An Integrative Mini Case Problem - The Friendly Loan Company Mr. and Mrs. Leung have found the house of their dreams and are attempting to finance its purchase. The Friendly Loan Company has offered them two options, each of which provides the Leungs with a $200,000 loan. Option One calls for a fixed interest rate of 9 percent per annum; this loan would be fully amortized with level annual payments over a 20-year term. Premature repayment of the mortgage is permitted at any time but a prepayment penalty of one-year's interest is levied on the amount prepaid. Option Two involves a variable-rate loan; the initial interest rate is set at 8.0 percent per year and the maturity is initially set at 20 years. The mortgage payment is initially computed on a basis that will fully amortize the loan over the maturity. The interest rate on this loan is reevaluated each year, and if market rates have changed more than a stated amount from the level of rates existing when the loan was originated, then the interest rate on the Leung's variable-rate loan would be adjusted either through an increase (decrease) in the mortgage payment (leaving the maturity unchanged); or through an extension (rcduction) of the maturity date (leaving the amount of the annual payments unchanged). If the Leungs choose the variable-rate loan, they must indicate at that time which adjustment method they want employed when a change in the interest rate is called for. Premature repayment of the nortgage is permitted without penalty. The Leungs calf on you for aktistance in cvaluating their options. You leam shat they expect to live in the heuse for 10 years before talling th. At that time, the Leunga would repay tie morigage loan in full. Camparing yout interest-eate forecasts with the variable-fate loan provisions, you conclude that it is most likely that at the end of 4 years the variable rate will be increased to 10 percent, where it is likely to renain for the fallawitig 6 years. There are no other costs or fees to consider. Tax eonsiderations, if any, can be ignoted. a) Given these assumptions, assist the Leungs by providing them with the scries of payments (including end-of-term payments) callod for under each of the following options: Option Oae: Option Two (i): Variable-Interest Loan with variable mortgage payrnents and fixed maturity Option Two (ii): Variable-Interest Loan with variable maturity and fixed annual mortgage payments b) In choosing between the various options, what are the main considerations and tradeofts facing the Leungs? Which option would you recommend? 18. RRSP Versus Employer's Plan in a Job Change Situation You are currently eaming $76,000 per year salary which will increase at an average annual inflation rate of 6% until you mandatorily retire on your 65 th birthday. To-day is your 50 th birthday. You have now 16 years of pensionable service credit with your present employer where you are required to compulsorily participate in a "defined benefit pension plan". Such a pension plan gives you a contractual right to retire with an annual pension of (.017 number of years of service prior to retirement x average annual salary over 3 years of service prior to retirement). This pension will be indexed at 50 percent of expected inflation rate of 6 percent over your retirement years; and all pension benefits will terminate at your expected exit from this world at age 80 . You have now $65,000 in your pension account with your employer (which includes your contribution, your employer's contribution plus interest earned on the combined contributions). You are being tempted by another company with an offer of \$82,000 annual salary, rising at the average inflation rate of 6 pereent. This new company has exactly the same "defined benefit pension plan" and the same inflation indexation. Now, if you give in to the temptation, you will face the following two alternatives: (A): Transfer the $65,000 in your present pension account to your private RRSP which cannot be dissolved until you retirement at age 65 ; (B): Transier the $65,000 to your new employer's pension plan with full credit for your 16 years of pensionable service with the present employer. Now answer the following showing calculations: 1. At what riskless compound rate of return on your $65,000 RRSP investment will you be indifferent between the two options A and B ? 2. Suppose your RRSP investment will earn only 9 percent riskless compound rate of retum annually. Then, how many years before your presently expected death at age 80 must you die in order for the two altematives to be equally desirable? An Integrative Mini Case Problem - The Friendly Loan Company Mr. and Mrs. Leung have found the house of their dreams and are attempting to finance its purchase. The Friendly Loan Company has offered them two options, each of which provides the Leungs with a $200,000 loan. Option One calls for a fixed interest rate of 9 percent per annum; this loan would be fully amortized with level annual payments over a 20-year term. Premature repayment of the mortgage is permitted at any time but a prepayment penalty of one-year's interest is levied on the amount prepaid. Option Two involves a variable-rate loan; the initial interest rate is set at 8.0 percent per year and the maturity is initially set at 20 years. The mortgage payment is initially computed on a basis that will fully amortize the loan over the maturity. The interest rate on this loan is reevaluated each year, and if market rates have changed more than a stated amount from the level of rates existing when the loan was originated, then the interest rate on the Leung's variable-rate loan would be adjusted either through an increase (decrease) in the mortgage payment (leaving the maturity unchanged); or through an extension (rcduction) of the maturity date (leaving the amount of the annual payments unchanged). If the Leungs choose the variable-rate loan, they must indicate at that time which adjustment method they want employed when a change in the interest rate is called for. Premature repayment of the nortgage is permitted without penalty. The Leungs calf on you for aktistance in cvaluating their options. You leam shat they expect to live in the heuse for 10 years before talling th. At that time, the Leunga would repay tie morigage loan in full. Camparing yout interest-eate forecasts with the variable-fate loan provisions, you conclude that it is most likely that at the end of 4 years the variable rate will be increased to 10 percent, where it is likely to renain for the fallawitig 6 years. There are no other costs or fees to consider. Tax eonsiderations, if any, can be ignoted. a) Given these assumptions, assist the Leungs by providing them with the scries of payments (including end-of-term payments) callod for under each of the following options: Option Oae: Option Two (i): Variable-Interest Loan with variable mortgage payrnents and fixed maturity Option Two (ii): Variable-Interest Loan with variable maturity and fixed annual mortgage payments b) In choosing between the various options, what are the main considerations and tradeofts facing the Leungs? Which option would you recommend? 18. RRSP Versus Employer's Plan in a Job Change Situation You are currently eaming $76,000 per year salary which will increase at an average annual inflation rate of 6% until you mandatorily retire on your 65 th birthday. To-day is your 50 th birthday. You have now 16 years of pensionable service credit with your present employer where you are required to compulsorily participate in a "defined benefit pension plan". Such a pension plan gives you a contractual right to retire with an annual pension of (.017 number of years of service prior to retirement x average annual salary over 3 years of service prior to retirement). This pension will be indexed at 50 percent of expected inflation rate of 6 percent over your retirement years; and all pension benefits will terminate at your expected exit from this world at age 80 . You have now $65,000 in your pension account with your employer (which includes your contribution, your employer's contribution plus interest earned on the combined contributions). You are being tempted by another company with an offer of \$82,000 annual salary, rising at the average inflation rate of 6 pereent. This new company has exactly the same "defined benefit pension plan" and the same inflation indexation. Now, if you give in to the temptation, you will face the following two alternatives: (A): Transfer the $65,000 in your present pension account to your private RRSP which cannot be dissolved until you retirement at age 65 ; (B): Transier the $65,000 to your new employer's pension plan with full credit for your 16 years of pensionable service with the present employer. Now answer the following showing calculations: 1. At what riskless compound rate of return on your $65,000 RRSP investment will you be indifferent between the two options A and B ? 2. Suppose your RRSP investment will earn only 9 percent riskless compound rate of retum annually. Then, how many years before your presently expected death at age 80 must you die in order for the two altematives to be equally desirable