Finance 5405 Financial Management

Student

Instructor

Course

Institution

Date
 QUESTION ONE
a) Monthly Payment on the Mortgage

The mortgage is $375,000 with a nominal annual interest rate of 6.6%. The loan is for 20 years, with

monthly payments. The formula for calculating the monthly payment on a fixed-rate mortgage is.

P∗r ( 1+r )n
M= n
( 1+r ) −1

In this case,

 M is the monthly payment,

 P is the loan amount ($375,000),
 r is the monthly interest rate (annual rate divided by 12),
 n is the number of payments (loan term in months).

To get the monthly payments, we calculate the monthly interest rate as follows;

6.6 %
r= =0.55 %
12

The total number of months = n=20∗12=240

The total number of monthly payments;

000∗0.0055 (1+ 0.0055 )240

M =375 , 240
( 1+0.0055 ) −1

Monthly Payment on the Mortgage= $ 2061.50

b) Percentage of Payments in the Third Year Going Toward the Principal.

To calculate the percentage of payments going toward the principal in the third year,

we first need to calculate the loan balance after two years and use the amortization method to

separate the interest and principal components. In the first two years (24 payments), the
remaining balance can be calculated using the formula for the loan balance after a certain

number of payments.

n P
P∗( 1+r ) −( 1+ r )
Balance= n
( 1+ r ) −1

Where p is the number of payments made (24 after two years). After two years,

240 24
375,000∗( 1+0.0055 ) − (1+ 0.0055 )
Balance= 24
( 1+0.0055 ) −1

Balance= $ 355, 673.0102

The monthly interest in the third year = $ 355 673.0102*0.0055=$1 956.202.

The principal portion= $ 2061.50-$1 956.202

The principal portion= $105.30

$ 105.30
Percentage= ∗100=5 .11%
$ 2061.50

Thus, 5.11% of payments in the third year go toward the principal.

c) Remaining Balance After 4 Years

After 4 years (48 payments), the remaining balance is calculated using the same balance formula:

240 48
375,000∗( 1+0.0055 ) − (1+ 0.0055 )
Balance= 24 0
( 1+0.0055 ) −1

The remaining balance is $ 333626.80 after 4 years.

d) Effective Annual Rate

The effective annual rate (EAR) is calculated using the formula:

EAR=¿

Where;
 r
❑ nominal is the nominal annual rate (6.6%)

m is the number of compounding periods per year (12)

EAR=¿

0.068034

Thus, the effective annual rate is 6.80%

e) Maximum Amount that Can be Borrowed

The maximum payment the bank allows is $2,425 per month, and the new mortgage rate is 7.2% over

25 years. We need to find the maximum loan amount P.

Using the mortgage payment formula.

P∗r ( 1+r )n
M= n
( 1+r ) −1

7.2 %
r= =0.006
2

n=25∗12=300

Rearranging the formula to solve for P.

M∗[ ( 1+ r )n−1]
P= n
r (1+ r )

2425∗[ ( 1+0.006 )300 −1]

P= 300
0.006 ( 1+0.006 )

P= $336, 998.07

The maximum loan amount is $336, 998.07

QUESTION 2

a) Annual Contribution for $110,000 Withdrawal

First, we calculate the present value of Diane and James' desired withdrawals during retirement, a 20-

year annuity with annual payments of $110,000, discounted at an 8% return rate. The formula to

calculate the present value of an annuity is:

n
P∗1−( 1+ r )
PV =
r

Where;

P is the annual withdrawal amount of $110,000

R is the interest rate of 8% or 0.08

n is the number of years of withdrawal, which is 20 years

−20
110,000∗1−( 1+0.08 )
PV =
0.08

PV= $1,079,996.215

So, Diane and James will need $1,079,996.215 in their retirement account when they turn 65.

Next, we calculate how much they need to save annually to reach that amount. They already have

$140,000 in the account. Using the future value of an annuity formula, we can calculate their required

annual contribution. The formula is;

−n
A∗( 1+r )
FV =
r

A is the annual contribution,

r is the interest rate (8% or 0.08),

n is the number of years (25 years).

25
FV =140,000∗( 1+0.08 ) = $958,786.5275

Now, they need a total of $1,079,996.215 at retirement, so the remaining amount to save is
$1,079,996.215-$958,786.5275= $121,209.68735

Finally, using the annuity formula to solve for the annual contribution A

25
A∗( 1+0.08 )
121,209.68735=
0.08

121,209.68735=A∗85.60593995

A=(
121,209.68735
)
85.6059399 5

A= S1415.902768

Thus, Diane and James must contribute $1,415.903 at the end of the next 25 years.

b) Annual Contribution to Leave $1,200,000 Inheritance

To leave $1,200,000 as an inheritance, they need to accumulate $1,200,000 more than the

original $1,079,996.215, bringing the total required amount to;

$1,079,996.215+$1,200,000=$2,279,996.215

The future value of their current savings remains $958,786.5275, so the remaining amount to

save is;

$2,279,996.215-$958,786.5275=$1,321,209.688.

