STOCK MARKETS

55. A firm desires to sell stock to the public. The underwriter charges $0.4 million in fees and offers to
buy 6 million shares from the firm at a price of $19 per share. In addition, registration and audit fees
total $145,000, and marketing and miscellaneous fees add up to another $65,000. The underwriter
expects to earn gross proceeds per share of $21. What is the issuing firm's out of pocket dollar
transaction cost to issue the stock? Immediately after the stock was issued, the stock price rose to $23.
What is the issuing firm's opportunity cost? What is the total issuance cost, including opportunity costs,
as a percentage of the total funds available to the issuing firm?

Answer: Out of pocket cost = $400,000 + $145,000 + $65,000 = $610,000 Opportunity cost = 6 million
shares * ($23 - $19) = $24,000,000 Actual funds available to firm: 6 million * $19 = $114 million -
$610,000 = $113,390,000 Percentage cost = ($24,000,000 + $610,000) / $113,390,000 = 21.7% Page:
252-255 Level: Difficult

PENSION FUND

43. Suppose that a corporate defined benefit plan must keep pension fund reserves equal to the present
value of expected future pension benefits to be fully funded. The plan has expected payouts of $15
million per year for 20 years and then $20 million per year for the subsequent 10 years. All payments
are at year end. At the current 6% rate of return on the plan's assets, the plan is currently fully funded.
If the plan can increase the proportion of stock investments the fund holds and raise the expected rate
of return to 7%, how many dollars of pension assets can be freed up by the corporation?

Answer: Current fund assets = [$15 mill * PVIFA(6%, 20 yrs)] + [$20 mill * PVIFA(6%, 10 yrs)* PVIF(6%, 20
yrs)] = $217,947,017 Assets required at 7% = [$15 mill * PVIFA(7%, 20 yrs)] + [$20 mill * PVIFA(7%, 10
yrs)* PVIF(7%, 20 yrs)] = $195,210,752 Assets freed up by rate change $22,736,265 (Note: Actuaries
have to approve the rate change)

Actual calculations may be more complicated than this but this is a good time value example. Not in the
text. Page: 515 Level: Difficult

45. You are 30 years old and you make $70,000 per year. You calculate that you can't retire until you
have accumulated a lump sum amount of $2,000,000 to live on after retirement. You contribute 6% of
your salary to your 401(k) and your employer contributes 4% of your salary. You plan on investing 60%
of your funds in equities on which you expect to earn an average rate of return of 12%, and the rest in
bonds projected to earn 6%. If your salary does not grow, how old will you be when you can retire?

Answer: Employee contribution per year: $4,200 Employer: $2,800 Total contribution per year: $7,000
Expected rate of return = (0.60 * 0.12) + (0.40 * 0.06) = 0.096 or 9.6% $7,000 * (FVIFA(9.6%,N)) =
$2,000,000 N = 36.5 years so you will be 66 years old when you hit your retirement goal. Page: 519-
520 Level: Difficult
 46. An individual is considering contributing $4,000 per year to either a traditional or a Roth IRA.
Payments would begin in one year. If she uses the traditional IRA her contributions would be fully
deductible. She is 40 years old and is in a 28% tax bracket. On either IRA she can earn 7% pretax. When
she retires at age 65 she believes she will be in a 15% tax bracket. Which type of IRA should she choose
if she invests not only the $4,000 per year, but any tax savings due to the deductibility of her
contributions in a taxable investment earning a pretax rate of 7%. She will withdraw all her money upon
retirement and may owe taxes then depending of the type of IRA chosen.

Answer: Traditional IRA + Taxable investment Amount invested per year $4,000 Tax Savings = (0.28 *
$4,000) = $1,120 The IRA earns 7%, and the taxable investment earns 7% * (1 - 0.28) = 5.04% after tax
After tax future value of the IRA + Future value of the invested deductions (after tax): [$4,000*
(FVIFA7%, 25yr) * (1-.15)] + $1,120*(FVIFA5.04%, 25yr) = $215,046.73 + $53,750.08 = $268,796.81

Roth IRA: $4,000 * (FVIFA7%, 25yr) = $252,996.15 The expected FV of the Roth IRA is less than the
expected FV of the traditional IRA plus the invested tax savings; so she should choose the traditional IRA
and invest the tax savings. Page: 519-520,521 Level: Difficult

MORTGAGES
Use the following to answer questions 43-44:

A homeowner is looking to buy a home in Marvin Gardens. The most he can afford to pay in total is
$1,500 per month. Yearly property taxes will probably be about $2,950 (escrowed monthly) and
insurance is $65 per month. There are no other costs.

