Deck 14: Investment, Time, and Insurance

Question 1

Suppose that a bond with a $1,000 face value matures in one year and pays a 10% coupon rate. It is selling for $1,025. What interest rate would make a person indifferent between the selling price of $1,025 and the bond payment (face value and coupon) one year from now?

A) 9.8%
B) 7.3%
C) 11.1%
D) 10.2%

Answer 1

B

Question 2

A change in household tastes and preferences reduces the rate of saving. The market interest rate _____, and the quantity of capital _____.

A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

Answer 2

B

Question 3

Tom is considering an investment that gives a $400 payout in one year and a $600 payout in two years. If interest rates are 6%, the maximum price that Tom should pay for this investment is $____.

A) 869.53
B) 911.36
C) 943.40
D) 1,000

Answer 3

B

Question 4

(Table: Car Costs) The table shows the initial cost outlays of two versions of the Ford Escape and their estimated annual fuel costs. Stu is not sure whether he wants the hybrid or standard model. Although more expensive, the hybrid model has better gas mileage and would save $890 of gas per year. Assume both cars are worthless after six years. At a 7% interest rate, what should Stu do?

A) Buy the hybrid since the net present value of the total cost for the hybrid is less than the standard.
B) Buy the standard since the net present value of the total cost for the standard is less than the hybrid.
C) Buy the standard model since the net present value of the total cost for the standard is more than the hybrid.
D) Buy either model since the net present value of the cost difference between the hybrid and the standard model is zero.

Question 5

A corporate bond has a $10,000 face value and offers a 7% coupon rate. The bond matures at the end of three years. If the interest rate is 5%, the present discounted value of the bond is $____.

A) 10,000
B) 10,544.65
C) 9,523.81
D) 10,526.69

Question 6

A corporate bond has a $10,000 face value and offers a 7% coupon rate. The bond matures at the end of three years. If the interest rate is 7%, the present discounted value of the bond is $____.

A) 10,000
B) 9,345.79
C) 9,300
D) 10,752.69

Question 7

Liqin fixes up old cars and sells them to supplement his retirement income. Liqin came across a beat-up 1955 Corvette that she is considering rebuilding and selling. She estimates a 0.2 probability that she will gain 15% on the deal, a 0.2 probability that she will gain 10%, and a 0.6 probability that she will gain 5%. Liqin's expected return for fixing up and selling the Corvette is ____%.

A) 8
B) 11
C) 20
D) 30

Question 8

Daiyu's parents have decided to save for her college education. They estimate they will need $100,000 18 years from now to pay for it. If the interest rate remains fixed at 5% over this period, how much money will Daiyu's parents have to put into savings today to meet their goal (assuming no more money is saved over the years)?

A) $5,555.56
B) $95,238.10
C) $41,552.07
D) $5,291.05

Question 9

Assume a future payment of $10,000. If r = 0.2 and T = 5, then the present value of $10,000 is $____.

A) 2,000
B) 9,900
C) 9,057.31
D) 4,018.78

Question 10

(Figure: Utility and Income) Suppose that Sara has an income of $80,000 but if her business burns down, her income drops to $20,000. The probability that Sara's business will burn down is ____%.

A) 66.67
B) 33.33
C) 50
D) 20

Question 11

(Table: Investments I) The table depicts the costs and benefits of an investment. Which of the following statements is (are) TRUE? I. If the interest rate is 8%, the investment is worthwhile.
II) If the interest rate is 6%, the investment's net present value is $79.26.
III) If the interest rate is 4%, the investment is worthwhile.

A) II and III
B) I, II, and III
C) II
D) III

Question 12

(Figure: Total Utility I) The risk premium is:

A) $24,160.
B) $9,100.
C) $45,000.
D) $35,900.

Question 13

If principal is invested at a constant interest rate, the value of the account will increase:

A) at an increasing rate over time.
B) at a constant rate over time.
C) at a decreasing rate over time.
D) at a linear rate over time.

Question 14

(Table: Account Balance) Using an interest rate of 10%, the value of the savings account balance in year 10 is $____.

