an example to support your answer.

Problem 7. (9 marks)

Three years ago, you purchased a 30 year, $1,000 par value bond for a quoted price of 95.0. The bond pays its 5% coupon semi-annually.

1. If the present market rate on identical bonds is 4%, at what price should the bond trade today? (3 marks)

1. If you sell your bond today for the price you calculated above, what is your EFFECTIVE ANNUAL HOLDING PERIOD RETURN over the 3-year period? (6 marks)