43. If mortgage rates are 6% for a 30 year fixed rate mortgage, how large can his mortgage be?

Answer: Max monthly payment = $1,500 - $2,900/12 - $65 = $1,189.17 PV = $1,189.17 * PVIFA(6/12,
360) = $198,343 Page: 201-202 Level: Medium

44. If his parents give him $20,000 for a down payment, what is the most he can pay on a house with a
15 year mortgage if the interest rate is 5.25%?

Answer: $1,500 - $2,900/12 - $65 = $1,189.17 PV = $1,189.17 * PVIFA(5.25/12, 180) = $147,929 +

$20,000= $167,929 Page: 201-202 Level: Medium

FOREIGN EXCHANGE MARKETS

42. A U.S. FI has U.S. $200 million worth of 1 year loans earning an average rate of return of 7%. The FI
also has one year single payment Canadian dollar loans of C$154 million earning 9%. The FI's funding
source is $300 million in U.S.$ one year CDs, on which they are paying 5%. Initially the exchange rate is
C$1.54 per $1 U.S. The one year forward rate is C$1.57 per $1 U.S. What is the bank's spread if they
hedge fully using forwards?

Answer: Hedge by selling C$ forward. The current C$ amount is C$154 Million. In one year these loans
will be worth $154 Million * 1.09 = C$167,860,000. Selling this amount forward C$167,860,000/C$1.57
will give U.S.$106,917,197. This gives a rate of return of [U.S.$106,917,197/U.S.$100 million] - 1 =
6.917%. Average rate of return = (2/3 * 7%) + (1/3 * 6.917%) = 6.972% The cost rate = 5%, so the spread
= 6.972% - 5% = 1.972% Page: 230-231 Level: Difficult

111

MONEY MARKETS

44. A government securities dealer needs to make an 8% pre-tax annual return on $10 million of capital
employed to make it worthwhile to make a market in T-Bills. If the bid discount on $10,000, ninety day
T-Bills is 3%, and the dealer can expect to do 5400 round trip deals today what must the ask discount
be? Hint: A round trip is a buy and a sell transaction.

Answer: Bid Price = 10,000 × [1 - .03× (90/360)] = $9,925 $10 million × (0.08/365) = (Required Ask Price -
$9,925) × 5400 deals Required Ask = $9,925.4059 Ask Discount = (($10,000 - $9,925.41)/$10,000) ×
(360/90) = 2.9836% Page: 131 Level: Difficult

47. A corporate treasurer has $6 million to park (invest) for 60 days. Commercial paper rates are a
3.44% discount and CD rates are 3.52%. Comparing the bond equivalent yields over a 365 day year,
which is the best alternative? What is the opportunity cost of leaving the funds idle?

Answer: Find the BEY on each CP: Price = $6 mill * [1 - 0.0344*(60/360)] = $5,965,600 [($6 mill /
$5,965,600) - 1] * (365 / 60) = 3.5079% BEY CD: $6 mill × [1 + 0.0352*(60/360)] = $6,035,200
[($6,035,200/$6 mill) - 1] * (365/60) = 3.5689% BEY The best deal is the CD and the opportunity cost is
3.5689% Page: 123, 125 Level: Difficult

50. Ninety day commercial paper can be bought at a 4% discount. What are the bond equivalent yield
and the effective annual rate on the commercial paper? Why do these rates differ?

Answer: Commercial paper price/100 of par = 100*(1 – (0.04*90/360)) = 99.00 Effective annual rateCP =
(100 / 99.00)365/90 – 1 = 4.16% Bond equivalent yield = [(100 – 99.00) / 99.00] * 365/90 = 4.097%

The discount quote is an annual quote calculated as (Par - Price) / Par, assuming that there are 360 days
in a year. The bond equivalent yield is an annual rate calculated as (Par - Price) / Price, which is the
normal way to express a percentage return ($ return per $ invested), assuming that there are 365 days
in the year. The effective annual return or EAR is the same as the bond equivalent yield, except that the
EAR annualizes the rate of return assuming the proceeds from each 90 day period are reinvested during
the next 90 day period and so on. Page: 126 Level: Medium
51. You are a corporate treasurer for Esso Oil. The quoted rate on dollar denominated euro commercial
paper is just blipped down recently. Your firm can issue $5 million of 30 day euro commercial paper in
the London markets at 3.45%. You can also invest the proceeds in the U.S. in comparable maturity
negotiable dollar denominated CDs which are quoting 3.95%. Ignoring any transactions costs, how much
money, if any, can Esso make by borrowing in the euro markets and investing in the U.S.? Is this a good
deal or not? Should you expect it to last? Explain.

