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The Basic Tools of Finance 6761
43. Managed mutual funds usually outperform mutual funds that are supposed to follow some
stock index.
a. True
b. False
44. Speculative bubbles may arise in part because the value of the stock to a stockholder
depends on the final sale price.
a. True
b. False
45. Available evidence indicates that stock prices, even if not exactly a random walk, are
very close to a random walk.
a. True
b. False
6762 The Basic Tools of Finance
46. If you wish to rely on fundamental analysis to choose a portfolio of stocks, then you have
no choice but to do all the necessary research yourself.
a. True
b. False
47. If you believe the stock market is informationally efficient, then it is a waste of time to
engage in fundamental analysis.
a. True
b. False
48. Actively managed mutual funds usually fail to outperform index funds, and this fact
provides evidence in favor of the efficient markets hypothesis.
a. True
b. False
The Basic Tools of Finance 6763
49. In the 15 years ending June 2010, most active portfolio managers failed to beat the
market.
a. True
b. False
50. Demonstrate that whether you would prefer to have $225 today or wait five years for
$300 depends on the interest rate. Show your work.
51. 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.
6764 The Basic Tools of Finance
52. Write the rule of 70. Suppose that your great-great-grandmother put $50 in a savings
account 100 years ago and the account is now worth $1,600. Use the rule of 70 to
determine about what interest rate she earned.
53. Give an example of adverse selection and an example of moral hazard using homeowners
insurance.
The Basic Tools of Finance 6765
54. What's the difference between firm-specific risk and market risk? Will diversification
eliminate one or both? Explain.
55. List three different ways that a risk-averse person can reduce financial risk.
6766 The Basic Tools of Finance
56. Discuss the statistical evidence concerning the efficient markets hypothesis.
57. In the 1990s, several stocks had very, very high price to earnings ratios. These stocks
appeared overvalued to many observers. What might the people who bought them have
been thinking?
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58. Give two conditions that are important to the efficient market theory. List one
implication of the efficient market theory.
6768 The Basic Tools of Finance
59. 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.
The Basic Tools of Finance 6769
Problems
1. Write the formula for finding the future value in n years of $x today.
2. Write the formula for finding the future value of $1,000 today in 10 years if the interest
rate is 4 percent.
3. Anthony closes out his account in which he deposited $500 five years ago at an interest
rate of 5%. Mark closes out his account in which he deposited $500 ten years ago at an
interest rate of 5%. Who had more in their account? About how much more did he have?
6770 The Basic Tools of Finance
4. Write the formula to find the present value of $x to be paid in n years.
5. Write the formula to find the present value of $750 to be paid in 5 years if the interest
rate is 3 percent.
6. A payment of $10,000 is to be made in the future. The interest rate 3%. Is this payment
worth more if it is paid in 5 years or 10 years? How much more is it worth?
The Basic Tools of Finance 6771
7. 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.
8. If the interest rate is 5 percent, then what is the present value of $2,000 to be received in
three years?
9. If the interest rate is 8 percent, then what is the present value of $5,000 to be received in
ten years?
6772 The Basic Tools of Finance
10. If a savings account pays 7% interest, then according to the rule of 70 how long will it
take for the account balance to double?
11. If a savings account pays 3.5% interest, then according to the rule of 70 how long will it
take for the account balance to double?
12. Suppose you invest $10,000 at 7% interest to be withdrawn by your heirs in 100 years.
According to the rule of 70, approximately how much will your heirs be able to withdraw?
The Basic Tools of Finance 6773
13. 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?
14. Suppose you place $1,000 into a savings account that will pay you 4% interest per year.
What will be the future value of the savings account in 10 years?
15. Suppose you place $500 into a savings account that will pay you 6% interest per year.
What will be the future value of the savings account in 15 years?
6774 The Basic Tools of Finance
16. Suppose the interest rate is 3% and that you are to receive three annual payments of
$1,000, with the first payment today, the second payment one year from now, and the
third payment two years from now. What is the present value of this stream of
payments?
17. 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?
18. A company has an investment project that will cost $2 million today and yield a payoff of
$3 million in 5 years. If the interest rate is 7%, should the firm undertake the project?
Show evidence to support your answer.
The Basic Tools of Finance 6775
19. A company has an investment project that will cost $2 million today and yield a payoff of
$3 million in 5 years. If the interest rate is 9%, should the firm undertake the project?
Show evidence to support your answer.
20. 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?
21.
6776 The Basic Tools of Finance
22. 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.
23. Suppose your bank account pays a 5% interest rate. You are considering purchasing a
share of stock in DH Corporation for $250. The stock will pay you a $10 dividend at the
end of years 1, 2, 3, 4, and 5. You expect to be able to sell the stock at the end of year 5
for $300. Is DH a good investment? Provide evidence to support your answer.
