1

Suggested Solution for Chapter 3

1. Lisa spent every cent she had and then borrowed $1,000 to purchase an elaborate
wardrobe worth $2,000. Ignoring all of Lisas other assets and liabilities,
construct her balance sheet after the purchase. Suppose that, a year later, Lisas
wardrobe-now completely out of style-is worth only $100. If Lisa has paid off
$500 of her loan, what does her balance sheet look like now? Comment on her
present financial position.
Solution:
Balance Sheet for Lisa Rich (at purchase)
Assets Liabilities
Personal wardrobe $2,000 Outstanding loan $1,000
Total liabilities 1,000
Net worth $1,000
Total liabilities
Total assets $2,000 and net worth $2,000
Balance Sheet for Lisa Rich (one year later)
Assets Liabilities
Personal wardrobe $100 Outstanding loan $ 500
Total liabilities 500
Net worth $(400)
Total liabilities
Total assets $100 and net worth $ 100
Ignoring all other assets and liabilities, the net worth of Lisa Rich after the
purchase of the wardrobe is $1,000. However, one year later her net worth has
declined to $(400). Thus, her current financial position has been seriously
affected by the $1,000 decrease in the market value of the wardrobe.
2. Would you classify the following expense items as flexible or inflexible?
Property taxes (called rates in HK), house mortgage payments, clothing, car
licenses, insurance and family members personal allowances
Solution:
(a) Property taxes are inflexible expenses, (b) house mortgage payments are
inflexible expenses, (c) clothing is a flexible expenses, (d) car licenses/registration
is an inflexible expense, (e) insurance is an inflexible expense, (f) personal
allowances are flexible expenses.
3. Question 20 on page 73 in the textbook.
Solution:
Calculation of Variances and Cumulative Variances:
June Variances Cumulative Variances
Salaries $ 400 $ (1,200)
Expenses:
Rent (20) (120)
Transportation (15) 70
Food (25) 100
All others 70 (90)
Payroll taxes (100) 300
Savings $ 310 $ (940)
2
The budgeter planned to save $200 each month:
$3,000 ($300 + $200 + $550 + $850 + $900)
At the end of June, savings were budgeted at $1,200 ($200 x 6). Since there is an
unfavorable cumulative variance of $940, actual savings is $260 ($1,200 - $940).
4. Assume that inflation was 10 percent during 2005, evaluate Kims financial
performance for that year given the following data for Kim:
2004 2005
Income during the year $30,000 $32,000
End of year: Assets 50,000 60,000
Liabilities 40,000 49,000
Solution:
Kims balance sheet for 2004 indicates a net worth of $10,000, which increased to
$11,000 in 2005. In addition, personal income increased $2,000 during the same
period. With an inflation rate of 10%, her financial performance would not be
satisfactory. Although her net worth increased by $1,000, it is important to
recognize that this 10% increase equals the 10% annual inflation rate.
Furthermore, Kims income increased approximately 7% in 2005, which does not
match the inflation rate for the same year. Changes in net worth and personal
income should equal or exceed the annual inflation rate to remain in sound
financial condition. In this case, the value of asset probably increases more than
the inflation rate to offset the negative effect of income increase. Kim may also
spend less or borrow to invest to increase her net worth.
5. Explain how you would forecast the following expense items for an upcoming
budget year: Mortgage payments, Food and household items, Income and other
payroll taxes, and Family members personal allowance
Solution:
Forecasting expense items is sometimes the most difficult aspect of preparing a
budget unless expenses are known with certainty or referenced to previous budget
periods. (a) Mortgage payments are amortized and scheduled, (b) food and
household items must be estimated and/or referenced to a previous period, (c)
income and other payroll taxes can be determined from previous pay periods or
computed, (d) family members personal allowances should be estimated based
on need and/or referenced to a previous period. All the above items should be
adjusted for inflation except for mortgage payments.
6. Indicate what the following ratios are supposed to test. How would you evaluate
each, given its specific numbers? Discuss whether you think the person to whom
these ratios apply is a good credit risk.
Liquid assets to take-home pay = 0.08; liquidity ratio = 0.75; debt ratio = 1.20;
debt service coverage ratio = 1.10
Solution:
A financial ratio is a measure of comparison that explains significant areas of
financial performance. In addition, financial ratios can be used to determine the
achievement of specific financial goals.
a. The liquid assets-to-take-home-pay ratio is a measure of liquidity that
determines financial ability to meet current expenses. The ratio of .08 is
3
equal to about one month, which is below the satisfactory level of three
months of liquid assets to take-home pay.
b. The liquidity ratio is a measure of liquidity that examines liquid assets and
current liabilities. This ratio considers the level of existing liabilities that
require payment within one year. The ratio of .75 indicates that there is
$.75 of liquid assets for every $1.00 of existing current liabilities. An
adequate ratio should be any number greater than 1.0.
c. The debt ratio measures total liabilities against total assets. The smaller
the ratio is, the greater the capacity to meet existing debt obligations. A
ratio of $1.20 in total liabilities for each $1.00 of total assets suggests that
there is an excessive use of debt and that current debt should be reduced.
d. The debt service coverage ratio measures take home pay against total debt
service charges. The ratio of 1.10 indicates that $1.10 in take-home pay
was earned for each $1.00 of required debt repayment and interest. A
ratio of 1.0 means all of the after-tax income is needed to pay existing
debts and a ratio greater than 1.0 indicates greater debt-carrying capacity.
Summary: an analysis of these financial ratios indicates that the applicant would
not be a safe credit risk. Moreover, each ratio is not adequate to meet the
expected criteria of a good credit risk.

