TAHIL, RADDY S.

APRIL 17, 2022

BS MATHEMATICS MATH 129

MATHEMATICAL FINANCE
ASSIGNMENT
CHAPTER 8
8.) A borrower deposits $200 immediately for the guarantee to be able to borrow $1000 at the end of
one year. The borrower must repay the $1000 at the end of two years.

a) Find the two positive yield rates for this transaction.

b) Truth in lending does not resolve this situation since there is only one advance.
Compute the APR using the method of equated time on the payments rather than on the advances.

SOLUTION
(a) The equation of value is
200 1( + i)2 −1000 1( + i) +1000 = 0
(1+ i)2 −5 1( + i) + 5 = 0.
Now solving the quadratic, we obtain
√ √
1+= 𝑖5 2
(5)
= 5 ± 2.5
((−5)(2)) (−1)(41)

=1.382 and 2.618

so that i =.382 and 2.618, or 38.2% and 261.8%.

(b) The method of equated time on the payments is

t= = .
This method then uses a loan of 1000 made at time t =1 repaid with 1200 at time t = 53. The equation
of value is 1000 1( + j)=1200 or j =.20 for 2/3 of a year.

Thus, the APR = 3/2 j =.30, or 30%.

16.) A company is considering the possibility of acquiring new computer equipment for $400,000. The
salvage value is estimated to be $50,000 at the end of the six-year life of the equipment. Maintenance
costs will be $4000 per month, payable at the end of each month. The company could lease the
equipment for $12,000 per month, payable at the end of each month. Under the lease agreement, the
lessor would pay the maintenance costs. The company can earn 12% convertible monthly on its capital.
a) Calculate the NPV of the "buy" option.
b) Calculate the NPV of the "lease" option.
c) Which option should be chosen?

14. SOLUTION
(a) The NPV of the “buy” option is
 (
50,000 (1.01)−72 − 400,000+ 4000
a
72 .01 ) = 24,424.80−604,601.57 = −$580,177.
(b) The NPV of the “lease” option is −12,000a= −$613,805.
72 .01

(c) The “buy” option should be chosen since it is the least negative.

20.) A $100,000 loan is to be repaid by 30 equal payments at the end of each year. Interest on the loan
is at 8% effective. In addition to the annual payments, the borrower must pay an origination fee at the
time the loan is made. This fee is 2% of the loan but does not reduce the loan balance. When the second
payment is due, the borrower pays the remaining loan balance in full. Determine the yield to the lender
considering the origination fee and the early pay-off of the loan.

18. SOLUTION
The loan origination fee is .02 100,000( ) = 2000.
100,000
The mortgage payment is R = =8882.74.
a
30.08

Loan balance at t =1: B1 =100,000 (1.08)−8882.74 = 99,117.26.

Loan balance at t = 2: before any payments B2′ = 99,117.26 1.08( ) =107,046.64.

Adjusted loan L*=100,000− 2000 = 98,000. Thus, the equation
of value becomes
98,000 =8882.74v +107,046.64v2
and solving the quadratic

v =−8882.74 ± (8882.74)2 −( )4 (107,046.64)(−98,000)

2 107,046.64( )
=.91622 rejecting the negative root.
1
Finally, i = − =1 .0914, or 9.14%. v

There are 10× =4 40 payments on this loan. The quarterly interest rates are j2 j1 ==.03 and =.035.
a
The loan balance B12 =1000 28 .03 =18,764.12. The loan 4
balance after 12 more payments is

B24 = (18,764.12)(1.035)12 −1000s

 12 .035 =
$13,752 to the nearest dollar.
a
30.08

The loan balance B10 = 5329.64a 20.08 = 52,327.23. The amount of the “wraparound” mortgage is

(.85)(120,000)−52,327.23= 49,672.77. The payment on the “wraparound” mortgage is R2 =

49,672.77
= 5834.54. The total payment required is

a
20.10

R1 + R2 = $11,164 to the nearest dollar.

27.) An installment loan of $690 is being repaid with six monthly payments of $50 each followed by six
monthly payments of $75 each. Use the constant ratio method to approximate the rate of interest on
the loan.

25. SOLUTION
The total payments are 6 (50)+ 6 (75)= 750. Now, K = 750 −690 = 60, so that
60/750 =.08 of each payment is interest and .92 is principal. Therefore, principal payments are 46
for the first six months and 69 for the last 6 months. The 12 successive loan balances are:
690, 644, 598, 552, 506, 460, 414, 345, 276, 207, 138, 69

which sum to 4899. We then have

icr = =.147, or 14.7%.

