Question 1

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

Accepted Answer

Risk aversion refers to the preference for avoiding losses over acquiring equivalent gains; it's about the preference for certainty over uncertainty, not just disliking bad things.

Question 2

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

Accepted Answer

Higher interest rates increase the cost of borrowing and the discount rate used to calculate the present value of future cash flows, making fewer investment projects appear profitable due to lower present values.

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.

Accepted Answer

Using the formula for the present value, $PV = \frac{FV}{(1 + r)^n}$, where $PV$ is the present value, $FV$ is the future value, $r$ is the interest rate, and $n$ is the number of periods, we can calculate the present value of $800 received 6 years from today at an 8.148% interest rate. Plugging in the values, $PV = \frac{800}{(1 + 0.08148)^6}$, which equals approximately $500. This means at an 8.148% interest rate, you would be indifferent between receiving $500 today or $800 in 6 years, as their present values are equivalent.

Question 4

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

Accepted Answer

The future value of $1 saved today is actually $1 * (1 + r)^n, where r is the interest rate and n is the number of periods. The formula $1/(1 + r) represents the present value of $1 received in the future, not its future value.

Question 5

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

Accepted Answer

Risk-averse individuals dislike losses more than they like comparable gains, which is a reflection of loss aversion, a concept in prospect theory.

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.

Accepted Answer

An increase in the interest rate increases the future value of money saved in a bank account because the amount of interest earned on the saved money will be higher.

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.

Accepted Answer

The project has a positive net return of $2,000 over the cost, and with an interest rate of 3%, the cost of borrowing $50,000 for one year would be $1,500 ($50,000 * 0.03), which is less than the return, making the project financially viable.

Question 8

The market for insurance is an example of diversification.

Accepted Answer

In insurance, risk is pooled among many policyholders, spreading out the financial impact of individual losses, which is a form 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.

Accepted Answer

The present value concept reflects the idea that a specific amount of money in the future is worth less than the same amount today, due to the potential earning capacity of money over time at current interest rates.

Question 10

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

Accepted Answer

The rule of 70 applies to both a growing savings account and a growing economy, as it is a way to estimate the number of years required for an investment or economy to double in size at a constant annual growth rate.

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.

Accepted Answer

The present value (PV) of $1,000 to be received in 4 years at an 8 percent interest rate can be calculated using the formula PV = FV / (1 + r)^n, where FV is the future value ($1,000), r is the annual interest rate (0.08), and n is the number of years (4). Plugging in these values gives PV = $1,000 / (1 + 0.08)^4 = $1,000 / 1.36049 = $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.

Accepted Answer

The answer of ZZL Corporation has the opportunity to undertake...

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.

Accepted Answer

Given the information, if the project yields $13,310 in 3 years from a $10,000 investment today, the implied annual return can be calculated using the formula for the future value of a single sum: $FV = PV(1 + r)^n$, where $FV$ is the future value ($13,310), $PV$ is the present value ($10,000), $r$ is the annual interest rate, and $n$ is the number of periods (3 years). Solving for $r$ gives an annual interest rate of approximately 10%. Therefore, if the market interest rate is higher than 10%, the return on the investment would be less attractive compared to the market rate, leading PZX Corporation to forgo the project.

Question 14

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

Accepted Answer

The concept of present value indicates that a dollar received in the future is worth less than a dollar today due to the opportunity cost of not having that dollar to invest. As interest rates increase, the cost of borrowing (and thus the future repayment amount) increases, making loans less attractive and decreasing the quantity of loanable funds demanded.

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.

Accepted Answer

The Rule of 70 is a way to estimate the number of years it takes for an investment to double, by dividing 70 by the annual rate of return. In this case, 70 divided by 5 equals 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.

Accepted Answer

The rule of 70 is a way to estimate the number of years it takes for an investment to double at a given annual interest rate. By dividing 70 by the interest rate (3.5), you get approximately 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.

Accepted Answer

The present value of a sum of money to be received in the future decreases as the time to receipt increases, due to the time value of money. Therefore, $100 to be paid in two years has a higher present value than $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.

Accepted Answer

The present value of a future payment decreases as the interest rate increases or the payment is received later, because present value is inversely related to the interest rate and the time until payment.

Question 19

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

Accepted Answer

Risk-averse individuals have a stronger negative reaction to potential losses than the positive feeling they get from equivalent gains, leading them to avoid situations where there is a risk of a bad outcome.

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%.

Accepted Answer

The present value of a future payment decreases as the interest rate increases, because a higher rate means a greater discount is applied to the future payment.

Quiz 27: Tools of Finance