Chapter 5
1. Explain what is meant by interest rate volatility and then discuss the risk of
investing in CDs in periods of interest rate volatility.
Solution:
Interest rate volatility refers to the fluctuating behavior of interest rates.
Economic conditions generally influence interest rates, as these rates rise or fall
substantially throughout the economic cycle.
During periods of interest rate volatility, investment in CDs locks in existing
higher interest rates when rates are generally beginning to fall. However, the risk
of interest rates rising while funds are locked into long-term accounts has
certainly influenced the implicit use of this strategy.
2. A local bank offers a free checking account if you maintain a minimum balance
of $1,000. Is the account really free? Explain.
Solution:
Unless the advertised checking account pays interest, it is not free to the depositor.
While there is no traditional service charge as long as there is a minimum $1,000
balance, the opportunity cost of forgone interest earned on a comparable NOW
account or savings account explains why the checking account is not free.
3. Identify or explain the following items: Certificate of deposit; right of
survivorship; bounced check; stop-payment order; certified check; cashiers
check; travelers check; ATM.
Solution:
a. A certificate of deposit is a savings vehicle with a fixed maturity and a
fixed interest rate over its life. Early redemption of CDs results in a
penalty, which reduces the interest accrual.
4
b. The right of survivorship feature transfers funds held in a joint account to
the surviving spouse, and they are not liable for estate taxes.
d. A bounced check or overdraft occurs when a check is written without
sufficient funds to cover it.
e. Stopping payment on a check is commonly referred to as a stop payment
and involves directing the bank not to pay a specific check.
f. A certified check, cashiers check, or travelers check is a form of
payment that is guaranteed by the bank making the funds immediately
available to the payee. Certified check is a personal check certified by the
bank that it has sufficient fund. A cashiers cash is a check written by the
bank. A travelers check is check that is issued by some well-known
company (like American Express) for travelers. It is generally accepted by
shops frequently visited by tourists.
g. Automated teller machines (ATMs) involve the use of electronic
technologies to facilitate several banking activities and financial
transactions.
4. Suppose Alex wants to sell you a 3-year CD linked to the weather of Wisconsin.
Alex says you will not lose your money for sure. You dont quite understand how
this CD works. You decide to ask the professors in HKBU, one of the top
universities in the world. However, no one can fully understand this CD. Should
you invest in this CD? Why?
Solution:
Investors are betting against the banks or investment bankers who sell these
securities. They know much more than ordinary investors. Investors normally do
not know the fair value of these securities and hence, are subject to over-pricing
without knowing it. Unless these securities offer unique opportunities to invest in
something that ordinary investors have no access, investors on average are at a
disadvantage. I would not invest.

CHAPTER 6
Brendas Debt Repayment Choices
1. It is likely that credit cards will carry the highest rate and the student loan the
lowest rate.
2. She should pay off the loan that carries the highest after-tax rate. That is probably
the credit card.
3. She must take into consideration both risk and return on the alternative strategies.
She should first compare the after-tax cost of the loan with the after-tax return on
the investment she is considering. She must also consider the risk associated with
those financial investments. The worst case scenario should not impair her ability
to repair her debts.
5
Evaluating Mikes Revolving Account
The interest rate per month is 1.333% (=16%/12)
Average daily balance is as follows
Period (a) # Days (b) Balance (c) x (b)
11/01 11/04 4 $600 $2,400
11/05 11/9 5 $600 + $80 = $680 3,400
11/10 11/14 5 $680 - $200 = $480 2,400
11/15 11/29 15 $480 + $100 = $580 8,700
11/30 1 $580 + $50 = $630 630
$17,530
Average daily balance=($17,530/30) = $584.33
a. Interest with average daily balance: $584.33 x .01333 = $7.79
b. Interest with previous balance method: $600 x .01333 = $8.00
c. Interest with adjusted balance method: ($600 - $200) x .01333 = $5.33

Suggested Solution for Chapter 8 (Housing)
1. What is the relationship of market rates of interest and affordable housing?
The market rate of interest is inversely related to housing affordability. The higher
the market rate of interest, the greater is the monthly payment on a given loan.
Thus, a higher family income will be needed to qualify for a given loan amount
when interest rates are high. We can observe the effect of this relationship in the
housing market. During periods of tight credit, the housing market is generally in
a slump.