A) 3,855.43
B) 11,000
C) 20,000
D) 25,937.42

Question 15

(Table: Utility Function II) Suppose the person's utility function is given by U = I^0.5, where I is income. What guaranteed income level would offer the same expected utility level as that from the uncertain income (i.e., find the certainty equivalent)?

A) $432,600
B) $464,400
C) $448,900
D) $457,000

Question 16

The market for capital is in equilibrium at an interest rate of 3% and a quantity of $10 million. Suppose that businesses become more optimistic about future demand and start to invest heavily in capital. This would cause the equilibrium interest rate to ____ and the equilibrium quantity of capital to ____.

A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease

Question 17

(Table: Payback Period) If management uses the net present value method and requires a two-year period to reach the payback period, then management will ____ the investment because the total benefits over the first two years are ____.

A) approve; less than $5,000
B) not approve; less than $5,000
C) approve; greater than $5,000
D) not approve; greater than $5,000

Question 18

The market for capital is in equilibrium at an interest rate of 3% and a quantity of $10 million. Suppose that households become more frugal and decide to spend less and save more. This would cause the equilibrium interest rate to ____ and the equilibrium quantity of capital to ____.

A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease

Question 19

A firm is considering an investment project that today would cost $20,000. At the end of one year, there is a 70% probability that the investment will pay out $28,000 and a 30% probability that it will pay out $16,000. Using a 10% interest rate, what is the expected net present value of this investment?

A) -$670.85
B) $483.14
C) $2,181.82
D) $4,020.19

Question 20

(Table: Investments III) What is the payback period of the investment?

A) five years
B) four years
C) three years
D) It depends on the interest rate.

Question 21

(Table Cash Flows I) At a 7% annual interest rate, what is the present discounted value of the cash flows?

A) $1,688.08
B) $1,324.86
C) $1,275.33
D) $1,109.70

Question 22

Jiayi would like to save for a car that will cost her $20,000 in five years. If the current interest rate is 6% per month, how much will she need to set aside, assuming monthly compounding (assume Jiayi does not add any more money after today)?

A) $18,867.92
B) $314.47
C) $606.29
D) $333.33

Question 23

Using the Rule of 72, how many years does it take for an account balance to double at an 8% interest rate?

A) 10
B) 9
C) 8
D) 7

Question 24

Suppose that a firm generates $40,000 of profit per year, and this profit will continue forever. At a 10% interest rate, what is the present discounted value of the firm's profit?

A) $400,000
B) $4 million
C) $4.4 million
D) $360,000

Question 25

Sam is considering the purchase of a vending machine to sell sodas. The cost of the vending machine is $3,400. Sam estimates that the vending machine will last for five years and will provide net income of $800 each year for its lifetime. If Sam pays $3,400 for the vending machine today, the net present value at 5% is $____.

A) 63.58
B) 409.52
C) 3,463.58
D) 53.34

Question 26

Sam is considering the purchase of a vending machine to sell sodas. The cost of the vending machine is $3,400. Sam estimates that the vending machine will last for five years and will provide net income of $800 each year for its lifetime. Suppose the seller of the vending machine allows Sam to defer, without penalty or interest, payment for the vending machine until the end of the first year. The net present value at 7% is $____.

A) -119.84
B) 102.58
C) 3,738.32
D) 109.77

Question 27

Jerome operates a car repair shop and is considering whether to purchase a computer diagnostic tool for Korean automobiles. The tool, which costs $4,000, will enable Jerome to service Korean automobiles. This added business will give Jerome additional income of $2,000 in each of the next three years. The net present value of the tool at 5.5% is $____.

A) 1,395.87
B) 5,395.87
C) 5,687.20
D) 1,692.64

Question 28

(Table: Taxi Fleet) Metro Cab is considering replacement of its fleet of old taxicabs. To replace its fleet, Metro must spend $150,000 on new taxicabs. The new taxis will incur $5,000 of maintenance expenses per year. Alternatively, Metro could spend $20,000 today to refurbish its taxicabs and incur an additional $20,000 per year of maintenance expenses for the next three years. Metro would then have to buy new taxicabs for $150,000 at the end of three years, leading to lower maintenance expenses of $5,000 per year. Using an interest rate of 20%, the net present value of the first three years is $____.

