COMM 111 – In-Class Exercise – Week 9
1. A company may look to raise additional money by issuing bonds. A bond has two cash flow
streams: (1) the periodic interest payments that are an annuity, and (2) the principal
repayment at maturity that is a lump-sum. When a company issues bonds, they are recorded
at the present value of these two cash flow streams as a liability on the balance sheet.
ABC Company issues $100,000 of bonds due in 10 years. The bonds pay $10,000 of interest
annually. The current market rate of interest is 8%.
Required:
a. Determine the present value of the periodic interest payments.
Determine inputs and find present value of an annuity factor.
N = 10
i = 0.08 PV of annuity factor = 6.7101 PV = 67,101
PMT = 10,000
b. Determine the present value of the principal repayment.
Determine inputs and find present value of lump-sum.
N = 10
i = 0.08 PV factor = 0.4632 PV = 46,320
FV = 100,000
c. At what value are the bonds recorded on the balance sheet?
PV of interest payments + PV of principal repayment = PV of bond
67,101 + 46,320 = 113,421
d. Repeat steps (a) – (c), but now assume the market rate of interest is 10%.
PV of Interest PV of Principal PV of annuity factor = 6.1446
N = 10 N = 10 PV factor = 0.3855
I = 0.10 N = 0.10
PMT = 10,000 FV = 100,000
PV = 61,446 PV = 38,550 PV of bond = 99,996 (round to 100,000)
e. Repeat steps (a) – (c), but now assume the market rate of interest is 12%.
PV of Interest PV of Principal PV of annuity factor = 5.6502
N = 10 N = 10 PV factor = 0.3220
I = 0.12 N = 0.12
PMT = 10,000 FV = 100,000
PV = 56,502 PV = 32,200 PV of bond = 88,702
f. What do you notice about how the interest rate changes the present value?
As the interest rate increases, the present value decreases.
g. What do you notice about the value of the bond on the balance sheet in relation to the
principal value of the bond? Why do you think this might be?
If less than 10%, present value is greater than the principal value.
If 10%, present value = principal value
If greater than 10%, present value is less than principal value.
This occurs because the bond is paying less, the same, or more interest than the market.
2. You want to purchase a home. You have $70,000 to put as a down payment. You can afford
a maximum monthly payment of $2,300. You can secure a 25-year mortgage with a fixed
interest rate of 4%.
Required:
a. Determine the inputs for calculating the present value of the monthly mortgage payments.
Be careful, mortgage payments are made monthly, but mortgage period and interest rate
are stated annually.
N = 300 (convert 25 years to months)
i = 0.0033 (convert 4% annual interest rate to monthly interest rate)
PMT = 2,300
b. How much home can you afford? To answer this question, you need to determine the
present value of the monthly mortgage payments (an annuity). Given the inputs above, the
present value of an annuity factor is 302.9532.
2,300 * 302.9532 = 696,792
c. How will a change in the interest rate affect how much home you can afford?
If the interest rate increases, then the PV will decrease, meaning you can afford less.
d. How will a change in the length of the mortgage affect how much home you can afford?
If the mortgage term increases (e.g., 30-year term) then you can afford more because the
payments are being dispersed over a longer period.
e. What will happen to your monthly mortgage payment if you increase your down payment?
If you increase your down payment, then you can afford a more expensive home at the
same maximum monthly payment amount. Alternatively, if you increase the down
payment on a home with a given value, then your monthly payment will decrease.
f. The calculation above only considers the payment of principal and interest on the
mortgage. What other factors will affect how much home you can afford?
Closing costs paid at time of purchase. Additional monthly costs include home insurance,
property taxes, and mortgage insurance (if your down payment is less than a certain
amount). Additionally, bigger homes come with higher monthly utility bills.
g. What does this mean for you?
Homes are becoming less affordable as interest rates and property values increase. If you
hope to buy a home one day, you should start saving early. Additionally, you should build
good credit to qualify for lower interest rates. Further, you should be aware of all the costs
associated with buying a home so that you do not commit to buying a home that you
cannot afford and may later default on.