Econ 134A Test 1 Spring 2012

1. Econ 134A Test 1Spring 2012 Solution sketches

2. Lyric loans $360,000 from Music National Bank today. The stated annual interest rate for the loan is 3.6%, compounded monthly. The first payment will be made one month from today. (a) The loan is amortized over 30 years with monthly payments, and Lyric pays an equal amount of principal each month of repayment. How much will each of the first two payments be? Principal paid each month: $360K/360 = $1K Interest 1st month: $360K(.036/12) = $1,080  total payment is $2,080 Interest 2nd month: $359K(.036/12) = $1,077  total payment is $2,077 LyricMusic National Bank

3. LyricMusic National Bank • (b) Suppose that instead the loan is amortized such that equal monthly payments of $1,000 are made over 35 years. Will the loan be paid off after 35 years? Will money still be owed after 35 years? If so, how much will be owed? • Use the annuity formula to find the PV of all payments • PV = (C/r)(1 – 1/(1+r)T), plug in C = $1,000, r = .003, T = 420  PV = $238,603.48 • PV owed is $360K – PV of payments = $121,396.52 • FV owed in 35 years is $121,396.52(1.003)420 = $427,167.41 • Answer: Loan is not paid off after 35 years, so money will still be owed; amount owed is $427,167.41

4. LyricMusic National Bank • (c) Suppose that instead the loan is amortized with monthly payments made over 40 years. The first payment of $X will be made one month from today. Each subsequent payment will be 0.1% higher than the previous payment. Find X. • Use the growing annuity formula from the formula sheet, PV=$360,000, r=.003, g=.001, T=480 • Solving for C, you get $1,168.12 (this is X)

5. Dexter • Dexter has just purchased a zero-coupon bond that will mature five years from today, for $3,200. The face value of the bond is $4,000. For this problem, assume that all yields to maturity are expressed as yearly rates. • (a) What is the yield to maturity? • 3,200(1+r)5 = 4,000  r = .04564 = 4.564%

6. Dexter • (b) Suppose that later today, the yield to maturity changes to 4%. How much does the value of the bond change. (Please make sure to clearly state if the bond goes up or down in value.) • 4,000/(1.04)5 = $3,287.71 • The value has gone up by $3,287.71 - $3,200, or $87.71

7. 6700 block of DP • There are two investments that could go on an empty lot of the 6700 block of Del Playa Dr. Due to the small size of the lot, only one of the investments can be implemented. This lot cannot be used for any other purposes in the next five years. Assume an effective annual discount rate of 8%. • To implement an investment called “Deltopia Falls,” $50,000 must be invested today, and $100,000 will be received five years from today. • To implement an investment called “Halloween DP,” $20,000 must be invested today, and $39,000 will be received one year from today.

8. 6700 block of DP • (a) Whatis the internal rate of return of each investment? • Deltopia Falls: $50,000(1 + IRR)5 = $100,000  IRR = .14870 = 14.870% • Halloweentown: $20,000(1+IRR) = $39,000  IRR = .95 = 95%

9. 6700 block of DP • (b) Which investment should be chosen? You must justify your answer in 40 words or less. You can also show additional work below, if needed. • Deltopia Falls • NPV = 100,000/1.085 – 50,000 = $18,058.32 • Halloweentown • NPV = 39,000/1.08 – 20,000 = $16,111.11 • Choose the project with the highest NPV, if positive • Choose Deltopia Falls

10. Solve each of the following • (a) Ava will receive $500 three months from today and $1000 nine months from today. The effective annual interest rate is 9%. Find the total of the present value of the two payments. • PV = $500/1.090.25 + $1,000/1.090.75 • PV = $1,426.75

11. Solve each of the following • (b) Amanda will receive $900 every two years forever, starting five years from now. The effective annual interest rate is 14%. Find the total of the present value of all payments. • The interest rate every two years is 1.142 – 1 = 29.96% • I can treat this like receiving a perpetuity every two years, starting three years from now, with interest rate every two years of 29.96% • I can use the perpetuity formula to find the future value 3 years from now (remember that our time frame is every two years) • FV = 900 / .2996 = $3,004.01 • Discount by 3 years to get PV = $3,004.01/1.143 = $2,027.62

12. Solve each of the following • (c) Elena will take out a loan for $5,000 later today. The effective annual interest rate for the loan is 17%. She will make yearly payments (starting one year from today) of $1,500 for 3 years. She will also make a balloon payment 3 years from today to pay off the loan. How much will the balloon payment have to be in order to pay off the loan? • PV of payments is $1500/1.17 + $1500/1.172 + $1500/1.173 = $3,314.38 • PV of balloon payment is $5,000 - $3,314.38 = $1,685.62 • FV of balloon payment 3 years from now is $1,685.62(1.17)3 = $2,699.72

13. Savannah • For this problem, assume that the effective annual interest rate (EAIR) is 8%: Savannah is set to receive five payments such that the total of all of the payments add up to a present value of $600. The first payment is to be made today, and each subsequent payment will be made one year after the previous. (Note that the final payment will be received by Savannah four years from today.) In nominal terms, each payment is set to be the same amount. How much does each payment need to be? • Note first payment is made today, so we can use the annuity formula with T = 4, and add an additional undiscounted payment today • PV = (C/r)(1 – 1/(1+r)T) + C • Plug in PV = $600, r = .08, T = 4 to get… • 600 = 4.3121C  C = $139.14