40.) A company buys two machines. Both machines are expected to last 14 years, and each has a salvage
value of $1050. Machine A costs $2450, while Machine B costs SY. The depreciation method used for
Machine A is the straight-line method, while the depreciation method used for Machine B is the sum of
the year’s digits method. The present value of the depreciation charges made at the end of each year for
Machines A and B are equal. If the effective rate of interest is 10%, calculate Y.

SOLUTION

Machine A: D = =100

and the present value of these depreciation

charges is 100a= 736.67.
14 .10

Machine B: S14 = (14)(15) =105.

The pattern of depreciation charges is .
 14
(Y −1050), 105
105
13
(Y −1050),,105
1
(Y −1050 .)

The present value of these depreciation charges is

Y −1050(14v14 +13v13 + + v14 ) = Y −1050(Da)14 .

105 105
14 − a
Now evaluating (Da)14 = 14 .1
= 66.3331
.1
47.) Machine I sells for $100,000, has an annual maintenance expense for the first year of $3000, and
has a useful life of 20 years with no salvage value. Machine 2 has an annual maintenance expense for
the first year of $10,000 and has a useful life of 15 years with no salvage value. It is anticipated that the
cost of the machines and the annual maintenance expenses will increase by 4% per year indefinitely into
the future: Machine 2 produces output twice as fast as Machine 1. Maintenance expenses are paid at
the beginning of each year. Assuming the effective rate of interest is 8%, find the price of Machine 2 at
which a buyer would be indifferent between the two machines. Answer to the nearest $100.

SOLUTION
Machine 1:
For the first 20 years periodic charges are

H1 =100,000i + 100,000 + 3000 1.04( )t−1 = 100,000 + 3000 1.04( )t−1

s a
20 20

for t =1,2,,20. The

present value is

⎡ ⎛1.04 ⎞ ⎛1.04 ⎞2 ⎛1.04 ⎞19 ⎤

100,000+3000 1⎢ + ⎜ ⎟+⎜ ⎟+ +⎜ ⎟ ⎥ =142,921.73.
⎣ ⎝1.08⎠ ⎝1.08⎠ ⎝1.08⎠ ⎦
For the next 20 years it is H (1.04)20 continuing indefinitely. Thus, the capitalized cost is
⎡ ⎛1.04⎞20 ⎛1.04⎞40 ⎤
142,921.73 1⎢ + ⎜ ⎟ +⎜ ⎟ + ⎥ = 269,715.55.
⎣ ⎝1.08⎠ ⎝1.08⎠ ⎦
Machine 2:
t −1
A
 )
H2 = a +10,000 1.04( for t =1,2,,15.
15

The present value is

⎡
X +10,000 1⎢ + ⎛⎜1.04 ⎞⎟ + + ⎛⎜1.04 ⎞⎟14 ⎤⎥ =116,712.08+ X.
⎣ ⎝1.08⎠ ⎝1.08⎠ ⎦
The capitalized cost is

(116,712.08+ A)⎡⎢1+ ⎛⎜1.04 ⎞⎟15 +⎛⎜1.04 ⎞⎟30 + ⎤⎥ = (2.31339)(116,712.08+ A).

⎣ ⎝1.08⎠ ⎝1.08⎠ ⎦

MATHEMATICAL FINANCE
ASSIGNMENT
CHAPTER 9
4.) Rates that associate assets and liabilities This basis looks at related assets and liabilities in
determining the applicable rate and does not consider an asset or liability in isolation. This is an
important type of analysis and will be discussed further in Chapter 11.

SOLUTION
The question is asking for the summation of the “real” payments, which is and solving the quadratic we
obtain .0241, or 2.41%.

14.) An amount of $10,000 is deposited for 10 years in a mutual fund which is expected to earn 8%
effective and has an annual expense ratio of 2%. Assume half of the expenses can be invested at the end
of each year by the mutual fund company in another account at an annual rate of 9%. Calculate the
accumulated value in this other account at the end of 10 years.

