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Chapter 21 Rents, Profits, and the Financial Environment of Business 273

194) What is the difference between accounting profits and economic profits? Which of the two

concepts is more appropriate for explaining decisions made by entrepreneurs? Explain.

195) Why is limited liability so important when firms try to raise large amounts of financial capital?

How is this advantage of a corporation tied to a disadvantage of a corporation?

196) For which type of organization is unlimited liability likely to be the greater

problem proprietorships or partnerships? Why?

197) Amber has opened a coffee shop for many years on a piece of land that she has also owned. She

has also made accounting profits from the coffee shop. This year, rents in the area rose

considerably, and Amber responded by deciding to sell the land and the coffee shop to an

apartment builder. How can you explain Amber s decision to sell her business?

198) Economic profits are less than or at most equal to accounting profits. Do you agree or

disagree? Explain.

21.3 Interest

1) Interest is paid to

A) all holders of stock. B) individuals who own gold.

C) owners of capital. D)

b

orrowers of funds.

2) Which of the following is correct?

A) real interest rate nominal interest rate anticipated inflation rate

B) real interest rate nominal interest rate anticipated inflation rate

C) real interest rate nominal interest rate * anticipated inflation rate

D) real interest rate nominal interest rate / anticipated inflation rate

3) Interest can be defined as

A) the amount of funds loaned to a creditor.

B) the participation of a shareholder in the operations of a firm.

C) the return paid to owners of capital.

D) the return above opportunity cost paid to owners of a firm.

4) In economic terms, interest is the payment for

A) current command over resources. B) producers goods.

C) stocks. D)

b

oth consumer and capital goods.

5) Which of the following characteristics is NOT likely to increase the interest on a loan?

A) A high risk proposal B) A non creditworthy borrower

C) A short term loan D) A larger dollar loan

6) In most cases, the higher is the quality of the collateral for a loan is,

A) the higher is the interest rate.

B) the lower is the interest rate.

C) the riskier is the loan.

D) the greater is the handling charge for the loan.

7) Creditors require collateral in many cases, because

A) it helps offset the risks of lending the funds.

B) the borrower is a low risk.

C) the loan is small.

D) none of the above.

8) Because handling charges are relatively fixed, the interest rate on a loan generally

A) increases with the size of the loan.

B) decreases with the size of the loan.

C) is constant regardless of the size of the loan.

D) is unrelated to the size of the loan.

9) People basically borrow in order to

A) go into debt.

B) have more funds.

C) have interest payments.

D) have current consumption rather than waiting to consume in the future.

10) Interest rates are positive because

A) people prefer future consumption over current consumption.

B) people prefer current consumption over future consumption.

C) usury laws require rates to be very high.

D)

b

anks are not competitive.

11) The greater is the risk of non repayment of a loan, the

A) higher is the expected rate of interest.

B) longer is the expected time to repay the loan.

C) lower is the handling charges for the loan.

D) lower is the expected rate of interest.

12) Which combination of circumstances will most likely raise the rate of interest for a loan the

most?

A) Low handling charges and low risk

B) Low handling charges and a long length of time for repayment

C) High risk and low handling charges

D) High risk and a long length of time for repayment

13) Under which one of the following situations would you be better off?

A) You have $10,000 in your savings account paying 5 percent per year and unanticipated

inflation is 8 percent per year.

B) You have paid $500 for a $1,000 U.S. savings bond that matures in 10 years and

unanticipated inflation is 10 percent per year.

C) You lend a friend $1,000 at 6 percent to be repaid in one year and unanticipated inflation is

7 percent during the year.

D) You borrowed $2,500 at 7 percent to pay for this year s college expenses and unanticipated

inflation is 12 percent during the year.

14) Suppose that you borrow $5,000 from the bank to purchase some land and you agree to pay 9

percent interest on the loan. If the loan must be repaid in 12 months and the inflation rate is 13

percent during the year, then

A) you will repay the bank with dollars with more purchasing power than you initially

borrowed.

B) you will repay the bank with fewer dollars than the bank initially loaned you.

C) you will repay the bank with dollars with less purchasing power than it initially loaned

you.

D) the bank will receive fewer dollars, because of inflation, than it had initially expected to

receive.

15) If the rate of inflation is zero, prices are expected to remain stable, and the nominal rate of

interest is 5 percent, then the

A) real rate of interest is equal to the nominal rate.

B) real rate of interest is less than the nominal rate.

C) nominal rate is greater than the real rate of interest.

D) investment demand schedule will shift upward.

16) When the anticipated rate of inflation declines, the real rate of interest

A) increases. B) decreases.

C) is not affected. D) increases exponentially.

17) The real rate of interest will approximately be equal to

A) the nominal interest rate plus the expected rate of inflation.

