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ADMS3541 Fall 2014 Solutions of selected textbook questions(Chs.8-16): Chapter 9 1. (a) For Reed Chalmer, he only need to concern about property and liability risks. At age 62 and being a university professor for 30 years, he must have accumulated most of his pension/retirement savings already. However, the Chalmers must ensure that the pension conditions provide a sufficient survivor's pension for Florimel (see also Chapter 18). (b) For Schmendrick and Molly, disability of either one is the most serious risk since neither has much money or income, and neither would likely be able to earn anything if disabled. Premature death is somewhat of a risk, because two can live more cheaply together than separately. However, it is not that serious, since there are no children. There is no property risk, since they have none. There is no liability risk, since they have nothing to lose! (c) It seems that Brian M. has been the breadwinner. Therefore, the most serious risks are disability and premature death of Brian. He is old enough now (in his 50s) that both are material risks. The disability or premature death of his wife are also significant risks, although she is somewhat younger. The loss would be the loss of her services in the household, which are especially important with three dependent children. Property and liability are also risks, since it is likely that they have some property. (d) Failure to get his job back is the critical risk for Salvatore Cuchimel. Control is the only possibility — this is an uninsurable risk because of moral hazard. He is also at high risk of disability and premature death due to his current state of health and lifestyle. The disability risk is probably uninsurable, and once again the best management is control. These risks are particularly serious because there is no other way for his child to receive support, it seems. In case (c), for example, it would be possible for the wife to start working if the husband died or became disabled. The children would grow up and leave home, becoming self-supporting. Property loss is also an insupportable risk, because he has no reserves. In this case, the main property is the house. Chapter 13 7.(a) (b) GDS = (PMT × 12 + $ 3,000)/$80,000 PMT = $1,750 per month = 30% TERM RATE AMRTZN. E.M.R. MONTHLY MAX FIRST IN YEARS P.A. IN YEARS (M) PMT MORTGAGE 1 7.00% 25 0.575% $1,750 $249,852 2 7.50% 25 0.615% $1,750 $239,216 3 8.00% 25 0.656% $1,750 $229,294 4 8.25% 25 0.676% $1,750 $224,581 5 8.50% 25 0.696% $1,750 $220,025 According to the 75% rule they only qualify for three times their down payment of $ 50,000, therefore they only qualify for a first mortgage of $ 150,000. 11. Information of Mr. Maxi’s property is given as follows: Projected price increase per month Projected increase started Frontage cost per foot Space cost per foot ($1,000/100) Air conditioning Fireplace Finished recreation room 2% 3 months $2000 $10.00 $1,000 $5,000 $10,000 Problem 13.12: Adjustments for Direct Market Comparison Subject Property Sale Price Time Adjustment Location Lot size House size Washrooms Garage Air conditioning Fireplace Finished rec room Modern kitchen Walkout basement Total Adjustments Adjusted Sale Price Now Address 50' 2400 No Yes No Sale #1 Sale #2 Sale #3 $222,000.00 $200,000.00 $250,000.00 0 12,241.6 0 0 1,000.00 -1,000.00 0 0 0 222,000.00 4000.00 2000.00 -10,000.00 -1,000.00 -1,000.00 -1,000.00 5,000.00 0 -10,000.00 -10,000.000 12,241.60 242,155.00 -22,000.00 239,000.00 Sale #2 is not the most recent sales, and it also requires the most adjustments. Of the remaining two sales, #1 is as recent as #3 but requires the least amount of adjustment. Therefore, the estimated value of the subject property is $222,000. 