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PS - 2 Spring, 2010

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21 views2 pages

PS - 2 Spring, 2010

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ECE 472S - PROBLEM SET # 2 (suggested completion date: February 26th, 2010)

1. The parents of a small child have decided to create an education fund by making equal annual deposits
into a mutual fund of government and corporate bonds. They believe that the historical real return for the
fund of 2% annually is a good estimate for the returns from the fund over their planning horizon. The first
deposit will be made on the child’s fifth birthday and the last deposit on the fifteenth birthday. Then
starting on the eighteenth birthday, the following annual withdrawals to cover the actual cost of college
will be made. The parents have assumed a constant rate of inflation over the planning horizon and that
education costs will increase at the same rate as the general rate of inflation. What equal annual deposits
must the parents make?

Birthday Withdrawal
18 $18 100
19 $18 825
20 $19 575
21 $20 360

2. The ABC Credit Union offers two different savings accounts. The "Savings Advantage" account has an
annual interest rate of 2.4 per cent compounded quarterly. Interest is calculated on the minimum quarterly
balance in the account. The "Money Multiplier" account offers an annual rate of 2 per cent compounded
quarterly. However, interest is earned from the time of deposit.

An investor plans to deposit $10 000 on January 1st and $6 000 on February 1st into one of these accounts.
Which account should the investor choose to maximize accumulated interest at the end of the first quarter
(March 31)?

(a) How much additional interest (in dollars and cents) will the investor earn versus the other account?
(b) If the number of accounts is not a constraint, what is the optimal savings strategy and how much
further ahead is the investor?

(Assume: (1) that the balance in an account is determined by the daily closing value; (2) that all months
are of equal length; i.e., a monthly interest rate may be used.)

3. Maintenance costs for the new engineering building are expected to be $100 000 each year for the first
five years; $125 000 for each year 6 through 10 inclusive; and $175 000 each year after that. Assume that
the building will have an indefinite service life. The donated funds will earn 6% per year in the
University's endowment investment pool.

(a) What amount of donations should the Dean of Engineering seek now in order create a fund to cover
all the expected future maintenance costs for the building?
(b) How much less will the Dean need to raise if the service life of the building is assumed to be 35
years?

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4. During the time that Nortel was attempting to make a financial comeback, Nortel went to the debt market
to raise funds by issuing convertible bonds. Consider an investor at that time evaluating a new issue of a
7-year Nortel convertible bond with a face value of $100 000 and a bond rate of 5% per annum payable
semi-annually. The bond is currently selling for $103 000. She plans on owning the bond for five full
years (receiving the interest payment at the end of Year 5) at which time she will sell it. Her expected
annual rate of return is 6%. In light of current interest rates, discuss why the bond is selling at a premium
above its face value. What must she sell the Nortel bond for (or convert it into Nortel stock) at the end of
Year 5 to realize her expected rate of return? Assume that she can reinvest her interest payments at 2%
compounded semi-annually.

A convertible bond may be exchanged for a company’s equity shares at a stated price at the option of the
bondholder. Convertible bonds, which act as stock-bond hybrids, have become increasingly popular
recently as Nortel, Lucent and a host of other blue-chip companies have run into tough times. Lenders
prefer convertible bonds because if the company and its stock stage a comeback, the financier can convert
the bonds to stock and score a big win. If no comeback occurs, the lender still has a guaranteed return.

Would this have been a good investment?

5. Given the three cash flow profiles shown below, determine the values of X and Y so that all three cash
flow profiles are equivalent at an annual interest rate of 5%. Show all your work and use an approach that
minimizes the number of calculations.

End of Year Cash Flow A Cash Flow B Cash Flow C


0 -10 000 -2 000 0
1 2 000 2X 2Y
2 4 000 1.75X 2Y
3 6 000 0 2Y
4 8 000 1.25X Y
5 10 000 X Y

6. A young couple shopping for a new home are trying to decide how “much house” they can afford to buy.
They can afford $3 000 per month in mortgage payments and do not want to finance more than 75% of
the purchase price. Keeping below the 75% limit means that they do not have to pay costly mortgage
insurance. They will obtain a three-year mortgage with monthly payments at 6% compounded monthly.
The amortization period will be 25 years.

(a) What is the most expensive house that they can buy and what down payment do they need?
(b) How much interest will they pay over the three-year term?
(c) Assuming their house increases in value by 3% per year, what percentage of the house do they own
at the end of the three-year term?

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