# FIN 5405 What percentage of your payments the first year goes toward repayment of principal

Finance 5405 – EMBA17Group Problem Set #1Financial ManagementJ. HoustonGroup Members: Team 5 – David Costa, Joe Forkum, Eric Malnove, Robbin Seago, Chris Wynn1. You are in the process of obtaining a 20-year fixed rate mortgage on a house that you arebuying. The mortgage amount is $250,000 and the mortgage rate is 6%. (This is thenominal annual rate.) Assume that all monthly payments are made at the end of everymonth.a.b.c.d.e.What is the monthly payment on the mortgage? (2 points)$1,791.08What percentage of your payments the first year goes toward repayment ofprincipal? (2 points)31.05%After 2 years (24 months), what will be the remaining balance on your mortgage? (2points)$236,239.34What is the effective annual rate of the mortgage? (2 points)6.17%Another bank has calculated that based on your financial situation, your householdcan obtain a mortgage with a maximum payment of $1,500 a month. However, thisbank will offer you a 25-year fixed-rate mortgage with a nominal annual rate of6.6%. Again, assume that all payments are made at the end of the month. Giventhese terms, what is the maximum amount that you can borrow from this bank? (2points)$220,112.692. You have recently been hired as a consultant for a personal financial planning firm. Oneof your first projects is creating a retirement plan for a couple, Lauren and SteveLaGrange. They have just celebrated their 50th birthdays and after paying for theirchildren’s education, they have decided to get serious about saving for retirement.Lauren and Steve hope to retire 15 years from now (on their 65th birthdays), and theyexpect to live until age 85. Their hope is to be able to withdraw $120,000 a year fromtheir retirement account – the first withdrawal will occur on their 65th birthdays, and the20th and final withdrawal will occur on their 84th birthdays. After their final withdrawal,the account is expected to have a zero value (i.e., they don’t expect to have any remainingfunds left for their children’s inheritance).Lauren and Steve currently have $300,000 saved in a retirement account, whichconsists of a portfolio of mutual funds that is expected to produce an annual return of 7%.In order to accomplish their goals, they would like to deposit an equal annual amount intotheir account starting one year from today (on their 51st birthdays) and continue to makethose deposits through age 65. (Again, the account has an expected annual return of 7%.)Thus, they will make 15 annual end-of-year deposits to this account.a.How much do Lauren and Steve need to contribute to the account at the end of eachof the next 15 years in order to accomplish their goals? (5 points)1b.c.d.e.$17,651.79If they wanted to leave their children $500,000 for inheritance when they die at age85, how much would they need to contribute to the account at the end of each of thenext 15 years? (Assume everything else stays the same.) (3 points)$22,793.63If they instead expected to earn only 5% a year from their mutual funds, how muchwould they need to contribute to the account at the end of each of the next 15years? (Continue to assume that they want to have $500,000 available forinheritance when they die at age 85.) (3 points)$49,133.55Lauren and Steve realize that there are a lot of variables in their retirement plan.The two variables that they are particularly interested in are the expected return oftheir mutual funds and the amount they have available for inheritance. Create inExcel a two-input Data Table that tests the sensitivity of their annual depositamount by varying the expected returns from 3% to 11% in 1% increments andvarying the inheritance level from 0 to $4,000,000 in $500,000 increments. Thedata table should be constructed with the expected returns shown on the side of thetable and the amount available for inheritance shown across the table. [Hint: AnExcel file (in xlsx format) explaining how to create a Data Table is contained in theCalculator Tutorials & Excel Tools folder on the class web page.] You MUST setup a correctly working Excel data table using Excel’s Data Table feature to receivecredit. When correctly set up, an Excel Data Table will automatically recalculatewhen input variables are changed. (5 points)NOT FINISHEDLauren and Steve have one last concern. They recognize that the value of their$120,000 annual withdrawals during retirement will steadily decline because ofexpected inflation. Assume that they want to have the value of these withdrawalsincrease by 3% a