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September 2022

The Highwell Case

Present Value: Applications to Life’s Financial Problems*

It is 11:00 pm on March 9, 2022, and Jocelyn and George Highwell should be relaxing
before their daughter Laila’s fourth birthday party the following day. But Jocelyn and
George have been working on their 2021 taxes and are now pondering some tough
financial realities. They were a bit overwhelmed.

The first reality is that Laila will grow up fast. Jocelyn and George have not even begun
to save money for Laila’s college. Jocelyn worked her way through school, delaying
graduation until she was 27, and she feels strongly that they should be able to pay most of
Laila’s college bills.

As a goal, Jocelyn and George want to establish a fund from which they can draw
$60,000 per year for four consecutive years, beginning exactly when Laila turns 18. (So,
the first draw of money will be 14 years from now). One complication is that they want
$60,000 per year in today’s purchasing power. So, the actual dollars withdrawn each
year will be more than $60,000.

Jocelyn and George plan to put money into Laila’s college fund every year, once per
year, beginning one year from now. They will continue to do so for 17 years – 13 years
before Laila goes to college, plus four more years to help pay for college expenses. So,
their last payment into the college fund will be exactly 17 years from now – the exact
date of their last withdrawal from the fund.

The second reality is that the interest rate on Jocelyn and George’s adjustable-rate home
mortgage will reset in May 2022, two months from now. In May, they will have made 5
years (60 months) of payments on the mortgage loan, which has a term of 30 years (or
360 months). The original loan balance was $600,000 and the interest rate for these first
five years has been 4.5% per year, compounded monthly. If they keep this mortgage, the
rate will adjust upward to 5.75% per year, compounded monthly. The rate of interest will
then be fixed at 5.75% for the remainder of the loan.

Rather than keeping their current mortgage, Jocelyn and George have considered
refinancing their loan, effective in May. If rates in May are the same as they are now,
they can refinance their existing balance with a 30-year fixed rate loan with a rate of
5.0%, compounded monthly. But they would have to pay fees and “points” on the new
loan equal to 3% of the outstanding loan amount.

* This case was written by Jonathan M. Karpoff for purposes of class instruction. Copyright ©2022.
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September 2022

Case Preparation Questions:

Suppose Jocelyn and George were to ask you for financial advice. In considering the
questions below, assume that Jocelyn and George’s investments will be placed in mutual
funds and that it is reasonable to assume that these funds will earn 4.5% per year for the
next 17 years. (This is the rate at which future cash flows should be discounted.)
Assume also that the rate of inflation is expected to be 3.0% per year for the next 17
years. (This is the rate that tells you the nominal number of dollars Jocelyn and George
will withdraw for each of Laila’s college years.)

1. Jocelyn and George plan to place the same number of dollars into Laila’s college
fund each year, making their first payment into the fund one year from now. (Again, they
will make a total of 17 contributions to the college fund, once per year for 17 years.)
What is the minimum annual amount they need to place in the fund to meet their
objectives for the fund?

2. Now consider Jocelyn and George’s home mortgage loan.

(a) What is their current monthly payment for principal and interest?

(b) How much will they owe in May, after they make their 60th monthly loan
payment?

(c) How much will their monthly payment be if the interest rate adjusts to
5.75%?

(d) Suppose that, if they refinance their outstanding balance in May at 5.0%,
they will pay the necessary fees and points out of pocket, that is, they will not
borrow to pay the fees and points. How much will their monthly payment be
if they refinance in May?

(e) What would you recommend to Jocelyn and George? Should they keep their
existing loan, for now anyway, or refinance at 5.0% in May? In answering,
please consider any factors that you think are relevant.