A) 65,000
B) 32,000
C) 20,000
D) -34,509

Question 29

(Table: Total Utility II) Because Qingling is _____ risk averse than Huian, Huian will pay the _____ risk premium.

A) more; larger
B) less; larger
C) less; smaller
D) more; smaller

Question 30

Let π = inflation rate, r = real interest rate, and i = nominal interest rate. Which of the following statements is (are) TRUE?

A) π = (r)(i)
B) π = i + r
C) r = i - π
D) i = r - π

Question 31

(Table: Payback Period) The payback period on this investment is ____ years.

A) one
B) two
C) three
D) four

Question 32

Assume a future payment of $10,000. If r = 0.2 and T = 1, then the present value of $10,000 is $____.

A) 10,000.00
B) 9,803.92
C) 8,333.33
D) 9,980

Question 33

In the market for capital, the discovery of new productive technologies increases the profitability of investments. The market interest rate _____, and the quantity of capital _____.

A) increases; increases
B) increases; decreases
C) decrease; decreases
D) decreases; increases

Question 34

The present discounted value of $500 received annually until the end of time at a 15% interest rate is $____.

A) 434.78
B) 500
C) 3,333.33
D) 7,500

Question 35

Suppose that a bond with a face value of $10,000 and coupon rate of 7% matures a year from now. It is selling for $9,880. What interest rate would make a person indifferent between the selling price of $9,880 and the bond payment (face value and coupon) one year from now?

A) 7%
B) 5.7%
C) 1.3%
D) 8.3%

Question 36

What interest rate would make a person indifferent between receiving $1,250 today and $1,500 at the end of one year?

A) 16.7%
B) 12.5%
C) 24%
D) 20%

Question 37

Sam is considering the purchase of a vending machine to sell sodas. The cost of the vending machine is $3,400. Sam estimates that the vending machine will last for five years and will provide net income of $800 each year for its lifetime. If Sam pays $3,400 for the vending machine today, the net present value at 7% is $____.

A) -119.84
B) 119.84
C) 3,738.32
D) 109.77

Question 38

The demand and supply of capital are given by Q^D = 50 - 8r and Q^S = 4r - 10, where Q is the quantity of capital in millions of dollars and r is the interest rate measured as a percentage. What is the equilibrium quantity of capital?

A) $5 million
B) $60 million
C) $10 million
D) $12 million

Question 39

Benny was seriously injured at his place of employment and can no longer work. If Benny hadn't been injured, he would have worked five more years and would have earned $60,000 each year. The present discounted value of Benny's lost earnings at a 5% interest rate is $____.

A) 60,000
B) 259,768.60
C) 285,714.13
D) 300,000

Question 40

The demand for capital is Q^D = 80 - 15r and the supply of capital is Q^S = 20r - 60, where r is the interest rate and Q is the quantity of capital in millions of dollars. Businesses become more optimistic about the business environment and borrow $70 million more capital at each interest rate level. The equilibrium quantity of capital as a result of this newfound optimism is ____.

A) 40
B) 20
C) 50
D) 60

Question 41

The real interest rate is the rate:

A) advertised in capital markets; it does not account for changes in the price level.
B) expressed in terms of purchasing power.
C) that measures the return in numbers of dollars.
D) that removes the distortionary effects of compounding.

Question 42

The demand for capital is Q^D = 80 - 15r and the supply of capital is Q^S = 20r - 60, where r is the interest rate and Q is the quantity of capital in millions of dollars. Businesses become more optimistic about the business environment and borrow $70 million more capital at each interest rate level. The equilibrium interest rate as a result of this newfound optimism is r = ____.