Using the same annuity formula as before, we calculate the new annual contribution as follows;

25
A∗( 1+0.08 ) −1
$ 1,321,209.688=
0.08

$ 1,321,209.688= A∗$ 73.10593995

 $ 1,321,209.688
A=
$ 73.10593995

A= $1,8072.5354

Thus, they need to contribute $1,8072.5354 annually to meet their goal of leaving $1,200,000 for their

children.

QUESTION 3

NOPAT = $105 million

EBITDA = $200 million

Net income = $90 million

Net capital expenditures = $72 million

Net operating working capital increase = $3 million

After-tax capital costs (WACC × Total Invested Capital) = $95 million

Tax rate = 25%

a) What is the company’s depreciation expense?

First, we need to find EBIT (Earnings Before Interest and Taxes). EBIT can be calculated

from NOPAT using the formula;

NOPAT =EBIT ( 1+Tax Rate )

105
EBIT =
1−0.25

EBIT= 140 Million.

Depreciation=EBIT −EBITDA

200-140=60 Million
 b) What is the company’s interest expense?

Net Income
Interest Expense=EBIT −
1−Tax Rate

Substitute EBIT = $140 million, Net Income = $90 million, and Tax Rate = 25%:

Interest Expense=140− ( 090, 75 )

Interest Expense =140-120= 20 Million.

c) What is the company’s free cash flow (FCF)?

The formula for Free Cash Flow (FCF) is

FCF=NOPAT+Depreciation−Net Capital Expenditures−ΔWorking Capital

Substitute NOPAT = $105 million, Depreciation = $60 million, Net Capital Expenditures =

$72 million, and ΔWorking Capital = $3 million.

FCF=105+60−72−3=90 million

d) What is the company’s EVA (Economic Value Added)?

EVA=NOPAT−(WACC×Total Invested Capital)

We are given that the after-tax capital costs (WACC × Total Invested Capital) are $95

million. So, we can calculate EVA as;

EVA=105−95=10 million

QUESTION 4
We can use the relationship between ROA and ROE to find the equity multiplier, which will

help us determine the debt ratio;

a) Debt Ratio

Using the given values of ROE and ROA

15 %=12 % × EM

15 %
EM =
12 %

EM= 1.25

1
EM =
1−Debt Ratio

1
1−Debt Ratio=
1.25

Debt Ratio=1−0.8

Debt Ratio=0.2

b) Total Assets Turnover

ROA 12 %
Total Assets Turnover= −
Profit Margin 8 %

Thus, the Total Assets Turnover is 1.5.

QUESTION 5

Given that the maturity risk premium is 0, the pure expectations hypothesis formula is:
( 1+¿ )n =( 1+ ℑ )m × (1+ fm , n−m)n −m

in is the interest rate for the n-year security.

im, is the interest rate for the m-year security.

fm,n−m, is the forward rate between m and n-m years from now.

In this case;

i 6 ​=3.50 % (yield on a 6-year bond),

i2=2.10 (yield on a 2-year bond),

We are trying to find the 4-year forward rate two years from now, denoted as f 2 , 4

4 ( 1+0.035 )6
( 1+ f 2 , 4 ) = 2
(1+ 0.021 )

( 1+ f 2 , 4 )4 =1.179208537

Now, take the fourth root of 1.179208 to find 1+ f 2 , 4

( 1+ f 2 , 4 )=(1.179208537)1/ 4

( 1+ f 2 , 4 )=1.04207182 5

f 2 , 4=1.04207182 5−1

f 2 , 4=4.21 %

The market expects that the interest rate on 4-year securities two years from now will

be 4.21 %

QUESTION 6

a) Price of Each Bond

The price of a bond is the present value of its future cash flows (coupons + face value). The

formula for the price of a coupon bond is:

−8
5∗1−( 1+0.08 ) 1000
Price of Coupon Bond=3 + 8
0.08 ( 1+0.08 )

Price of Coupon Bond=$ 741.40

 F
Price of Zero Coupon Bon d=
(1+ r )n

1000
Price of Zero Coupon Bon d=
(1+ 0.08 )7

Prize of Zero Coupon Bond= $583.49

b) Duration of Each Bond

n
1
D= ∗∑ ¿ (t∗C)/(1+r)^t +(n*F)/(1+r)^n
P t =1

For zero-coupon bonds, the duration is equal to the bond’s maturity because all cash flows

are received at the end.

Duration= 8 Years

c) Percentage Change in Price if Yield Increases to 12%

To calculate the percentage change in price when the yield increases, we first calculate the

new bond prices using the same formulas from part (a), but replacing the yield with 12%. The

percentage change as follows.