Answer: Initial proceeds from issuing euro commercial paper (CP) = $5 million * [1-(0.0345*30/360)] =
$4,985,625 Invest the proceeds of $4,985,625 in 30 day CDs and will wind up with $4,985,625 *
[1+(0.0395*30/360)] = $5,002,036 Repay the $5,000,000 owed on the CP and Esso will clear $2,036.

If the CDs are not very risky then this represents an arbitrage opportunity for Esso, because they are not
using their own money the rate of return is infinite. Since this is an arbitrage strategy we would not
expect this big a difference in the rates to persist. (Exxon constructed a similar arbitrage several years
ago using euro commercial paper and T-bills.) Page: Integrative Level: Difficult

66

INTEREST RATES

53. A 15 year, 7% coupon annual payment corporate bond has a FPV of $1045.62. However you pay
$1054.32 for the bond. By how many basis points is your Err different from your rrr?

Answer: rrr = 6.51% 1045.62 = 70× [PVIFA15 yr, rrr] + 1000× [PVIF15 yr rrr] Err = 6.42% 1054.32 = 70×
[PVIFA15 yr Err] + 1000× [PVIF15 yr, Err] Err is 9 basis points less than your rrr. Page: 64-65 Level:
Medium

An investor owned a 9% annual payment coupon bond for 6 years that was originally purchased at a 9%
required return. She did not reinvest any coupons (she kept the money under her mattress). She
redeemed the bond at par. What was her annual realized rate of return? What if she did reinvest the
coupons but only earned 5% on each coupon? Why are your answers not equal to 9%?

Answer: You can't use the bond price formula in this case because of the lack of reinvestment. First
alternative: Do not reinvest the coupons at all PV = $1,000 purchase price (coupon = ytm when
purchased) FV = $90x6 = $540 + $1000 par = $1540 $1000 (1+r)6 = $1540 r = 7.46%%
Second alternative: Reinvest coupons at 5% PV = $1,000 purchase price (coupon = ytm when purchased)
FV = $90 x [FVIFA5%, 6 yrs] + $1000 par = $1,612.17 $1000 (1+r)6 = $1,612.17 r =8.29%

The realized returns are less than 9% because the investor did not reinvest the coupons at the required
rate of return. In order to earn a compound rate of return equal to the promised yield an investor must
reinvest the coupons and earn the promised yield for the remaining time to maturity. Page: 68 Level:
Medium

An investor is considering purchasing a Treasury bond with a 20 year maturity, an 8% coupon and a 9%
required rate of return. The bond pays interest semiannually. a) What is the bond's modified duration?
b) If promised yields rise 25 basis points immediately after the purchase what is the predicted price
change in dollars based on the bond's duration?

Answer: a) The bond's price is $907.99 and the bond's modified duration is Σ[(t*CFt / (1.045)t ] /
($907.99 * 2) = 9.833 years Modified duration = 9.833 / 1.045 = 9.409876 years b) With an increase of 25
basis points in promised yields: Predicted ∆ Bond Price = -9.409876 × .0025 = -2.35% or a $ price change
of -0.0235 × $907.99 = -$21.36 Page: 82-83 Level: Medium

DETERMINANTS OF INTEREST RATES

51. Suppose you borrow $9,875 and then repay the loan by making 12 monthly payments of $863.58
each. What rate will you be quoted on the loan? What is the effective annual rate you are paying?

Answer: The interest rate is the solution to the following: PV = PMT * [(1 - (1+r)-N)) / r] or
$9,875=$863.58 * [(1 - (1+r)-12)) / r] r = 0.75% per month You will be quoted the monthly rate times 12
or 0.75% *12 = 9%. The effective annual rate is then found as 1.007512-1 = 9.38%. Page: 37 Level:
Medium

BOND

54. A bondholder purchased a 10% coupon, $1,000 par 5 year bond at a 10% yield. Interest rates then
immediately fell to 7% and his bond was called at a price of $1,055. He reinvested his money and earned
7% on the $1,055 for 5 years. Did the call help or hurt the bondholder? What was his five year rate of
return?

Answer: $1,055(1.07)5 = $1,479.69 $1000 (1+r)5 = $1,479.69 r = 8.15%

The call hurt the bondholder; he earned 185 fewer basis points in rate of return. Page: 178-179 Level:
Difficult