Exam 14: The Basic Tools of Finance: Part A

Why might someone be willing to pay more than the fundamental value for a stock?

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?

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?

Until recently,shares of stock accounted for 40 percent of Jimmy's savings.A few days ago,Jimmy sold some bonds and bought some additional shares of stock.Now shares of stock account for 70 percent of Jimmy's savings.How did this change affect Jimmy's expected retun on his savings? How did it affect the risks he faces?

The objective of diversification is to reduce risk.How does a person diversify a stock portfolio? How is risk measured?

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

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?

At about what number of companies does the reduction in risk from adding stocks of more companies to a portfolio do little to reduce risk?

Demonstrate that whether you would prefer to have $225 today or wait five years for $300 depends on the interest rate.Show your work.

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.

Draw graphs showing the following three relationships. 1.The relation between utility and wealth for a risk averse consumer. 2.The relation between standard deviation and the number of stocks in a portfolio. 3.The relation between return and risk.

How does adverse selection affect the insurance market?

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?

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?

Suppose the McCormick Corporation releases an earnings report that fails to meet the market's expectations.What does the efficient markets hypothesis predict will happen to McCormick's stock price?

Scenario 27-2 Suppose Dave has a utility function where W is his wealth in millions of dollars and U is the utility he obtains. -Refer to Scenario 27-2.Suppose Dave is faced with a choice between two options.With option A Dave receives a guaranteed $2 million.With option B Dave faces a lottery that pays $0 with probability 0.8 and pays $10 million with probability 0.2.Given Dave's utility function,will he prefer option A or option B? Provide evidence to support your answer.

Give an example of adverse selection and an example of moral hazard using homeowners insurance.

As the interest rate increases,what happens to the present value of a future payment? Explain why changes in the interest rate will lead to changes in the quantity of loanable funds demanded and investment spending.

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.