Case Study II: How Expensive a Home Can You Afford to Buy (20 points) Lenders ge

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Case Study II: How Expensive a Home Can You Afford to Buy (20 points)

            Lenders generally allow clients to borrow as much as they believe borrowers can afford, based on their income, debts, and credit history. When deciding whether or not a potential buyer qualifies for a first mortgage on a home, lenders usually look at two ratios, called the front-end and the back-end ratios,. Each ratio generally produces a different home price that a buyer can afford. The maximum home price a buyer can afford is the lesser of the two affordable home prices produced by the two ratios.

The front-end ratio is the monthly cost of ownership, which includes the monthly payments on the mortgage (principal plus interest), taxes, insurance, and any home-owners association dues, as a percentage of the buyer’s monthly income. Lenders used to limit front-end ratios up to 33 percent, but later they allowed up to 40 percent.

The back-end ratio is the sum of the monthly cost of ownership (as in part a) plus other debt payments, such as loans for cars, furniture, and home appliances, as a percentage of the buyer’s monthly income. Lenders used to limit back-end ratios up to 36 percent, but later they allowed up to 42 percent (and sometimes higher).

* * * * * * * * * ** * * * ** * * * ** * * * *

            Marilyn and Paul Jones are potential first-time home owners. Their combined annual income is $145,000. They are making $570 monthly payments on a 3-year old car and $105 monthly payments for the furniture they have had in the apartment they have rented for the past two years. They have saved enough money to make a down payment of $130,000 on the purchase of a home.

            The annual cost of home ownership and liability insurance would be 0.5% of the selling price of the home, and the annual taxes would be 1% of the selling price of the home. The lender will charge an annual interest rate of 4.4% on a conventional 30-year first mortgage.

a. Using the guide lines above, what is the maximum mortgage and home price Marilyn and Paul can afford? Include both a front-end and back-end analysis side-by-side on a single worksheet. Use maximum allowable values of 40% for the front-end ratio and 42% for the back-end ratio. Show all input data and all calculations or results. Use an IF statement to identify the maximum mortgage and home price Marilyn and Paul can afford.

b. Suppose Marilyn and Paul used $10,000 to pay off the entire balance of their car and furniture loans, thereby reducing their home down payment to $80,000. How would this change the maximum mortgage and home price they can afford?

Case Study 3 Financial Projections (15 points)

Calamity Industries has prepared the condensed forecast income statement for the year ending December 31, 2016.

In thousands except for Per Share data.

After creating the forecast, Calamity develops a new product, which will require $100 million in additional capital expenditures at the beginning of 2016. With the new product, EBIT in 2016 is expected to be 15 percent higher than the amount forecast in Exhibit above. To finance the increase in the capital budget, Calamity is considering a plan using 50 percent equity and 50 percent long-term debt. New equity would be issued at $25.00 net proceeds per share and the interest rate on the new long-term debt would be 6.5%. Calamity is reviewing how this financing, if completed on December 31, 2015, would affect the company’s EPS

A. Construct a pro forma income statement for 2016, assuming the financing plan is adopted.

Instead of using 50 percent equity and 50 percent long-term debt, Calamity decides to finance the entire capital budget increase by issuing $100 million in new long-term debt.

Jack Deven, a fixed income portfolio manager with LightStreet Investments, is concerned about the effect of such a large debt issuance on Calamity’s s credit quality and calculates selected pro forma financial credit quality ratios, shown in Exhibit below. LightStreet owns previously issued option-free Calamity bonds in its U.S. Corporate Bond portfolio. These bonds have a 10-year maturity and a modified duration of 6.5 years.

Deven wants to compare his recalculated credit ratios to LightStreet’s credit quality standards, also shown in Exhibit below. Calamity satisfied each of these credit quality standards prior to the new debt issue. For each standard no longer satisfied after the new debt issue, Deven believes the yield on the previously issued Calamity bonds will increase by 10 basis points.

Calamity Industries

Light Street Credit Quality Standards and

Selected Pro Forma Financial Credit Ratios

B.

i. Identify the ratios that would contribute to an increase in the total yield on the

previously issued Calamity bonds if Deven’s analysis is correct.

ii. Calculate the direction and magnitude of the percentage price change due to the change in yield.

Earnings before interest and taxes (EBIT) 94,500 Interest Expense 11,000 pretax income 83,500 income taxes (30%) 25,050 net income 58,450 shares outstanding 12,000 Earnings Per Share (EPS) 4.87

Explanation / Answer

Case study 3: If Devan’s proposal is accepted then impact on EPS reduced financial structure;

Existing Proposal

New proposal

Earnings before interest and taxes

94500

With 15% increase

108675

Interest Expenses

11000

with 6.5 % loan on $ 100000

14250

pretax income

83500

94425

income tax

25050

28328

net Income

58450

66098

shares outstanding

12000

14000

earnings per share

4.87

4.721

Impact of new financial structure will reduction in the EPS from 4.87 TO 4.72. This is primarily because of increase in number of share holdings.

Part B

ii. Calculate the direction and magnitude of the percentage price change due to the change in yield.

Existing Proposal

New proposal

Earnings before interest and taxes

94500

With 15% increase

108675

Interest Expenses

11000

with 6.5 % loan on $ 100000

17500

pretax income

83500

91175

income tax

25050

27353

net Income

58450

63823

shares outstanding

12000

12000

earnings per share

4.87

5.32

          This table shows that with increased debt component, the EPS is go on to increase. This is primarily increase there is no change in the shareholding and the advantage of cheap capital is being passed on to the capital investors.

Existing Proposal

New proposal

Earnings before interest and taxes

94500

With 15% increase

108675

Interest Expenses

11000

with 6.5 % loan on $ 100000

14250

pretax income

83500

94425

income tax

25050

28328

net Income

58450

66098

shares outstanding

12000

14000

earnings per share

4.87

4.721

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