Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual

Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition, Instructor’s Manual
5. a. The expected real rate of return is 5 percent, and the inflation premium is 4 percent.
b. The lender gains in that his real return is 7 percent instead of the 5 percent that was
expected. In contrast, the borrower suffers in having to pay a higher real return than
expected. In other words, the loan is repaid with more expensive dollars than
anticipated.
c. With 6 percent inflation, the real return of the lender is only 3 percent, so he suffers
whereas the borrower gains.
6. No specific solution is recommended. The student should consider default risk, maturity,
marketability, and any tax effects.
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a. Henry is responsible for all liabilities, book as well as contingent. If the lawsuit were
lost, he would lose all his net assets, as represented by a net worth of $467,000. Without
the lawsuit, he still is responsible for $90,000 in liabilities if for some reason the
business is unable to pay them.
b. He still could lose all his net assets because Kobayashi’s net worth is insufficient to
make a major dent in the lawsuit: $600,000 - $36,000 = $564,000. As the two partners
have substantially different net worths, they do not share equally in the risk. Henry has
much more to lose.
c. Under the corporate form, he could lose the business, but that is all. The net worth of
the business is $263,000 - $90,000 = $173,000, and this represents Henry’s personal
financial stake in the business. The remainder of his net worth, $467,000 - $173,000 =
$294,000, would be protected under the corporate form.
2. Depreciation charges for the equipment:
Year Percent Amount
1 20.00% $ 3,200.00
2 32.00 5,120.00
3 19.20 3,072.00
4 11.52 1,843.20
5 11.52 1,843.20
6 5.76 921.60
Total $16,000.00
TESTBANKEDUCATION.COM
3. a. At $2 million in expenses per $100 million in loans, administrative costs come to 2
percent. Therefore, to just break even, the firm must set rates so that (at least) a 2
percent difference exists between the deposit interest rate and the mortgage rate. In
addition, market conditions dictate that 3 percent is the floor for the deposit rate, while
7 percent is the ceiling for the mortgage rate. Suppose that Wallopalooza wished to
increase the current deposit rate and lower the current mortgage rate by equal amounts
while earning a before-tax return spread of 1 percent. It would then offer a deposit rate
of 3.5 percent and a mortgage rate of 6.5 percent. Of course, other answers are possible,
depending on your profit assumptions.
b. Before-tax profit of 1 percent on $100 million in loans equals $1 million.
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