Case Solution on Time Value of Money

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Case Solution on Time Value of Money

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Studebaker had spared a considerable amount of money in excess of $30,000 that was in mutual

funds. His mortgage balance was $45,000 with an annual rate of 7% and a yearly payment of

4,248 with 20 years remaining. Morton advised Studebaker to get a new mortgage so that he

could unlock $25,000 of equity. This, he explained, would accumulate $176,392 in twenty years,

factoring in the $30,000 that he would have to invest in a single-premium insurance policy. He

was assured of getting a yearly 6% return as opposed to the 5% that he was getting at that time.

However, the new investment strategy would have a downside, as mortgage payments would

increase by $3,052, from $4,248 to $7,300. However, the yearly earnings from the life insurance

policy would surpass the increase in cost, as the first year was estimated to increase by $3,300,

from $55,500 to $58,800. Over the 20-year period, the earnings were expected to increase by

$9,984.Studebaker decided to seek a second opinion, and he contacted Phyllis Corner, who

worked in the economics department. Corner identified errors in Mortons assumptions such as

the omission of taxes, $5,000 fees involved in moving Studebakers equity into insurance policy,

increase in mortgage from 7% to 9%, and the problem of getting an unnecessary life policy as

other long-term investments would also give out similar returns. She advised that the $30,00 and

the $3,052 increase in annual mortgage could be invested in other investments that would earn

higher returns. She stressed upon the importance of considering lost opportunities for accruing

interest on the $30,000, and for the additional mortgage payments amounting to $3,052 that

would have been invested elsewhere, therefore earning interest.

1

Questions Answer

1. Morton notes that the $55,000 invested in the single-premium life insurance policy

would grow to $176,392 in 20 years for a return of 6% per year. Explain how this

return was calculated.

Answer:

=55,000(1+6%)20

=$176,392

The $55,000 was derived from the $30,000 that Baker had invested in a money market mutual

fund and the $25,000 that he would likely save by getting a new mortgage. The yearly earnings

from the life insurance policy amounted to 6%. As such, the policy accrues accumulation value

each year for 20 years. The first year accrues $3,300, an amount that is added to the initial policy

payment of $55,000 to make up $58,300. The policy value increases each year to reach

$176,392 in the 20th year. The rate is calculated in a compounding basis so as to determine the

future value of a cash flow.

2. In order to re-position the equity in his home, Studebaker would have to take out a 30-

year, $75,000 mortgage at 9 percent. Explain how the yearly mortgage payments on this

loan were obtained.

=$75,000/(1+9%)30

=$5,651.7

The 9% was arrived at after calculating the present value of a cashflow with regards to the

present purchasing power. The process is known as discounting as it shows the value of the cash

flows after factoring in todays purchasing power.

2

3. For the 9% mortgage in Exhibit 4, find the loan balance at the end of years 19 and

20.

Amount(1) Principle(2)- Balance(1)-

(3)=(4) (4)

19 24500.88 4380.12 2205 2175.12 22325.76

20 22325.76 4380.12 2009.32 2370.80 19954.96

Given,

PV= $45000

n= 30

Here,

PMT=PV/(PVIFA, i, n)

=$45,000/10.2737

=$4,380.12

4. Exhibit 3 indicates that $176,392 will be accumulated after 20 years in the life

insurance policy. Is this really true? (Hint: If Studebaker were to make this investment,

how would his debt position look like in 20 years?)

If we calculate the payment policy in annuity basis policy payment would be $55,000.

5.(a) If the excess $30,000 were invested in a long-term asset yielding 8 percent a year, how

much would be accumulated after 20 years?

Given,

PV= $30,000

i=8%

n=20

Now,

FV20= PV (1+0.08)20

3

=$30000*4.66

= $139,828.71

5. (b) Suppose Studebaker placed $3,052 a year into long-term investment paying 8% a

year. How much would be accumulated after 20 years (amounts invested at the end of each

year)?