year during retirement to account for expected inflation. In otherwords, they want to withdraw $120,000 at age 65, $123,600 at age 66, and 123,600× 1.03 at age 67, and etc. Going back to the other original assumptions (7% returnand no expected inheritance), how much would they need to contribute to theaccount at the end of each of the next 15 years in order to meet this revised goalwhich protects them against rising inflation? Set up this problem using Excel. As aguide, it will be helpful to refer to the Growing Annuity Example spreadsheet thatwe went over in class during Visit 1. (6 points)$30,725.043. Last year, Powers Auto Parts Company (PAPC) had net operating profit after-taxes(NOPAT) of $750 million. Its EBITDA was $1,800 million and net income amounted to$300 million. During the year, PAPC made $225 million in net capital expenditures(remember that net capital expenditures equal gross capital expenditures lessdepreciation), and its net operating working capital increased by $10 million. Finally,PAPC’s finance staff has concluded that the firm’s total after-tax capital costs were $575million and its tax rate is 40%. Assume that the company does not have any amortizationcharges. Based upon this information, answer the following four questions. (3 pointseach)2a.b.c.d.What is the company’s depreciation expense?What is the company’s interest expense?What is the company’s free cash flow?What is the company’s EVA?$550 MM$750 MM$515 MM$175 MM4. Last year, Isola Manufacturing Industries had an ROE = 10% and its ROA = 7.5%.Isola’s total assets equal total debt plus common equity (i.e., there is no preferred stock).Furthermore, we know that the company’s profit margin is 4%. Answer the followingquestions on the basis of this information. (4 points each)a.b.What is the company’s debt ratio (as measured by debt to total assets)?25%What is the company’s total assets turnover?1.8755. In today’s market you observe the following yield curve for government securities:Maturity1 year2 years3 years5 years7 years8 years10 yearsYield1.00%1.20%1.60%2.75%4.20%5.20%7.00%Assume that the pure expectations hypothesis holds (i.e., the maturity risk premium = 0).What does the market expect will be the interest rate on 3-year securities five years fromnow? (6 points)9.41%6. You are considering an investment in two different bonds. One bond matures in six yearsand has a face value of $1,000. The bond pays an annual coupon of 8.5% and has a 7%yield to maturity. The other bond is a 5-year zero coupon bond with a face value of$1,000 and also has a yield to maturity of 7%.a.b.c.What is the price of each bond? (2 points)Bond 1 = $1,071.50Bond 2 = $712.99What is the duration of each bond? (3 points)Bond 1 = 4.98 yearsBond 2 = 5 yearsIf the yield to maturity of each bond were to immediately increase to 9%, whatwould be the percentage change (including the correct sign) in the price of eachbond (from the price found in part a)? (2 points)3d.e.Bond 1 = -8.77%Bond 2 = -8.84%If the yield to maturity of each bond were to immediately decrease to 5%, whatwould be the percentage change (including the correct sign) in the price of eachbond (from the price found in part a)? (2 points)Bond 1 = 9.91%Bond 2 = 9.89%Assume that you plan on holding the coupon bond for six years and reinvesting allof the coupons when they are received at the going interest rate (which is the yieldto maturity). Assume that after the zero matures you invest in a 1-year security thatearns the going interest rate. (10 points)i. Set up a table where you show what happens to the value of each investment(zero and coupon bond) over time if the yield to maturity remains at 7%.Specifically, show what the cumulative value of each investment (includingthe value of the reinvested coupons for the coupon bond) would be at the endof each of the next six years. For example, at the end of Year 1, you wouldcalculate the value of the coupon bond (with one year less remaining untilmaturity) and you would receive the interest coupon payment. However, nointerest would be earned on that interest coupon payment in Year 1.