A) 4
B) 3
C) 5
D) 6

Question 43

A drug company is considering investing $100 million today to bring a weight loss pill to the market. At the end of one year, the firm will know the payoff; there is a 0.50 probability that the pill will sell at a high price and generate $37 million per year of profit forever and a 0.50 probability that the pill will sell at a low price and generate $1 million per year of profit forever. The interest rate is 10%. What is the expected net present value of this investment?

A) $280 million
B) $112 million
C) $44 million
D) $90 million

Question 44

Conrad has $10,000; he is considering whether to (1) invest in a mutual fund with an 8% annual interest rate or (2) remodel his kitchen. If he remodels the kitchen, he will be able to sell his home for an additional $13,000 when he moves at the end of five years. Which of the following statements is (are) TRUE?
I) The net present value of remodeling the kitchen is -$1,152.42.
II) Conrad is better off investing his money in the mutual fund.
III) If Conrad invests in the mutual fund, his money will grow to $10,800 at the end of five years, making this a worse investment than the kitchen remodel.

A) II
B) I
C) I and II
D) I and III

Question 45

Tankim has $4,000 in his savings account, which pays an annual interest rate of 2%. The value of his account at the end of eight years is:

A) $4,200.
B) $4,686.64.
C) $4,640.
D) $4,808.16.

Question 46

The demand and supply of capital are given by Q^D = 200 - 60r and Q^S = 20r - 40, where Q is the quantity of capital in millions of dollars and r is the interest rate measured as a percentage. What is the equilibrium interest rate?

A) 5%
B) 2%
C) 8%
D) 3%

Question 47

There is an 80% probability that Hong will be in good health during the year and incur only $200 in medical expenses, but there is a 20% probability that he will be ill and incur $20,000 in medical expenses. If an insurance company charged Hong an actuarially fair premium, how much would Hong pay for health insurance?

A) $3,840
B) $4,000
C) $4,160
D) $3,460

Question 48

Roulan has wealth of $40,000 as long as his business does not burn down. However, there is a 50% probability that his business will burn down, causing a loss of $30,000 and leaving him with $10,000 of wealth. Roulan's utility function is given by U = W^0.5, where W is wealth. Suppose Roulan purchases insurance to cover the potential $30,000 loss. If the insurance premium is actuarially fair, Roulan's utility with insurance is:

A) 100.40.
B) 145.23.
C) 158.11.
D) 161.51.

Question 49

Todd, who just started college, is promised $10,000 by his grandmother at the end of four years if he graduates with honors. What is the present discounted value of this payment at a 6% interest rate?

A) $9,400.68
B) $8,180.26
C) $6,000.32
D) $7,920.94

Question 50

Reed is interested in purchasing a machine for his business that costs $10,000. The machine would be used for three years and generate $4,000 per year of cash flow. After three years, the machine could be sold for $3,000. What is the net present value of the machine at 12%?

A) $1,742.67
B) $3,200.23
C) $2,012.18
D) $4,158.40

Question 51

The demand for capital is Q^D = 46 - 10r and the supply of capital is Q^S = 2r - 2, where r is the interest rate (measured as a percentage) and Q measures the quantity of capital in millions of dollars. The equilibrium quantity of capital is ____.

A) 6
B) 36
C) 9
D) 7.2

Question 52

For calculating net present value (NPV), the interest rate represents the _____ of investing, so a higher interest rate _____ the NPV.

A) opportunity cost; increases
B) opportunity cost; reduces
C) benefit; increases
D) benefit; reduces

Question 53

The demand for capital is Q^D = 100 - 20r and the supply of capital is Q^S = 12r - 28, where r is the interest rate and Q is the quantity of capital in millions of dollars. The equilibrium interest rate is r = ____.

A) 5
B) 2.33
C) 4
D) 9

Question 54

The demand for capital is Q^D = 100 - 20r and the supply of capital is Q^S = 12r - 28, where r is the interest rate and Q is the quantity of capital in millions of dollars. Assume that households increase savings such that households save $20 million more at every interest rate level. The new equilibrium quantity of capital is ____.