SOLUTION
The expense invested in the other account in year k is

10,000 1.06( )k−1 (.01) for k =1,2,,10. The

accumulated value of the account after 10 years will be

100⎡⎣(1.09)9 + (1.06)(1.09)8 + + (1.09)9 ⎤⎦

⎤
⎡(1.09)10 −(1.06)10
 =100⎢ ⎥ = $1921.73
.09−.06 ⎦
by a direct application of formula (4.34).

18.) A company has a asset with a depreciation basis of $100,000 which will be depreciated according to
the following schedule:

Year Percent
1 33.33
2 44.45
3 14.81
4 7.41

The depreciation charge at the end of each year is tax deductible. The marginal tax rate is 35% and the
pretax borrowing rate is 12%. Calculate the present value of the tax deductions created by the
depreciation schedule. Answer to the nearest dollar.

SOLUTION
The tax deduction is 35% of the depreciation charge.
Year Depreciation charge Tax deduction
1 33,330 11,666
2 44,450 15,558 3 14,810

5,184
4 7,410 2,594

The after-tax yield rate is (.12)(.65) =.078.

Thus, the present value of the tax deductions is

11,666 15,558 5184 2594

+ 2
+ 3
+ 4
= $30,267 to the nearest dollar.

1.078 (1.078) (1.078) (1.078)

29.) The forecasted cash flows of a project in millions of euros are as follows:

𝐶0 𝐶1 𝐶2 𝐶3 𝐶4 𝐶5
-80 10 20 23 27 25

The current exchange rate is $1.2 = €1. The interest rate in the U.S. is 8% and the euro interest rate is
6%.
a) Calculate the NPV of the euro cash flows.
b) What are the dollar cash flows from the project?
c) Calculate the NPV of the dollar cash flows.
9.8 Reflecting risk and uncertainty

SOLUTION
(a) NPV =− +80 10 1.06( )−1 + 20 1.06( )−2 + 23 1.06( )−3 + 27 1.06( )−4 + 25 1.06( )−5 = €6.61 million.

(b) The expected exchange rate expressed in dollars per €1 (not in euros per $1) at

1.08 ee e
1.223. The cash flow at time t =1 in dollars then
time t =1 is = and e = 1.06 1.2
is

(10)(1.223) = $12.23 million.

Using the same procedure to calculate the expected exchange rate and cash flow in dollars each year
gives the following:
Time 0 1 2 3 4 5

ee 1.2 1.223 1.246 1.269 1.293 1.318 $ million -96 12.23 24.91
29.19 34.92 32.94

(c)NPV = −96+12.23 (1.08)−1 + 24.91 (1.08)−2 + 29.19 (1.08)−3 + 34.92 (1.08)−4

+32.94 (1.08)−5 = $7.94 million.

Interestingly, this answer could also be obtained from the answer in part (a), as (6.613)(1.2) = 7.94.
This demonstrates the internal consistency in using interest rate parity.
36.) A mortgage company issues $1,000,000 in two-year mortgages which carry an effective rate of
interest of 8%. The mortgages will be repaid with equal payments of principal at the end of each of the
two years in addition to any interest then due. The borrowers may prepay the mortgages at the end of
the first year without penalty. The effective rate of interest at the end of one year is equally likely to be
either 6% or 10%. The mortgage company can reinvest all proceeds received at the end of the first year
at this rate for the second year. It is assumed that borrowers will exercise any option to prepay to their
advantage. The probability of default is zero.
a) Find the expected accumulated value of these mortgages to the mortgage company at the end of two
years.
b) Find the standard deviation of the accumulated value in (a).
c) Find the expected yield rate to the mortgage company mortgages. d) Justify from general reasoning
that the answer in (c) is less than 8%. in issuing these

SOLUTION
(a) Assume that the borrower will prepay if the interest rate falls to 6%, but not if it rises to 10%. The
expected accumulated to the mortgage company is

.5 80,000 [(1.06)+1,000,000 (1.06)]+.5 580,000 [(1.10)+ 500,000 (1.08)]

=.5 1,144,800( )+.5 1,178,000( )= $1,161,400.

(b) Var =.5 1,144,800( −1,161,400)2 +.5 1,178,000( −1,161,400)2 = 275,560,000 and

(c) S.D.= 275,560,000 = $16,600.

(d) We have 1,161,400 =1,000,000 1( + i)2 which solves for i =.0777, or 7.77%.
(e) The option for prepayment by the borrower has a value which reduces the expected yield
rate of 8% that the lender could obtain in the absence of this option.