B) the stated rate of interest in a high inflation economy.

C) the nominal interest rate minus the expected rate of change in the price level.

D) the stated rate minus the opportunity cost of capital.

18) The nominal rate of interest is

A) the same as the price level.

B) the real rate of interest minus the previous year s change in the price level.

C) the interest rate actually paid by the borrower.

D) lower than the real rate in a period of inflation.

19) The real rate of interest is

A) the nominal interest rate minus the anticipated rate of inflation.

B) the interest rate actually paid explicitly by the borrower.

C) the interest rate received by the lender minus the handling charges of the loan.

D) the average rate of interest over the last 20 years.

20) In an inflationary atmosphere that everyone anticipates will persist, lenders will

A) desire a lower nominal interest rate to increase the real rate.

B) desire a higher nominal interest rate to protect against the inflation.

C) tend to see the real rate of interest increase, particularly if the inflation is unforeseen.

D) have the real rate of interest guaranteed by the Federal Reserve Board.

21) When the anticipated rate of inflation is 5 percent and the real rate of interest is 4 percent, the

nominal rate of interest is

A) 1 percent. B) 4 percent. C) 5 percent. D) 9 percent.

22) Suppose that the nominal rate of interest is holding steady at 8 percent even as the anticipated

rate of inflation rises. What is happening to the real rate of interest?

A) It is unchanged. B) It is increasing.

C) It is decreasing. D) It equals the nominal interest rate.

23) One role of the interest rate is to

A) allocate capital to its most efficient uses.

B) redistribute income from the wealthy to the poor.

C) reduce the rate of inflation by encouraging government borrowing.

D) discourage saving and encourage current consumption.

24) A star basketball player signs a contract that newspaper reports indicate is worth $10 million.

The player receives $2 million upon signing, and $2 million every year for four years. The

contract is worth

A) less than $10 million since the present value of $2 million received one or more years from

now is less than $2 million.

B) more than $10 million since the present value of $2 million received one or more years

from now is more than $2 million.

C) $10 million as reported in the press.

D) some amount around $10 million. To determine whether it is more or less than $10 million

we need to know whether the interest the player can earn is more or less than the market

rate of interest.

25) If the interest rate is 5 percent per year and you borrow $100 for one year, at the end of the year

you must pay back

A) $95. B) $100. C) $105. D) $5.

26) If the interest rate is 5 percent per year and you borrow $100 for two years, at the end of the

second year you must pay back

A) $90.70. B) $10.25. C) $105. D) $110.25.

27) Given a discount rate of 10 percent, the present value of receiving $10,000 two years in the

future is

A) $12,000. B) $8,000. C) $8,264.46. D) $12,100.

28) What is the future value of $1,000 in three years if the rate of discount is equal to 5 percent?

A) $1,150.00 B) $1,005.00 C) $1,157.63 D) $863.84

29) Suppose that you borrow $10,000 for one year, and at the end of the year, you must repay

$10,450. The interest rate is

A) 14.5 percent. B) 8.0 percent. C) 4.5 percent. D) 2.7 percent.

30) Suppose that you borrow $10,000 for one year, and at the end of the year, you must repay

$10,450. Also, during that year inflation was 2.5%. The real interest rate is

A) 12.0 percent. B) 7.0 percent. C) 4.5 percent. D) 2.0 percent.

31) Suppose that you borrow $10,000 for two years, and at the end of the second year, you must

repay $11,664. The interest rate is

A) 16.7 percent. B) 8.0 percent. C) 7.0 percent. D) 9.0 percent.

32) Assuming a market interest rate of 6 percent per year, what is the present value of $5,000

payable at the end of three years?

A) $4,717 B) $4,450 C) $4,198 D) $4,317

33) The rate of discount is best described as the rate of

A) return on physical capital after the cost of capital has been removed.

B) return on financial assets after an inflation adjustment has been made.

C) interest used to derive the present values of future sums.

D) return on financial capital that has not been adjusted for inflation.

34) The interest rate used to bring future sums back to present value is

A) always negative. B) zero when there is no inflation.

C) the rate of discount. D) the prime rate.

35) When the rate of interest is 10 percent, the present value of $100 payable in two years is

approximately

A) $65. B) $83. C) $100. D) $117.

36) Present value is

A) the value of a future amount expressed in today s dollars.

B) the value of a dollar received a year from now, expressed in terms of its future value.

C) the inverse of the interest rate.

D) the nominal value instead of the real value of something.

37) The present value of $110 to be received one year from now

A) is $110. B) is $100.

C) is $121. D) depends on the rate of discount.

38) If the present value of $110 to be received one year from now is $100, what will $100 be worth

two years from now?

