Stanford ENGINEERING Engineering Economics and Sustainability Module 27 Problem

Question

Stanford ENGINEERING Engineering Economics and Sustainability Module 27 Problem Set Topics: Bonds Mortgages P1 30 points): You are considering buying a 20-ycar corporate bond. The bond has a facc value of $1000 and pays 6% interest per year in two semiannual payments. If you want to receive 8% interest, compounded semiannually, h0W much should you be willing to pay for the bondP P2 (60 points): An automaker is buying some special tools for $100,000. The tools are being depreciated by double declining balance depreciation using a 4-year depreciable life and a $6,250 salvage valuc. It is expected the tools will actually be kept in service for 6 years and then sold for S6,250. The before-tax benefit of owning the tools is as follows: 30,000 30,000 35,000 40,000 10,000 10,000 6,250 Selling price Instead of paying $100,000 cash for the tools, the corporation will pay $20,000 now and borrow the remaining $80,000. The depreciation schedule will remain unchanged. The loan will be repaid by 4 cqual end-of-ycar payments of $25,240. Prepare an expanded cash flow table that takes into account both the special tools and the loan. Compute the after-tax rate of return for the tools, taking into account the $80,000 loan. Assume a combined corporato tax rate of 46%. Hints: Each payment is made up of part interest and part principal. Interest portion for any year is 10% of balance due at the beginning of the year. 1. 2 Interest payments are tax deductible ic, they reduce taxable income and thus taxes paid). Principal payments are not. principal portions. h payment into interest and 3. The Year-0 cash flow is-$20,000. 4. After-tax cash flow will be before-tax cash flow -interest payment principal payment taxes. P3 (10 points): Most mortgages are structured as level payment loans. Briefly explain why.

Explanation / Answer

(P1)

Semi-annual bond interest payment = $1,000 x 6% x (1/2) = $30

Semi-annual (nominal) interest rate = 8%/2 = 4%

Number of compounding periods = 20 x 2 = 40

Bond price ($) = Present Value of bond interest payments + Present value of redemption price (face value)

= 30 x P/A(4%, 40) + 1,000 x P/F(4%, 40)

= 30 x 19.7928** + 1,000 x 0.2083**

= 593.78 + 208.30

= 802.08

**From P/A and P/F factor tables

NOTE: As per Chegg Answering Policy, first question is answered.

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