2. Given an affordable monthly mortgage payment of $5,600, and a mortgage
interest rate of 6 percent on a 30-year loan, what is the size of the affordable
mortgage? Given this affordable mortgage, and a 10 percent down payment, what
is the affordable purchase price?
Since the monthly interest rate is 0.5%, the size of the affordable mortgage is

( )
04 . 033 , 934
005 . 0
005 . 0 1 1
5600
) 1 ( 1
360
=
(
(

+
=
(

+
=

k
k
PMT PVA
n
n

The affordable purchase price is $1,037,814 (=934,033/0.9).
3. A lender is offering an 11 percent fixed rate mortgage, requiring a down payment
equal to 20 percent of the homes purchase price. The lender estimates that
closing costs should be equal to $4,000 plus 4 points. How much will closing
costs be on a $2,000,000 home?
The closing cost is
000 , 68 ) 8 . 0 000 , 000 , 2 ( 04 . 0 000 , 4 $ = +
4. Suppose housing prices rise at a 5 percent annual rate over the next five years. If a
house now costs $2,000,000, how much will it bring after five years and the
payment of a 5 percent sales commission?
After five years, the house will bring:
934 , 424 , 2 ) 05 . 0 1 ( 05 . 1 000 , 000 , 2 $
5
=
5. Five years ago, Christy took out a 30-year mortgage to buy her dream house when
she was married to Eric. The interest rate is prime rate minus 2.85%. Today the
6
balance of her mortgage is $5 million. In the past two weeks, the bank lowered
the prime rate from 6.75% to 5.75%. How much money is she going to save per
month before the tax effect?
The interest rate before rate cut was 3.9% (=6.75%-2.85%). The monthly interest
rate was 0.00325 (= 0.039/12). The mortgage is a 25-year mortgage now (n=300
months). With a mortgage balance of $5 million now, the mortgage payment
before interest rate cut was:
( )
55 . 26116
00325 . 0
00325 . 0 1 1
5000000
) 1 ( 1
300
=
(
(

+
=
(

+
=

k
k
PVA
PMT
n
n

The interest rate after rate cut is 2.9% (=5.75%-2.85%). The monthly interest rate
is 0.002417 (= 0.029/12). The mortgage payment after interest rate cut is:
( )
32 . 23451
002417 . 0
002417 . 0 1 1
5000000
) 1 ( 1
300
=
(
(

+
=
(

+
=

k
k
PVA
PMT
n
n

The monthly saving is $2665.23.
6. In the example on mortgage insurance, suppose you can borrow $500,000 from
the bank (with lump sum of $75,620 insurance premium) or from your friend
Alex at 8%. The bank is charging 5.75% on the 30-year mortgage with monthly
payment. Will you go to the bank or Alex?
If the amount of $500,000 were borrowed from Alex, the monthly payment would
have been:
( )
82 . 3668
006667 . 0
006667 . 0 1 1
500000
) 1 ( 1
360
=
(
(

+
=
(

+
=

k
k
PVA
PMT
n
n

If the amount of $500,000 were borrowed from the bank, the monthly payment
would have been:
( )
86 . 2917
004792 . 0
004792 . 0 1 1
500000
) 1 ( 1
360
=
(
(

+
=
(

+
=

k
k
PVA
PMT
n
n

The saving is $750.96 per month for 360 months. The present value of saving is:
( )
343 , 102
006667 . 0
006667 . 0 1 1
96 . 750
) 1 ( 1
360
=
(
(

+
=
(

+
=

k
k
PMT PVA
n
n
or
( )
683 , 128
004792 . 0
004792 . 0 1 1
96 . 750
360
=
(
(

+
=

n
PVA
The saving is definitely higher than the cost of insurance, $75,620. Actually the
answer depends on the return you will get by investing the $75,620. If you can
earn return higher than 11.54%, the benefit of saving the insurance premium and
investing is higher than the cost of higher monthly payment to Alex.
7. Vera, a HKBU student, comes from Shanghai. She just gets an offer from a big
accounting firm and is looking for a shelter. The monthly rent will be about
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$7,000. For comparable space, the house will cost about $2,000,000. Suppose she
can put 10% of the sales price as down payment and borrow the rest with a 30-
year mortgage at 3% interest rate (monthly payment). Alex tells her that the house
will appreciate by 5% a year. Vera plans to sell the house (if she buys one) and go
back to China in 5 years. Assume she can invest her money in stock market and
earn 10% return.
a. Should she buy or rent?
To make it simple, we assume there is no tax advantage in mortgage. The
house price is $2,000,000. In the case of buying a flat, Vera puts down
$200,000 as down payment (10%) and borrows $1,800,000. The monthly
payment will be
( )
87 . 7588
0025 . 0
0025 . 0 1 1
1800000
) 1 ( 1
360
=
(
(