13. Step 1: Estimation of land value: $870 × 46 = Step 2: Reproduction cost new $78 × 2800 = Step 3: Accrued depreciation: Storm door Window Painting Broadloom (39 × 200) Total 350 900 4,600 7,800 13,650 Market Value by Cost Approach $ +40,020 218,400 - 13,650 $244,770 Or round to $245,000. Chapter 14 2. Investment A: E(r) = 8.15% S.D. = 8.97% Investment B: E(r) = 9.50% S.D. = 15.24% These two investments cannot be ranked by the dominance concept, because the higher expected rate of return also has a higher standard deviation, or risk. 4. (a) Goal = FV (PV $26,000, N =32) FV PV N CPT (b) 3,000,000 (= Goal) 26,000 (= Lottery Prize) 32 (= 65 – 33) I/Y = 16% p.a. Suppose he has a tax rate of 40%. Then, his required before-tax return is .16/.6 = 26.7%. Investments offering this rate of return are very scarce, and very risky. This answer is anticipating Chapters 14-16 a bit. The instructor might suggest that the students look at Appendix D, where they will see that no investment class comes close to this rate of return in the long-run. Therefore, the practical answer is that he needs to modify his goal or save more money. Chapter 15 2. (a) Assuming Semi-annual Coupons: (i) Price CM Face Value Maturity PV PMT FV N I/Y YTM = -9,500 475 10,000 40 5.04% 10.08% (ii) -10,500 512.50 10,000 60 4.87% 9.74% (iii) YTM = 10% which should be obvious at once, since the bond is trading at par. (b) No, for three reasons. The issuer may default on the payments. The price of the bond changes as market interest rates change (i.e., as the available alternative opportunities change). If you sell any time before maturity, you may receive a different price than expected. Finally, you must reinvest the coupons in an investment yielding exactly the same rate of return. This is an underlying assumption of the bond pricing mechanism — we also call this an internal rate of return, because the funds are assumed to be reinvested internally at the same rate. 6. Joe’s savings account ($40,000), chequing account ($5,000), and term deposit ($75,000) total to $120,000, of which only $100,000 is covered. Therefore, he should consider transferring at least $20,000 of these funds into another CDIC member institute. His RRSP account is fully and separately covered by CDIC. Mary’s investment in chequing ($1,000), savings ($5,000), and GICs ($100,000) total to $106,000, of which only $100,000 is covered. Therefore, she should consider transferring at least $6,000 of these funds into another CDIC member institute. Her RRSP is invested in an unqualified investment and therefore is not covered by CDIC. Each of their joint accounts is fully covered, since each is qualified and under $60,000. 12. (a) (b) = EAR = (1.02564)365/181 -1 PB = 30[PVIFA.035,20] + 1,000[PVIF.035,20] [ (c) 100,000 − 97,500 HPR 1 (1.035)20 97,500 = .02564 = .0523789 1 1 = 30 × [0.035 − 0.035×(1.035)20 ] + 1000 × = $928.94 ] PB(at end of year) = 30[PVIFA.04,18] + 1,000{PVIF.04,18] = $873.41 HPR = = = = Interest+P1 −P0 P0 60+873.41−928.94 928.94 4.47 928.94 $.0048 or 0.48% Chapter 16 7. (a) E(rp) = x1E(r1) + x2E(r2) + x3E(r3) + .... + xnE(rn) E(rp) Sp2 Sp (b) = 12.89% = 2 2 N ∑N i=1 xi si + ∑ ∑i≠1 2xi xj rij si sj = 14.20% E(rp) ÷ Sp = 0.1289 ÷ 0.1421 = 0.91 Therefore, the probability of a negative return is 18.14%. 9. THREE-YEAR INVESTMENT HORIZON LOAD FUND FRONT BACK ANNUAL COSTS FRONT LOAD BACK LOAD MANAGEMENT FEE TOTAL ANNUAL COSTS Dune 7.000% 0.000% 2.716% 0.000% 2.300% 5.016% Middle Earth 0.000% 0.000% 0.000% 0.000% 4.000% 4.000% Narnia 0.000% 9.000% 0.000% 2.772% 3.300% 6.072% SIX-YEAR INVESTMENT HORIZON LOAD FUND FRONT BACK ANNUAL COSTS FRONT LOAD BACK LOAD MANAGEMENT FEE TOTAL ANNUAL COSTS Dune 7.000% 0.000% 1.514% 0.000% 2.300% 3.814% Middle Earth 0.000% 0.000% 0.000% 0.000% 4.000% 4.000% Narnia 0.000% 9.000% 0.000% 1.227% 3.300% 4.527% TEN-YEAR INVESTMENT HORIZON LOAD FUND FRONT BACK ANNUAL COSTS FRONT LOAD BACK LOAD MANAGEMENT FEE TOTAL ANNUAL COSTS Dune 7.000% 0.000% 1.043% 0.000% 2.300% 3.343% Middle Earth 0.000% 0.000% 0.000% 0.000% 4.000% 4.000% Narnia 0.000% 9.000% 0.000% 0.621% 3.300% 3.921% For a three-year investment horizon Middle Earth would be the best alternative, and for six- and ten-year horizons Dune would be the best alternative.