(However, that coupon payment will remain in your account and earn interestin the years that follow.) The sum of these 2 amounts would be thecumulative value for the coupon bond at the end of Year 1.ii.Set up a table where you show what happens to the value of each investment(zero and coupon bond) over time if the yield to maturity immediately andpermanently increases to 9%. Specifically, show what the cumulative value ofeach investment (including the value of the reinvested coupons for the couponbond) would be at the end of each of the next six years.4iii.Set up a table where you show what happens to the value of each investment(zero and coupon bond) over time if the yield to maturity immediately andpermanently decreases to 5%. Specifically, show what the cumulative valueof each investment (including the value of the reinvested coupons for thecoupon bond) would be at the end of each of the next six years.iv.Plot on two graphs (one for the coupon bond and one for the zero) thecumulative value of the investment over the next six years under each of thethree scenarios outlined above.5v.Roughly speaking, after how many years would the value of the investment bethe same regardless of what happens to interest rates? What can explain this?NOT FINISHED7. You are a small money manager managing $20,000,000 in assets. Your investmentportfolio consists of 15% T-bills (with an estimated beta = 0), 20% bonds (with anestimated beta = 0.60), 30% mid-cap stocks (with an estimated beta = 1.00), and 35%growth stocks (with an estimated beta = 1.10).6a.b.The risk-free rate, rRF, is 2.5%. The market risk premium, (rM – rRF), is 6%. What isthe required rate of return on your investment portfolio? (3 points)7.33%If you switch $800,000 out of T-bills and invest $500,000 of it in growth stocks and$300,000 of it in mid-cap stocks, what would be the required rate of return on yourportfolio? (3 points)7.59%8. A recent Value Line report for McDonald’s Corporation (its ticker symbol = MCD) isprovided with this assignment on the e-Learning Canvas site. Based on the informationin this report, use the nonconstant dividend growth model to estimate the intrinsic valueof the stock. (Please do not use an updated Value Line report to work this problem.)More specifically:a.b.c.Based on Value Line’s estimate of beta, what is the required return on McDonald’sstock? Use the CAPM, and assume that the risk-free rate is 2.75% and the marketrisk premium (rM – rRF) is 5%. (2 points)6.25%Assume that today is January 1, 2016 and that at t = 1 the company will pay thedividend per share that Value Line is forecasting for 2016. (That is, assume thatthis forecasted 2016 dividend is D1, and that this is the first cash flow you receiveas an investor. This information is provided in the columns designated by year.)Now, look on the left-hand side of the report, note the section where Value Line’sanalyst forecasts annual growth rates – in particular, look at the estimated dividendsgrowth rate from ‘12-‘14 to ‘19-‘21. Assume that this is the dividend growth ratefor the three years after 2016 (2017-2019, which corresponds to Years 2, 3, and 4).Assume that after 2019 (after Year 4), the dividend grows at a long-run constantgrowth rate of 3% a year.(i) Given these assumptions, what is your estimate of the stock’s intrinsic value?(4 points)$116.95(ii) Compared to its current stock price and your analysis above, would youconclude that the stock is undervalued or overvalued? (1 point)OvervaluedSet up a simple Excel data table where you show how the estimated intrinsic valuevaries as the long-run growth rate varies over the following range (1.25%, 1.50%,1.75%, 2.00%, 2.25%, 2.50%, 2.75%, 3.00%, 3.25%, 3.50%, 3.75%, and 4.00%) –assuming everything else stays constant. You MUST use Excel’s Data Tablefeature to receive credit for this question and the Data Table must be workingcorrectly. When correctly set up, an Excel Data Table will automaticallyrecalculate when input variables are changed. Refer to the Calculator_Excel Toolssubdirectory under the Files page on the Canvas website. (3 points)79. A stock market analyst is evaluating the common stock of Morris ManufacturingProducts Inc. (MMPI). She estimates that the company’s operating income (EBIT) forthe next year will be $500 million. Furthermore, she predicts that MMPI will require$300 million in capital expenditures next year. The depreciation expense for next year isexpected to be $60 million and changes in net operating working capital are expected tobe $20 million. Free cash flow is expected to grow at a constant annual rate of 5% a yearand the company’s WACC is 9%. The company has $275 million of debt (market valueequals book value), $125 million of preferred stock (market value equals book value),and has 50 million shares of common stock. The firm’s tax rate is 40%.a.b.What is the estimated value of free cash flow the first year? (That is, what isFCF1?) (3 points)$40 MMUsing the free cash flow valuation method, what is its expected stock pricetoday? (4 points)$12.008