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The Basic Tools of Finance 6777
24. 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?
25. List two ways a risk adverse person may attempt to reduce risks.
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26. Describe the shape of the utility function of a risk averse person.
27. 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?
28. How does adverse selection affect the insurance market?
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29. How does moral hazard matter in the market for insurance?
30. Bill gets medical insurance and then exercises less. Lilly has health concerns and so
applies for medical insurance. Identify each of these as moral hazard or adverse
selection.
31. Can insurance be thought of as diversification? Defend your answer.
6780 The Basic Tools of Finance
32. The objective of diversification is to reduce risk. How does a person diversify a stock
portfolio? How is risk measured?
33. 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?
34. 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?
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35. Should a person who is risk averse hold a portfolio with no stock and only bonds?
Explain.
36. You are a financial advisor and a client tells you he is concerned about the amount of risk
in his portfolio. Assuming your client hasn’t already done them, what two things can you
suggest to reduce your client’s risk? What additional information about reducing risk
should you provide?
6782 The Basic Tools of Finance
37. Your boss asks you to do fundamental analysis of a corporation. What value is she asking
for and how would you estimate this value?
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Scenario 27-1
Lisa has a utility function where W is Lisa’s wealth in millions of dollars and U
is the utility she obtains.
38. Refer to Scenario 27-1. Use the following diagram to graph Lisa’s utility function for
.
6784 The Basic Tools of Finance
39. Refer to Scenario 27-1. Is Lisa risk averse? Explain.
40. Refer to Scenario 27-1. Suppose Lisa is faced with a choice between two options.
With option A Lisa receives a guaranteed $9 million. With option B Lisa faces a lottery
that pays $4 million with probability 0.4 and pays $16 million with probability 0.6. Given
Lisa’s utility function, will she prefer option A or option B? Provide evidence to support
your answer.
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41. Refer to Scenario 27-1. Suppose Lisa is faced with a choice between two options.
With option A Lisa receives a guaranteed $9 million. With option B Lisa faces a lottery
that pays $16 million with probability P and pays $4 million with probability (1-P). Given
Lisa’s utility function, how high does P need to be before Lisa will prefer option B?
6786 The Basic Tools of Finance
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.
42. Refer to Scenario 27-2. Use the following diagram to graph Dave’s utility function for
.
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43. Refer to Scenario 27-2. Is Dave risk averse? Explain.
44. 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.
6788 The Basic Tools of Finance
45. 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 $10 million with probability P and pays $0 with probability (1-P). Given Dave’s
utility function, how high does P need to be before he will prefer option B over option A?
46. Define the efficient markets hypothesis.
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47. According to the efficient markets hypothesis, what changes the price of a share of a
corporation’s stock? Make up an example.
48. If a friend tells you that he is certain a stock price will rise based on information he heard
on television or saw on the Internet, should you be skeptical? Explain.
49. What does “random walk” mean? According to the efficient markets hypothesis, should
stock prices follow a random walk?
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50. What is meant by an asset bubble?
51. Why might someone be willing to pay more than the fundamental value for a stock?
52. Suppose the Johnson Corporation releases an earnings report that beats the market’s
expectations. What does the efficient markets hypothesis predict will happen to Johnson’s
stock price.
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53. 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?