A) $110

B) $121

C) $100

D) Can t say since we don t know what the interest rate is

39) Financial capital is

A) the collection of stock and bond exchanges around the country.

B) funds used to purchase capital goods.

C) the foreign exchange market.

D) assets of financial institutions.

40) The funds used to purchase capital goods are called

A) investment. B) savings.

C) financial capital. D) dividends and interest.

41) In economics, interest refers to all of the following EXCEPT

A) the payment for current rather than future command over resources.

B) the cost of obtaining credit.

C) the return paid to owners of financial institutions.

D) the return paid to the owners of capital.

42) Businesses go to credit markets in order to

A) obtain capital.

B) obtain financial assets that can be used to buy capital.

C) obtain capital so they can earn rents.

D) channel their savings into investments.

43) The payment for current rather than future command over resources is

A) an implicit cost. B) an implicit benefit.

C) interest. D) opportunity cost.

44) Interest rates are higher the

A) shorter the duration of the loan.

B) greater the risk.

C) larger the amount of the loan, holding other things constant.

D) lower the inflation rate.

45) Larger loans, other things constant, have lower interest rates because

A) only large, financially sound corporations obtain such loans.

B) large loans always have collateral.

C) large loans are always for short time periods.

D) the fixed costs associated with the handling charges as a percent of the total loan are less.

46) Businesses demand funds because

A) they prefer earlier consumption to later consumption.

B) they have deficits to cover.

C) they prefer to purchase capital goods in the current year.

D) they make investments that they believe will increase productivity and profitability.

47) The real rate of interest is

A) equal to the nominal rate of interest less the anticipated rate of inflation.

B) equal to the nominal rate of interest plus the anticipated rate of inflation.

C) found by taking the nominal rate of interest and dividing it by the actual rate of inflation.

D) found by taking the nominal rate of interest and adding the actual rate of inflation.

48) The nominal rate of interest is

A) the rate observed in the market that includes an inflation premium.

B) not the rate observed in the market.

C) not adjusted for inflation.

D) expressed in dollars from the chosen base year.

49) If the nominal interest rate is high and rising, a possible cause is

A) increased lending activity. B) a rising inflation rate.

C) a falling real interest rates. D) increased government borrowing.

50) The real rate of interest is 4% and the anticipated rate of inflation is 1%. What is the nominal rate

of interest?

A) 1% B) 3% C) 4% D) 5%

51) The real rate of interest is 5% and the anticipated rate of inflation is 2%. What is the nominal rate

of interest?

A) 7% B) 5% C) 3% D) 2%

52) The nominal rate of interest is 4% and the anticipated rate of inflation is 1%. What is the real rate

of interest?

A) 1% B) 3% C) 4% D) 5%

53) The nominal rate of interest is 6% and the anticipated rate of inflation is 2%. What is the real rate

of interest?

A) 8% B) 6% C) 4% D) 2%

54) Interest rates perform the function of

A) signaling information about the inflation rate.

B) allocating funds, but only in the consumer sector.

C) allocating funds, which determines the allocation of physical capital.

D) rewarding those who save but has no direct allocative role.

55) Suppose the auto industry has several investment projects with an expected rate of return of 15

percent, the aluminum industry has projects with an expected return of over 20 percent, the

publishing industry projects with an expected return of 10 percent, the steel industry has

projects with an expected return of 7 percent and the rubber industry projects with an expected

return of 5 percent. The current market rate of interest is 7 percent. A reduction in the supply of

funds causes interest rates to rise to 11 percent. The effect is to

A) cause the firms in the steel and publishing industries to cancel their projects, which would

have been funded at the old interest rate.

B) cause the firms in the steel and the rubber industries to go ahead with their projects.

C) force the firms in the automobile industry and the publishing industry to rely on funding

their projects through other means.

D) make the projects of the aluminum industry and the steel industry unprofitable; the firms

in these industries will not borrow the funds or make the investments.

56) When interest rates allocate capital,

A) many worthwhile projects fail to get funded and society is worse off.

B) investment projects of firms tend to get funded while valuable social investments funded

by the government tend not to get funded.

C) only investment projects are funded for which the expected benefits of the projects equal

or exceed the opportunity cost of the projects.

D) there is an under investment in capital and overspending on durable consumer goods.

57) The value of a future amount expressed in today s dollars is

A) the interest rate. B) present value.

C) the discount rate. D) the inflation rate.

58) The most that someone would pay today to receive a certain sum at some point in the future is

known as

A) the interest rate. B) present value.

C) future value. D) economic profit.

59) What is the present value of $100 one year from now at an interest rate of 5%?

A) $5 B) $95.24 C) $100 D) $105

60) What is the present value of $100 one year from now at an interest rate of 6%?

A) $160 B) $106 C) $94.34 D) $6

61) What is the present value of $100 two years from now at an interest rate of 5%?