A) 22.7
B) 25.6
C) 32.4
D) 34.8

Question 55

The demand for capital is Q^D = 100 - 20r and the supply of capital is Q^S = 12r - 28, where r is the interest rate and Q is the quantity of capital in millions of dollars. Assume that households increase savings such that households save $20 million more at every interest rate level. The new equilibrium interest rate is r = ____.

A) 3.62
B) 3.38
C) 3.13
D) 2.68

Question 56

A drug company is considering investing $100 million today to bring a weight loss pill to the market. At the end of one year, the firm will know the payoff; there is a 0.50 probability that the pill will sell at a high price and generate $37 million per year of profit forever and a 0.50 probability that the pill will sell at a low price and generate $1 million per year of profit forever. The interest rate is 10%. Suppose the firm decides to wait one year to determine whether the pill will sell at a high or low price. The firm will not invest if it learns that the pill will sell at a low price. What is the net present value of waiting one year to make the investment?

A) $107.44 million
B) $88 million
C) $201.22 million
D) $64.5 million

Question 57

Jing purchased property and must make an annual mortgage payment of $6,000 for the next 30 years. What is the present discounted value of the payment stream at a 5% interest rate?

A) $88,450.42
B) $110,682.21
C) $92,234.71
D) $105,320.57

Question 58

Roulan has wealth of $40,000 as long as his business does not burn down. However, there is a 50% probability that his business will burn down and cause a $30,000 loss, leaving her with $10,000 of wealth. Roulan's utility function is given by U = W^0.5, where W is wealth. What is the maximum price that Roulan would pay for full insurance that covers the potential $30,000 loss?

Question 59

Roulan has wealth of $40,000 as long as his business does not burn down. However, there is a 50% probability that his business will burn down, causing a loss of $30,000 and leaving him with $10,000 of wealth. Roulan's utility function is given by U = W^0.5, where W is wealth. What is Roulan's expected utility?

A) 150
B) 48
C) 66
D) 120

Question 60

The Rule of 72 states that it will take _____ years for a savings account to double at a 9% annual interest rate.

A) 8
B) 9
C) 6.5
D) 6.1

Question 61

Suppose that you deposit $2,828 in your savings account, which pays 4% interest annually. What is your account balance at the end of four years?

A) $3,308.36
B) $2,417.39
C) $3,100.12
D) $2,988.44

Question 62

A drug company is considering investing $100 million today to bring a weight loss pill to the market. At the end of one year, the firm will know the payoff; there is a 0.50 probability that the pill will sell at a high price and generate $37 million dollars per year of profit forever and a 0.50 probability that the pill will sell at a low price and generate $1 million per year of profit forever. The interest rate is 10%. Suppose the firm decides to wait one year to determine whether the pill will sell at a high price or a low price. The firm will not invest if it learns that the pill will sell at a low price. What is the option value of waiting one year to make the investment?

A) $10 million
B) $46.4 million
C) $17.44 million
D) $8.1 million

Question 63

Which of the following statements is TRUE?

A) The present discounted value of future cash flows rises as the time to payoff increases.
B) The present discounted value of future cash flows rises with the interest rate.
C) The present discounted value of future cash flows falls when the interest rate rises.
D) The present discounted value of future cash flows remains constant as the time to payoff decreases.

Question 64

(Table: Benefit Payout) What is the expected value of the benefit payout?

A) $1.33 million
B) $1 million
C) $2.2 million
D) $2.5 million

Question 65

At a 10% interest rate, every $____ spent today reduces the amount of a person's savings by almost $100 in 10 years.

A) 10
B) 38.55
C) 100
D) 5

Question 66

(Table: Account Balance) Using an interest rate of 5%, the value of the savings account balance in year five is $____.

A) 7,835.26
B) 12,500
C) 12,762.82
D) 16,105.10

Question 67

What is the option value of waiting?

