Deck 27: Tools of Finance

Question 1

Risk aversion simply means that people dislike bad things to happen.

Answer 1

False

Question 2

As the interest rate increases, the present value of future sums decreases, so firms will find fewer investment projects profitable.

Answer 2

True

Question 3

If you are faced with the choice of receiving $500 today or $800 6 years from today, you will be indifferent between the two possibilities if the interest rate is 8.148 percent.

Answer 3

True

Question 4

The future value of $1 saved today is $1/(1 + r).

Question 5

Risk-averse individuals like good things more than they dislike comparable bad things.

Question 6

An increase in the interest rate causes a decrease in the future value of $1,000 that you have in a bank account today.

Question 7

A company that can build a project that will cost $50,000, but returns $52,000 in one year would make a good decision by turning this project down if the interest rate were 3 percent.

Question 8

The market for insurance is an example of diversification.

Question 9

The present value of any future sum of money is the amount that would be needed today, at current interest rates, to produce that future sum.

Question 10

The rule of 70 applies to a growing savings account but not to a growing economy.

Question 11

If the interest rate is 8 percent, then the present value of $1,000 to be received in 4 years is $735.03.

Question 12

ZZL Corporation has the opportunity to undertake an investment project that will cost $20,000 today. If the interest rate is 20 percent and if the project will yield the company $30,000 in 3 years, then ZZL will undertake the project.

Question 13

PZX Corporation has the opportunity to undertake an investment project that will cost $10,000 today and yield the company $13,310 in 3 years. PZX will forgo the project if the interest rate is higher than 10 percent.

Question 14

The concept of present value helps explain why the quantity of loanable funds demanded decreases when the interest rate increases.

Question 15

If a savings account pays 5 percent annual interest, then the rule of 70 tells us that the account value will double in approximately 14 years.

Question 16

According to the rule of 70, if you earn an interest rate of 3.5 percent, your savings will double about every 20 years.

Question 17

The present value of $100 to be paid in two years is less than the present value of $100 to be paid in three years.

Question 18

The sooner a payment is received and the higher the interest rate, the greater the present value of a future payment.

Question 19

People who are risk averse dislike bad outcomes more than they like comparable good outcomes.

Question 20

The present value of a payment of $500 to be made two years from today is greater if the interest rate is 7% than if it is 6%.

Question 21

The fact that we observe a trade-off between risk and return is puzzling to economists, because that observation conflicts with the notion that most people are risk averse.

Question 22

Moral hazard is illustrated by people who take greater risks after they purchase insurance.

Question 23

The market for insurance is one example of reducing risk by using diversification.

Question 24

Increasing the number of corporations whose stocks are in your portfolio reduces market risk.

Question 25

Historically the return on stocks has been higher than the return on bonds. In part this reflects the higher risk from holding stock.

Question 26

According to the efficient markets hypothesis, at any moment in time, the market price is the best estimate of the company's value based on publicly available information.

Question 27

When the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a speculative bubble.

Question 28

Adverse selection is illustrated by people who take greater risks after they purchase insurance.

Question 29

Diversification can reduce firm-specific risk.

Question 30

Because the statistic called the standard deviation measures the volatility of a variable, it is used to measure the return of a portfolio.

Question 31

From the standpoint of the economy as a whole, the role of insurance is to greatly reduce or eliminate the risks inherent in life.

Question 32

According to the efficient markets hypothesis, stocks follow a random walk so that stocks that increase in price one year are more likely to increase than decrease in the next year.

Question 33

If a person had increasing marginal utility, then the decline in utility from losing $1,000 would be greater than the increase in utility from gaining $1,000.

Question 34

Risk-averse persons will take no risks.

Question 35

A person with diminishing marginal utility of wealth is risk averse.

Question 36

According to fundamental analysis, when choosing stocks for your portfolio, you should prefer undervalued stocks.

Question 37

A person's subjective measure of well-being or satisfaction is called aversion.

Question 38

The value of a stock depends on the ability of the company to generate dividends and the expected price of the stock when the stockholder sells her shares.

Question 39

Diversification cannot reduce market risk.

Question 40

Historically, stocks have offered higher rates of return than bonds.

Question 41

Write the formula to find the present value of $x to be paid in n years.

Question 42

Speculative bubbles may arise in part because the value of the stock to a stockholder depends on the final sale price.

Question 43

Write the formula for finding the future value in n years of $x today.

Question 44

Actively managed mutual funds usually fail to outperform index funds, and this fact provides evidence in favor of the efficient markets hypothesis.

Question 45

Write the formula to find the present value of $750 to be paid in 5 years if the interest rate is 3 percent.

Question 46

If the interest rate is 5 percent, then receiving $1,000 eight years from now is worth more than receiving $700 today.​

Question 47

If you believe the stock market is informationally efficient, then it is a waste of time to engage in fundamental analysis.