Here,

FV20=$3052(1+0.08)20

=$14225.24

(a)

Given,

PV= $30,000

i=7%

n=20

Now,

FV20= PV (1+0.07)20

=$30,000*3.8697

=$116,090.53

(b)

Here,

FV20=$3,052(1+0.07)20

=$11,810.28

4

7. Comers criticism implied that the single life-insurance policy is unattractive investment

for Studebaker. What do your previous answers suggest?

i) The insurance costs too much: When a whole life insurance policy is sold (and theyre

always sold, never bought), the buyer and seller generally focus on the investment portion of the

policy, not the insurance policy. The silly buyer just naturally assumes hes getting the

insurance portion at the going rate (such as what he would pay for term insurance.) Fool. Like

any business, they charge what they can get away with. If youre not paying attention, youd

better believe the price gets jacked up. A bigger problem is that young people cant afford

enough whole life insurance to cover their actual need for insurance, so they end up buying a

separate term policy anyway, or worse, they dont and walk around under-insured.

ii) The fees are too high: We dont pay the fees directly, but we do pay them with lower

returns. For example, the commission on a whole life insurance policy is generally 100% of the

first years premiums then 6% of premiums every year after that. Thats money that doesnt get

invested on your behalf. By comparison, the commission on a term policy is about 50% of the

first years premiums, then 4% of premiums after that. Its pretty easy to see what the financial

incentive is. Sell whole life instead of term, and upgrade the policy at every opportunity. 100%

of a new policy is far better than 6% of an old one. But you dont pay the commissions, the

company does argues the salesman. Where do you suppose the company gets the money from?

iii) Complexity favors the issuer: After a while, people figured out that whole life insurance

was a rip-off. So to disguise that fact, the companies just made the products so complex that

only their actuaries could figure them out. Even those who have spent a great deal of time trying

to figure these policies out dont understand them. Even the guys selling them dont completely

understand them, but you better believe they understand the commission structure. Suffice to

say, the more complex it gets, the worse a deal it is for you.

invested at 8% interest. How much will he have to save in equal amount at the end of each

year of the next 20 years if he can earn 8% of any investment?

Here Given,

FVA=$400,000

n=20

We know,

FVA=C*{(1+i)n-1/i}

So, C= FVA/{(1+i)n-1/i}

=$400,000/45.76

=$8740.88

5

So, he need to save overall $8740.88 per year if he wants to accumulate the balance is $400,000.

Now,

$30,000 at 8% interest

=$2400

So,

=$6340.88

8.(b) Repeat part (a) but assume he will not be able to save any money in years 13 to 20,

this is he will save an equal amount at the end of years 1 to 12 and nothing thereafter.

=$174,817.6

=$14,568.13

So,

=$12,168.13

9. The yearly payment on the new 30-year, $75,000 mortgage is $7,300. This assumes one

payment is made at the end of each of the next 30-years. Suppose that payments must

be made at the end of each month. Would 12 of these monthly payments be equal to

one of the yearly payments? Explain.

No, there is difference between monthly payment and yearly payment. Monthly payment is

higher than the yearly payment.

So, FV=$1000(1+.1)1

=$1100

6

If the same amount invest on monthly interest basis then

FV=$1000(1+.1/12)1*12

=$1104.71

Here, we clearly see that there is difference between yearly payment & monthly payment.

10. Exhibit 3 suggests that the annual cost of the life insurance policy is $3, 052. With the

adjustments mentioned in the case, Comer calculated the cost to be $5,152 in Year 1

and $18,632 by year 20 assuming a 7% annual return. Explain how these were

determined.

Answer: The annual cost of the insurance amounting to $3,052 was added to $2,100 of lost

interest to amount to $5,152. Comer assumed that the $30,000 that would be invested in the life

insurance policy, therefore losing the interest that would have been earned on it. The cost could

have inflated to $18,632 by year 20 due to compounding interest that would have been earned on

$5,152.

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