What is the ear on the mortgage

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Reference no: EM131858454

Chapter 7 Problem 12

a). Complete the spreadsheet below by estimating the project's annual after tax cash flow.

b). What is the investment's net present value at a discount rate of 10 percent?

c). What is the investment's internal rate of return?

d). How does the internal rate of return change if the discount rate equals 20 percent?

e). How does the internal rate of return change if the growth rate in EBIT is 8 percent instead of 3 percent?

Facts and Assumptions
Equipment initial cost $	$ 350,000
Depreciable life yrs.	7
Expected life yrs.	10
Salvage value $	$0
Straight line depreciation
EBIT in year 1	28,000
Tax rate	38%
Growth rate in EBIT	3%
Discount rate	10%

Year	0	1	2	3	4	5	6	7	8	9	10
Initial cost	350,000
Annual depreciation		50,000	50,000	50,000	50,000	50,000	50,000	50,000
EBIT		28,000	28,840	29,705	30,596	31,514	32,460	33,433	34,436	35,470	36,534

Chapter 7 Problem 13

In many financial transactions, interest is computed and charged more than once a year. Interest on corporate bonds, for example, is usually payable every six months.

Consider a loan transaction in which interest is charged at the rate of 1 percent per month. Sometimes such a transaction is described as having an interest rate of 12 percent per annum. More precisely, this rate should be described as a nominal 12 percent per annum coumpounded monthly.

Clearly, it is desirable to recognize the difference between 1 percent per month compounded monthly and 12 percent per annum compounded annually. If $1,000 is borrowed with interest at 1 percent per month compounded monthly, the amount due in one year is:
F = $1,000(1.01)12 = $1,000(1.1268) = $1,126.80 This compares to F = $1,000(1+.12) =$1,120.00 for annual compounding.

Hence, the monthly compounding has the same effect on the year-end amount due as the charging of a rate of 12.68 percent compounded annually. 12.68 percent is referred to as the effective interest rate.

To generalize, if interest is compounded m times a year at an interest rate of r/m per compounding period. Then,

The nominal interest rate per annum, or the APR = m(r/m) = r.

The effective interest rate per annum,or the EAR = (1+r/m)m - 1.

Consider a $100,000, 30 year, fixed-rate, 9 percent, home mortgage requiring monthly payments.

a. The monthly interest rate on the mortgage is 9%/12 months = .75%. What is the APR on the mortgage?

b. What is the EAR on the mortgage?

c. The borrower's payment book will look something like the following. Complete the entries for the first 6 months.

d. After paying on this mortgage for 15 years, what will be the remaining principal outstanding?

	Outstanding Balance Beginning of Month	Monthly payment	Interest due	Principal payment	Outstanding Balance End of Month
Date	Outstanding Balance Beginning of Month	Monthly payment	Interest due	Principal payment	Outstanding Balance End of Month
01-31	$100,000
02-28
03-31
04-30
05-31
06-30

e. Suppose after 15 years the borrower has the opportunity to refinance the remaining principal on the mortgage with a new 15-year mortgage carrying an interest rate of 7 1/8%. Refinancing will involve $250 in costs and "points" equal to 1.5 percent of the amount borrowed.

If the borrower plans to live in the house for 15 more years, does it make economic sense to refinance? Does your answer change if the borrower only intends to live in the house for 5 more years and will pay off any loans outstanding at that time? You may ignore taxes and may assume there are no prepayment penalties on either mortgage.

Chapter 7 Problem 14

A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives appear below:

	Alternative	Alternative
	I	II
Initial investment	$64,000	$120,000
Annual receipts	$50,000	$60,000
Annual disbursements	$20,000	$12,000
Annual depreciation	$16,000	$20,000
Expected life	4 yrs	6 yrs
Salvage value	0	0

At the end of the useful life of whatever equipment is chosen the product will be discontinued. The company's tax rate is 50 percent and the discount rate is 10 percent.

a. Calculate the net present value of each alternative.

b. Calculate the benefit cost ratio for each alternative.

c. Calculate the internal rate of return for each alternative.

d. If the company is not under capital rationing which alternative should be chosen? Why?

e. Again assuming no capital rationing, suppose the company plans to produce the product indefinitely rather than quit when the equipment wears out. Which alternative should the company select? Why?

f. If the company is experiencing severe capital rationing, and plans to terminate production when the equipment wears out, would any of your answers above change?

Chapter 7 Problem 15

You work for Mattel, a profitable toy manufacturer, and you are negotiating with Warner Brothers for the rights to manufacture and sell Harry Potter lunchboxes (you already sell related action figures).

Your marketing department estimates that you can sell $800 million worth of lunchboxes per year for 3 years, starting next year. At the end of year 3, you will liquidate the assets of the business.

Given the following information about this new product investment, identify the relevant cash flows, and calculate the investment's net present value, benefit-cost ratio, and internal rate of return. Make whatever assumptions you feel necessary and explain them briefly.

($ in thousands)
Marketing Research Costs, to date	$ 20,000
Initial cost of new equipment	$ 300,000
Licensing rights to use images (To be expensed for tax purposes at time 0)	$ 350,000
Expected life	5 yrs
Salvage value	0
Depreciation method	Straight-line over 5 years to 0 salvage value
Selling price of new equipment in 3 years*	$ 130,000
Incremental annual sales	$ 800,000
Incremental annual production costs	$ 200,000
Incremental annual selling
and administrative costs	$ 80,000
Current annual overhead costs	$ 200,000
Immediate advertising expenses for launch (To be expensed for tax purposes at tme 0)	$ 190,000
Tax rate	40%
Working capital required, as a % of production costs	7.50%	(Needed at time 0.)
Minimum required rate of return	10%

The company must pay a 40% tax on the difference between the selling price and the asset's book value at time of sale.

Reference no: EM131858454

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