A) $105 B) $95.24 C) $90.70 D) $5

62) What is the present value of $100 two years from now at an interest rate of 6%?

A) $6 B) $89 C) $94.34 D) $106

63) What is the present value of $100 three years from now at an interest rate of 5%?

A) $85 B) $115.76 C) $90.70 D) $86.38

64) What is the present value of $100 three years from now at an interest rate of 6%?

A) $83.96 B) $82 C) $94.34 D) $119.10

65) The present value of $100 to be received one year from now

A) is $100.

B) is $110.

C) is $90.

D) cannot be determined without knowing the interest rate.

66) If the annual interest rate remains unchanged over the next two years, and the present value of

$120 to be received one year from now is $100, what will $100 be worth two years from now?

A) $120

B) $140

C) $144

D) Uncertain. We need to know the interest rate.

67) The general form for discounting is

A) PV At(1 i)t. B) PV At/(1 i)t.

C) PV (1 i)t/At. D) PV 1/(1 it)t.

68) A firm is considering three projects. Each costs $1 million now. Project A will yield $400,000 a

year for three years, beginning one year from now. Project B will yield $1.25 million three years

from now, and Project C will yield $600,000 for two years, beginning two years from now. If the

interest rate is 8 percent, which of these projects should the firm undertake?

A) Project A. B) Project B. C) Project C. D) None of these.

69) The present value of a sum to be received in the future is greater

A) the greater the interest rate.

B) the less the time period before receiving the sum.

C) the greater the inflation rate.

D) the greater the discount rate.

70) A firm is considering an investment that will cost $2 million today and $2 million a year from

now. It will generate revenues of $1 million a year for five years, beginning two years from now.

If the interest rate is 10 percent, the firm should

A) not make the investment because the present value of the net revenues is less than the

present value of the investment spending.

B) not make the investment because the present value of the net revenues is less than $4

million.

C) make the investment because the present value of the net revenues is greater than the

present value of the investment.

D) make the investment because the project will generate a net profit of $1 million.

71) The greater the interest rate,

A) the greater the present value of a sum to be received a year in the future.

B) the greater the opportunity cost of another dollar of current consumption.

C) the more a dollar invested today will be worth a year from now.

D) the lower the discount rate.

72) A star basketball player signs a contract that newspaper reports say is worth $20 million. The

player receives $5 million on signing, and $5 million a year for three years. The contract is worth

A) $20 million as reported in the papers.

B) less than $20 million since the present value of $5 million received one or more years from

now is less than $5 million.

C) more than $20 million because the present value of $5 million received one or more years

from now is more than $5 million.

D) either more or less than $20 million, depending on the value of the discount rate.

73) The difference between the nominal rate of interest and the real rate of interest is

A) handling charges. B) government regulatory charges.

C) administrative overhead charges. D) the anticipated rate of inflation.

74) Assuming a market rate of interest equal to 7 percent, what is the present value of $200 to be

received one year from today?

A) $123 B) $156 C) $187 D) $210

75) Assuming a market rate of interest equal to 7 percent and anticipated inflation is 2 percent, what

is the real (adjusted for inflation) present value of $200 to be received one year from today?

A) $190 B) $214 C) $187 D) $210

76) How much money would you have to put into a savings account today to be worth $500 three

years from now at a market rate of interest equal to 8 percent?

A) $397 B) $351 C) $420 D) $459

77) If the bank advertises 6 percent annual interest rate on a one year certificate of deposit and you

anticipate the rate of inflation to rise to 3 percent during the year, then the real rate of interest on

the certificate of deposit is

A) 9 percent. B) 6 percent. C) 3 percent. D) 2 percent.

78) The rate of interest that you pay on a home loan depends upon all of the following EXCEPT

A) the supply of houses in the real estate market.

B) the length of the loan.

C) your credit rating.

D) handling charges or loan fees.

79) What is the present value of $104.25 that you could receive one year from now, given that the

rate of interest is 4.25 percent?

A) $108.50 B) $0.00 C) $4.25 D) $100.00

80) What is the real (adjusted for inflation) present value of $104.25 that you could receive one year

from now, given that the rate of interest is 4.25 percent and the anticipated rate of inflation is 1

percent?

A) $99.05 B) $100.97 C) $107.64 D) $100.00

81) The higher the expected rate of inflation,

A) the lower is the nominal rate of interest.

B) the higher is the real rate of interest.

C) the higher is the nominal rate of interest.

D) the higher the real and nominal rates of interest.

82) The greater the risk of nonrepayment of a loan, other things being equal

A) the longer is the repayment term.

B) the lower is the charged loan fees.

C) the higher is the rate of interest.

D) the smaller is the amount of collateral that is used.

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