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SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The present value of $150 to be received in 10 years if the interest rate is 7
2. There are three ways in which a risk-averse person may reduce the risk she faces:
3. No. According to the e+cient markets hypothesis, the price of a share of stock
Chapter Quick Quiz
1. b
Questions for Review
1. If the interest rate is 7%, the present value of $200 to be received in 10 years is
2. Purchasing insurance allows an individual to reduce the level of risk he faces. Two
3. Diversi6cation is the reduction of risk achieved by replacing a single risk with a
4. Stocks have more risk because their value depends on the future value of the
5. A stock analyst will consider the future pro6tability of a 6rm when determining
6. The e+cient markets hypothesis suggests that stock prices re,ect all available
439
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 27/The Basic Tools of Finance ❖ 440
7. Economists who are skeptical of the e+cient markets hypothesis believe that
,uctuations in stock prices are partly psychological. People may in fact be willing
Problems and Applications
1. The future value of $24 invested for 400 years at an interest rate of 7% is
2. a. The present value of $15 million to be received in four years at an interest
b. The exact cutoE for the interest rate between pro6tability and nonpro6tability
is the interest rate that will equate the present value of receiving $15 million
in four years with the current cost of the project ($10 million):
3. a. Using the rule of 70, when the interest rate is 3.5 percent, the value of the
bond will double in approximately (70/3.5 =) 20 years. Therefore the value
b. Using the rule of 70, when the interest rate is 7 percent the value of the bond
will double in approximately (70/7 = ) 10 years. Therefore, the value today of
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 27/The Basic Tools of Finance ❖ 441
c. The value of a bond falls when the interest rate increases, and bonds with a
4. The value of the stock is equal to the present value of its dividends and its 6nal
5. a. A sick person is more likely to apply for health insurance than a well person is.
a. A risky driver is more likely than a safe driver to apply for car insurance. This
b. An old or unhealthy person is more likely to apply for life insurance than a
6. A stock that is very sensitive to economic conditions will have more risk
7. Shareholders will likely demand a higher return due to the stock’s 6rm-speci6c
8. a. Answers will vary, but may include things like information on new products
b. The fact that those who trade stocks based on inside information earn very
c. Insider trading is illegal because it gives some buyers or sellers an unfair
9. a. Yes, Jamal is risk averse. The marginal utility of an additional dollar of wealth
is diminishing. Figure 1 shows Jamal’s utility function.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 27/The Basic Tools of Finance ❖ 442
Figure 1
b. The expected value of option A = U(W = $4 million) = 2,000.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