+
=
(

+
=

k
k
PVA
PMT
n
n

At the end of five years, Vera will sell the house at a price of
563 , 552 , 2 05 . 1 000 , 000 , 2 $
5
=
But she has to pay the remaining of the mortgage, which is equal to
( )
99 . 313 , 633 , 1
0025 . 0
0025 . 0 1 1
87 . 7588
300
=
(
(

+
=

n
PVA
So the net benefit of buying will be $919,250 (=2552563-1633313).

Suppose she considers the alternative of renting instead of buying. She can
save the down-payment and invest the amount in the stock market for an
annual return of 10%. We ignore the risk here. Every month, she pays a
rent of $7,000 instead of the mortgage payment of $7588.87. Hence, she
can save $588.87 (=7588.87-7000) per month and invest them in the stock
market with an annual return of 10%. Assume monthly compounding, the
interest rate is 0.8333% per month. At the end of five years, all her
investment will be worth:
( )
656 , 374
00833 .
1 00833 . 0 1
87 . 588 ) 00833 . 0 1 ( 000 , 200
60
60
=
(
(

+
+ +
This is her benefit (in year 5) of renting.
Since these two amounts are at the same time, year 5, we can just compare
the magnitudes. The benefit of renting is less than the benefit of buying.
So Vera should buy a flat.
b. What other factors should Vera consider?
Other factors that would favor buying a house include tax saving of
interest payments, rate (property tax) paid by homeowners, the sweet
feeling of going home, formation of a habit to save. Other factors that
would favor renting include unfamiliarity with Hong Kongs environment,
the troubles of being a flat-owner, and the saving of house insurance.
Other factors needed to be addressed include the uncertainty of the length
8
of staying in Hong Kong, future appreciation rate of house price and the
rate of return of investment.

Suggested Solution for Chapter 9

1. No. Buyers of options do not have obligation but sellers of options have
obligation. Buyers of option will not lose more than the option premium but
sellers of options can lose more than the option premium.

2. If he put all his money in stock vs. option, investing in option is riskier. He can
lose everything in option easily. If he compares buying 400 shares of stock and
buying options on 400 shares, investing in stock is riskier because at most he can
only lose is $4000 in option. But in stock, he can lose more if the stock price goes
down by more than $10 per share.

3. In Hong Kong market, prices of warrants are less likely to be fair in comparison
to prices of options. Only issuers of warrants can issue (sell) more warrants.
Investors cannot short-sell warrants even if the prices are very high. However, in
options markets, if the prices are very high, investors can sell options even though
they do not have the options. The unfair pricing of warrant gives underwriters big
profit at the expense of individual investors. Individual investors pay a large price
to get this number one reputation for Hong Kong.

4. The bank buys the house. It sells a call option to the homeowner. The call option
gives the homeowner the right but not the obligation to pay the bank an amount
equal to the outstanding balance of the mortgage (specific price in the call option)
to buy the house (specific asset in the call option). Of course, the homeowner has
to pay to buy the call option. The premium (or cost) is the down-payment. If the
price of the house is above the outstanding balance of the mortgage, homeowner
chooses to pay the bank to keep the house. If not, the homeowner just let the
option expire and walk away.

5. As the volatility of the asset price increases, the value (or price) of call option and
put option will go up. As the length of the option period (called maturity of the
option) increases, the value of call option will go up. The value of put option
usually will go up too. Sometimes, the value of a put option may stay the same.
But this is beyond the scope of this course. As the asset price increases, the value
of call option will go up and the value of put option will go down. As the exercise
price (the price the option holders buy or sell the asset) increases, the value of call
option will go down and the value of put option will go up. Interest rate is another
factor but we will skip it here. Another factor not predicted by option theory is the
expectation of investors. If investors expect the stock price will go up in the future,
the stock price today will go up. So is the value of call option beyond the effect of
9
the stock price increase. In this course, you only need to know the volatility and
maturity and maybe investors expectation.

6. Suppose when the market opens, the stock price drops below $30. Then Alex
cannot sell his stock at $30.