Question 48

Suppose Dave drives more recklessly when he has car insurance than when he does not have car insurance. This is an example of the moral hazard problem associated with insurance.​

Question 49

In the 15 years ending February 2016, most active portfolio managers failed to beat the market.

Question 50

A payment of $10,000 is to be made in the future. The interest rate 3%. Is this payment worth more if it is paid in 5 years or 10 years? How much more is it worth?

Question 51

Anthony closes out his account in which he deposited $500 five years ago at an interest rate of 5%. Mark closes out his account in which he deposited $500 ten years ago at an interest rate of 5%. Who had more in their account? About how much more did he have?

Question 52

If the interest rate is 6 percent, then the present value of $5,000 received ten years from today is $2,583.34.​

Question 53

According to the efficient markets hypothesis, the number of people who think a stock is overvalued exactly balances the number of people who think a stock is undervalued.

Question 54

Studies find that mutual fund managers who do well in one year are likely to do well the next year.

Question 55

Write the formula for finding the future value of $1,000 today in 10 years if the interest rate is 4 percent.

Question 56

A person who is risk averse will like gaining $1,000 more than they will dislike losing $1,000.​

Question 57

If you wish to rely on fundamental analysis to choose a portfolio of stocks, then you have no choice but to do all the necessary research yourself.

Question 58

According to the Rule of 70, it takes 70 years for a sum of money to double in value when the interest rate is 5 percent.​

Question 59

Managed mutual funds usually outperform mutual funds that are supposed to follow some stock index.

Question 60

Available evidence indicates that stock prices, even if not exactly a random walk, are very close to a random walk.

Question 61

Suppose your bank account pays a 5% interest rate. You are considering purchasing a share of stock in DH Corporation for $250. The stock will pay you a $10 dividend at the end of years 1, 2, 3, 4, and 5. You expect to be able to sell the stock at the end of year 5 for $300. Is DH a good investment? Provide evidence to support your answer.

Question 62

A company has an investment project that will cost $2 million today and yield a payoff of $3 million in 5 years. If the interest rate is 9%, should the firm undertake the project? Show evidence to support your answer.

Question 63

Thompson Corporation is considering the purchase of a new piece of machinery. Thompson expects the new machinery to increase its revenues by $70,000 at the end of year 1, $60,000 at the end of year 2, and $50,000 at the end of year 3 at which point the machinery will have exhausted its useful life. If the interest rate is 4%, what is the most Thompson should be willing to pay today for this piece of machinery?

Question 64

If a savings account pays 3.5% interest, then according to the rule of 70 how long will it take for the account balance to double?

Question 65

Suppose the interest rate is 5% and that you are to receive three annual payments of $10,000, with the first payment one year from now, the second payment two years from now, and the third payment three years from now. What is the present value of this stream of payments?

Question 66

Describe the shape of the utility function of a risk averse person.

Question 67

A company has an investment project that will cost $2 million today and yield a payoff of $3 million in 5 years. What interest rate represents the cutoff between profitability and nonprofitability for this project?

Question 68

Suppose the interest rate is 3% and that you are to receive three annual payments of $1,000, with the first payment today, the second payment one year from now, and the third payment two years from now. What is the present value of this stream of payments?

Question 69

If the interest rate is 8 percent, then what is the present value of $5,000 to be received in ten years?

Question 70

Jack's Lock and Key is considering remodeling. It estimates that the remodeling will cost $6,000 and that as a result revenues will rise by $3,000 the first year, $2,500 the second year, $1,500 the third year and have no effect after then. If the interest rate is 5%, should Jack's remodel? Defend your answer by showing your work.

Question 71

A company has an investment project that will cost $2 million today and yield a payoff of $3 million in 5 years. If the interest rate is 7%, should the firm undertake the project? Show evidence to support your answer.

Question 72

From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life. Then what is its purpose?

Question 73

The nation of Zambonia experiences the same rate of population growth every year. If the population of Zambonia doubles every 35 years, then what is the approximate annual rate of population growth?

Question 74

Suppose you place $500 into a savings account that will pay you 6% interest per year. What will be the future value of the savings account in 15 years?

Question 75

Suppose you place $1,000 into a savings account that will pay you 4% interest per year. What will be the future value of the savings account in 10 years?

Question 76

Suppose you invest $10,000 at 7% interest to be withdrawn by your heirs in 100 years. According to the rule of 70, approximately how much will your heirs be able to withdraw?

Question 77

List two ways a risk adverse person may attempt to reduce risks.

Question 78

Suppose your bank account pays a 4% interest rate. You are considering purchasing a share of stock in ABC Corporation for $500. The stock will pay you a $10 dividend at the end of years 1, 2, and 3. You expect to be able to sell the stock at the end of year 3 for $550. Is ABC a good investment? Provide evidence to support your answer.

Question 79

If the interest rate is 5 percent, then what is the present value of $2,000 to be received in three years?

Question 80

If a savings account pays 7% interest, then according to the rule of 70 how long will it take for the account balance to double?