Download Chapter 13 Capital and Financial Markets

Chapter 13 Capital and Financial Markets
Review Questions
2.
If you receive $100 now, you can put it in the bank and earn interest; after one year you
will have (1 + r)$100, where r is the interest rate. This amount exceeds the alternative of
$100 received one year from now. That is, (1 + r)  $100 > $100.
4.
There is a positive relationship between the present value of a future payment and the
size of that payment, and an inverse relationship between the present value of a future
payment and the interest rate. The further in the future the date is at which the payment
will be received, the smaller is the present value of that future payment.
6.
Answers will vary. General human capital: ability to read or a course in plumbing repair.
Specific human capital: Knowledge of the bookkeeping practices of Target, knowledge of
inventory practices at GroceryWorks.com.
8.
A corporation cares about the price of its stock in the secondary market because any new
shares it issues will sell at the secondary market price, since the new shares are perfect
substitutes for the shares already trading.
10.
The efficient markets view is that stock prices reflect all information available in the
market, and therefore each stock’s price reflects the best estimate of the present value of
future receipts expected by shareholders. This implies that there are no exploitable
patterns in stock prices, so no one can beat the stock market on a consistent basis.
Problems and Exercises
2.
a. Yes, you should approve the purchase of the inventory control software, because the
total present value of salary savings = $60,000/(1.07) + $60,000/(1.07) 2 +
$60,000/(1.07)3 + $60,000/(1.07)4 = $203,232.68, which exceeds the $200,000
purchase price.
b. The answer would change. You should not approve the purchase of the inventory
control software if the annual interest rate is 9%, because the total present value of
salary savings would only be $194,383.19 (= $60,000/(1.09) + $60,000/(1.09)2 +
$60,000/(1.09)3 + $60,000/(1.09)), which is less than the $200,000 purchase price.
c. The answer would change. You should not approve the purchase because the total
present value of salary savings, $203,232.68, is less than the $220,000 purchase
price.
d. Compared to the answer in part (a), the answer would not change. You should
approve the purchase of the software, because the total present value of salary
savings = $60,000/(1.07) + $60,000/(1.07)2 + $60,000/(1.07)3 + $60,000/(1.07)4 +
$60,000/(1.07)5 + $60,000/(1.07)6 = $285,992.38, which exceeds the $220,000
purchase price.
4.
a. Your firm should purchase 2 computers, since the present value of the first two
computers is greater than their purchase price of $2600.
The present value of the first computer
= $3000/(1.1)1 + $3000/(1.1)2 + $3000/(1.1)3 = $7460.55
The present value of the second computer
= $2000/(1.1)1 + $2000/(1.1)2 + $2000/(1.1)3 = $4973.70
The present value of the third computer
= $1000/(1.1)1 + $1000/(1.1)2 + $1000/(1.1)3 = $2486.85
The present value of the fourth computer
= $500/(1.1)1 + $500/(1.1)2 + $500/(1.1)3 = $1243.43
b. Your firm should purchase 3 computers, since the present value of the first three
computers is greater than their purchase price of $2600.
The present value of the first computer
= $3000/(1.05)1 + $3000/(1.05)2 + $3000/(1.05)3 = $8169.79
The present value of the second computer
= $2000/(1.05)1 + $2000/(1.05)2 + $2000/(1.05)3 = $5446.50
The present value of the third computer
= $1000/(1.05)1 + $1000/(1.05)2 + $1000/(1.05)3 = $2723.25
The present value of the fourth computer
= $500/(1.05)1 + $500/(1.05)2 + $500/(1.05)3 = $1361.62
6.
a. Human capital investment would increase because the total present value of the
additional future income increases.
b. Human capital investment would increase because the total present value of the
additional future income increases.
c. Human capital investment would decrease because the total present value of the
additional future income decreases.
d. Human capital investment would decrease because the opportunity cost of acquiring
the human capital increases.
8.
The total value of your gold mine is $40,000 = (5 × $400)/0.05 = $2000/0.05.
10.
a. If the interest rate is 5%, this bond will sell for $100,000.
b. If the interest rate is 10%, this bond will sell for $87,565.74.
12.
If the interest rate is 10 percent, people will pay $100 per share ($100 = $10/0.10). If, in
the face of uncertainty, a discount rate of 15 percent is applied, people will pay $66.67
per share ($66.67 = $10/0.15).
Challenge Questions
2.
a. With the sequence of rising interest rates, Project A’s capitalized value is –$50 +
$18.18 + $16.38 + $14.61 = –$0.83. With a negative value, it should not be
undertaken. Project B has a capitalized value of –$33 + $18.18 + $24.57 + $29.22 =
$36.97. Project B should be undertaken.
b. With the sequence of falling interest rates, Project A’s capitalized value is –$50 +
$18.18 + $16.68 + $15.43 = $0.29. Project B’s value is –$33 + $18.18 + $25.02 +
$30.86 = $41.06. Both projects should be undertaken.
c. For any given current interest rate, fewer projects will be viable if the interest rate is
expected to rise over time, and more projects will be viable if the interest rate is
expected to fall over time.
Economic Applications Exercises
2. The marginal productivity of capital must have been much higher at that level of labor.