A) the increase in the net present value from postponing an investment until uncertainty about the investment returns is reduced
B) the use of a risk-free discount rate for the evaluation of risky investments
C) the difference between the present discounted value calculated from using the nominal interest rate and the real interest rate
D) the interest rate that causes the net present value of an investment to equal zero

Question 68

(Table: Health Status) Suppose the person's utility function is given by U = I^0.5, where I is income. What is the person's expected utility?

A) 270
B) 45
C) 184
D) 81

Question 69

The demand for capital is Q^D = 46 - 10r and the supply of capital is Q^S = 2r - 2, where r is the interest rate (measured as a percentage) and Q measures the quantity of capital in millions of dollars. The equilibrium interest rate is r = ____.

A) 4.6
B) 1
C) 4
D) 5.5

Question 70

(Figure: Utility and Income) Suppose that Sara has an income of $80,000 but if her business burns down, her income drops to $20,000. Sara's expected income is $____.

A) 60,000
B) 50,000
C) 100,000
D) 80,000

Question 71

Jerome operates a car repair shop and is considering whether to purchase a computer diagnostic tool for Korean automobiles. The tool, which costs $4,000, will enable Jerome to service Korean automobiles. This added business will give Jerome additional income of $2,000 in each of the next three years. Jerome ____ purchase the tool because the net present value of the tool is ____.

A) should; greater than zero
B) should; greater than $2,000
C) should not; less than zero
D) should not; less than $2,000

Question 72

If Chun puts $344 into his saving account, his account will have grown to $379.26 by the end of two years. What is the interest rate earned on Chun's savings account?

A) 3.5%
B) 4.2%
C) 5%
D) 7%

Question 73

If Franco deposits $1,000 today in his account, he will have $1,200 at the end of two years. The annual compounded interest rate on Franco's account is ___%.

A) 20
B) 10
C) 9.54
D) 2

Question 74

Assume a future payment of $10,000. If r = 1 and T = 1, then the present value of $10,000 is $____.

A) 10,000
B) 9,000
C) 8,000
D) 5,000

Question 75

Which of the following statements is (are) TRUE?

A) If the real interest rate is 3% and the nominal rate is 5%, the inflation rate is 8%.
B) If the nominal interest rate is 5% and inflation is 2.5%, the real interest rate is 2.5%.
C) If the nominal interest rate is 5% and inflation is 4%, the real interest rate is 9%.
D) If the real interest rate is 3% and inflation is 5%, the nominal interest rate is 2%.

Question 76

(Table: Investments IV) Suppose that the interest rate is 9% and a firm expects the following benefits and costs for a period of three years and a given investment. Which of the following statements is (are) TRUE? I. Based on the net present value, the firm should not undertake this investment.
II) The net present value of this investment is greater than zero.
III) Based on the net present value, the firm should undertake this investment.

A) I, II, and III
B) II and III
C) I
D) I and III

Question 77

(Table: Taxi Fleet) Metro Cab is considering replacement of its fleet of old taxicabs. To replace its fleet, Metro must spend $150,000 on new taxicabs. The new taxis will incur $5,000 of maintenance expenses per year. Alternatively, Metro could spend $20,000 today to refurbish its taxicabs and incur an additional $20,000 per year of maintenance expenses for the next three years. Metro would then have to buy new taxicabs for $150,000 at the end of three years, leading to lower maintenance expenses of $5,000 per year. Using an interest rate of 10%, the net present value of the first three years is $____.

A) 65,000
B) 37,272.73
C) 20,000
D) 195,000

Question 78

An increase in business confidence leads many firms to expand their factories, which causes the _____ capital to increase and interest rates to _____.

A) demand for; rise
B) demand for; fall
C) supply of; rise
D) supply of; fall

Question 79

(Table: Gambling and Risk) A _____ person prefers gamble _____ to gamble _____.

A) risk-averse; B; A
B) risk-averse; A; B
C) risk-neutral; A; B
D) risk-neutral; B; A

Question 80

A corporate bond has a $10,000 face value, five-year maturity, and an 8% annual coupon rate. If interest rates are 6%, what is the present discounted value of the bond?

A) $10,540.18
B) $9,805.25
C) $10,842.47
D) $11,220.82