Investment, Strategy, and Economic Rents

Chapter 11 – Investment, Strategy, and Economic Rents

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Chapter 11

Investment, Strategy, and Economic Rents

Multiple Choice Questions

1. One way to uncover forecasting errors in NPV estimates is by looking at:

I) Book values

II) Liquidating values

III) Market values

A. I only

B. II only

C. III only

D. I and II only

2. A new grocery store cost $50 million in initial investment. It is estimated that the store will

generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be

sold for $60 million. What is the NPV of the project at a discount rate of 10%?

A. $2.42 million

B. $10 million

C. $6.21 million

D. None of the above

3. A new grocery store cost $50 million in initial investment. It is estimated that the store will

generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be

sold for $55 million. What is the NPV of the project at a discount rate of 10%?

A. $2.42 million

B. $5 million

C. $3.1 million

D. None of the above

Chapter 11 – Investment, Strategy, and Economic Rents

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4. A rental property is providing 13% rate of return. Next year’s rent is expected to be $1.0

million and is expected to grow at 3% per year forever. What is the current value of the

property?

A. $7.7 million

B. $10 million

C. $33.3 million

D. none of the above

5. A building is appraised at $1 million. This estimate is based on a forecast of net rent of

$100,000 per year discounted at 10% [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of

repair and maintenance costs and taxes. Suppose the building is currently in disrepair and it

takes one year and $250,000 to bring it into rent able condition. How much would you be

willing to pay for the building today?

A. $1,000,000

B. $681,818

C. $750,000

D. None of the above

6. USGOLD Company has an opportunity to invest in a gold mine. The initial investment is

$250 million. The mine is estimated to produce 100,000 ounces of gold per year for the next

ten years. The extraction cost of gold per ounce is $150 and it is expected to remain at that

level. The current price of gold is $600 per ounce and it is expected to increase by 4% per

year for the next 10 years. What is the NPV of the project at a discount rate of 10%? (Ignore

taxes.)

A. $ – 3.8 million.

B. $240.8 million.

C. $257.8 million.

D. None of the above.

7. Suppose the current price of gold is $600 per ounce. The price of gold is expected to grow

at 4% per year for the foreseeable future. If the appropriate discount rate is 10%, then the

current value of gold per ounce is:

A. Less than $600 per ounce

B. $600 per ounce

C. Greater than $600 per ounce

D. Not enough information

Chapter 11 – Investment, Strategy, and Economic Rents

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8. Suppose the current price of gold is $650 per ounce. The price of gold is expected to grow

at 5 % per year for foreseeable future. If the appropriate discount rate is 8%, the present value

of gold is:

A. Less than $650 per ounce

B. Greater than $650 per ounce

C. $650 per ounce

D. None of the above

9. Suppose the current price of gold is $600 per ounce and the price of gold is expected to

increase at a rate of 5% per year for the foreseeable future. What is the current value of 0.2

million ounces of gold to be produced each year for the next five years (the discount rate is

8% per year)?

A. $600 million

B. $521.64 million

C. $690.86 million

D. None of the above

10. Goldsmith labs recover gold from printed circuit boards. It has developed new equipment

for the purpose. The following data is given.

(1.) Equipment costs $250,000

(2.) It will cost $200,000 per year to run

(3.) It has an economic life of 5 years and is depreciated using straight-line method

(4.) It will recover 300 ounces of gold per year

(5.) The current price of gold is $600 per ounce and it expected to increase at a rate 4% per

year for the foreseeable future

(6.) The tax rate is 30%

(7.) The cost of capital is 8%

What is NPV of the equipment?

A. $430,400

B. $520,510

C. $470,400

D. None of the above

Chapter 11 – Investment, Strategy, and Economic Rents

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11. The formula Po = Pt/((1 + r)^t) holds good for assets which:

I) Pay no dividends

II) Are traded in a competitive market

III) Cost nothing to hold

A. I only

B. I and II only

C. I,II, and III

D. II and III only

12. Investing in gold is like:

I) Investing in a stock that pays quarterly dividends

II) Investing in a stock that pays annual dividends

III) Investing in Treasury bonds

IV) Investing in a stock that pays no dividends

A. I only

B. II only

C. I,II, and III only

D. IV only

13. When you are using futures prices to estimate the cash flows of a project the discount rate

used is:

I) The cost of capital for the firm

II) The cost of capital for the project

III) The risk free rate

A. I only

B. I and II only

C. III only

D. II only

Chapter 11 – Investment, Strategy, and Economic Rents

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14. When futures prices are used to estimate cash flows, the estimates are:

I) Present value of future cash flows

II) Certainty equivalents

III) Same as the estimates using spot prices

A. I only

B. II only

C. III only

D. I and III only

15. The present value of risky cash flows is calculated as follows:

I) estimate the expected cash flows and discount these at a rate that is consistent with the risk

of the cash flows

II) estimate the certainty-equivalent cash flows and discount these at the risk-free rate

III) estimate the expected cash flows and discount these at the risk-free rate

A. I only

B. II only

C. I and II only

D. III only

16. Use of certainty-equivalent cash flows is advantageous in the following ways:

I) there is no need to estimate future prices

II) there is no need to estimate the discount rate

III) there may be large errors introduced because prices in a competitive market fluctuate

randomly

A. I only

B. II only

C. I and II only

D. I, II and III

17. Economic rents are:

A. Returns that are in excess of the opportunity cost of capital

B. Returns that are equal to the opportunity cost of the capital

C. Returns that are less than the opportunity cost of capital

D. None of the above

Chapter 11 – Investment, Strategy, and Economic Rents

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18. The following are some of the competitive advantages that can last longer:

I) patents

II) brand names

III) economies of scale

A. I only

B. II only

C. I and II only

D. I, II and III

19. The following are some of the competitive advantages that can last longer:

I) proprietary technology

II) protected markets with high barriers to entry by other firms

III) strategic assets that competitors cannot easily duplicate

A. I only

B. II only

C. I and II only

D. I, II and III

20. Which of the following is an example of a strategic asset?

A. trucks

B. diesel engine

C. rail road containers

D. rail road lines

Chapter 11 – Investment, Strategy, and Economic Rents

21. As a 19

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century economist, you are faced with the following problem. The world’s

shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or

passengers. The ships have similar sailing capacities but differ in their annual operating costs

as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii)

each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is

$114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the present value of a steam

ship?

A. $190,152

B. $251,326

C. $609,486

D. None of the above

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