−8
5∗1−( 1+0. 12 ) 1000
N ew Price of Coupon Bond=3 + 8
0. 12 (1+ 0.12 )

New Price= 577.7506198

577.7506198−741.40
%Change∈ Price of Coupon Bond= ∗100
741.40

%Change of Coupon Bond -22.07%

1000
Price of Zero Coupon Bon d=
(1+ 0.12 )7

New Price= $452.3492153

452.349−583.49
%Change∈ Price of Zero Coupon Bond= ∗100
583.49
%Change in Price of Zero Coupon Bond=-22.48%

d) Percentage Change in Price if Yield Decreases to 4%

To calculate the percentage change in price when the yield decreases, we first calculate the

new bond prices using the same formulas from part (a), but replacing the yield with 4%. The

percentage change as follows;

−8
5∗1−( 1+0. 04 ) 1000
N ew Price of Coupon Bond=3 + 8
0. 04 ( 1+0. 04 )

New Price= $ 966.336

966.336−741.40
%Change∈ Price of Coupon Bond= ∗100
741.40

% Change= 30.339%

1000
Price of Zero Coupon Bon d=
(1+ 0.04 )7

New Price= $759.918

759.918−583.49
%Change∈ Price of Zero Coupon Bond= ∗10 0
583.49

% Change=30.237%

e) Investment Value Over Time with Different Yield to Maturity Scenarios

We'll set up tables to show what happens to the value of both the coupon bond and the zero-

coupon bond over 8 years under three scenarios: (i) yield stays at 8%, (ii) yield increases to

12%, and (iii) yield decreases to 4%.

(i) Yield to Maturity Remains at 8%

We will reinvest each coupon at the 8% rate for the coupon bond. The value of the zero-

coupon bond increases as we approach its maturity.

Table 1: Investment Value with Yield at 8%

 Coupon Bond Value (Including
Year Reinvested Coupons) Zero-Coupon Bond Value
1 $769.39 $630.17
2 $801.77 $680.58
3 $835.99 $734.23
4 $872.14 $791.16
5 $910.33 $851.45
6 $950.68 $915.17
7 $993.33 $982.38
8 $1,038.44 $1,053.12

(ii) Yield to Maturity Increases to 12%

Here, the value of the bonds decreases since higher yields lead to lower bond prices.

However, reinvesting the coupon payments at the new 12% rate boosts the coupon bond's

growth.

Table 2: Investment Value with Yield at 12%.

Coupon Bond Value (Including Zero-Coupon

Year Reinvested Coupons) Bond Value
1 $734.62 $566.03
2 $763.29 $638.36
3 $793.82 $719.76
4 $826.31 $810.14
5 $860.86 $909.36
6 $897.60 $1,017.34
7 $936.64 $1,134.01
8 $978.14 $1,259.29

(iii) Yield to Maturity Decreases to 4%

In this scenario, bond prices rise, and reinvesting the coupons at a lower rate (4%) generates

less reinvestment growth.

Table 3: Investment Value with Yield at 4%

Coupon Bond Value (Including Zero-Coupon

Year Reinvested Coupons) Bond Value
1 $810.25 $745.06
2 $846.26 $812.51
3 $884.59 $884.60
4 $925.34 $961.75
5 $968.61 $1,044.29
 6 $1,014.53 $1,132.67
7 $1,063.22 $1,227.36
8 $1,114.82 $1,328.90

Graphs

We will plot the cumulative values over time for both the coupon bond and the zero-coupon

bond under all three yield scenarios;

Coupon vs. Zero-Coupond

1400

1200

1000

800

600

400

200

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Coupon Bond Zero-Coupond

For long-term bonds, the cumulative value converges as you approach maturity, primarily if

the investment is held to maturity. The values converge closer to the 8-year mark, regardless

of changes in interest rates, because the reinvestment rates have less time to impact the

bond’s overall value, and both bonds will reach their face values.

QUESTION 7

a) Calculate the required rate of return for the original portfolio

The portfolio beta is a weighted average of the individual asset betas. The weights are the

percentage allocations of each asset class in the portfolio.

βp=(0.15 × 0)+(0.10 × 0.60)+(0.40 ×1.00)+(0.35 ×1.40)

Now, we compute:

βp=0+0.06+ 0.40+0.49=0.9 5
Using the CAPM formula

Rp=3.5 % +0.95 ×7 %

RP=10.15 %

Hence, the required rate of return on the original portfolio is 10.15%.

b) New portfolio required return.

0.15∗20000000−1000000
T −bills :The new allocation= =10 %
20000000

Bonds: No change, so the allocation remains at 10%.

0. 40∗20000000+8 00000
Mid−cap stocks :The new allocation= =44 %
20000000

0.35∗20000000+2 00000
Growth stocks :The new allocation= =36 %
20000000

Now, we recalculate the portfolio beta

βp=(0.10 × 0)+(0.10 × 0.60)+(0.44 × 1.00)+(0.36 ×1.40)

βp=1.004

Estimating the new required rate of return.

Using the CAPM formula

Rp=3.5 % +1.004 × 7 %

Rp=3.5 % +7.028 %=10.5 3 %

Thus, the new required rate of return on the portfolio is 10.53%