CHAPTER 19: THE TOOLS OF FINANCE
1. According to an old myth, Native Americans sold the island of Manhattan about 400
years ago for $24. If they had invested this amount at an interest rate of 7 percent per
year, how much, approximately, would they have today?
If they had invested this amount at an interest rate of 7 percent per year, today
they have :
=> It is 13 million billion 605 thousand billion 744 billion 645 million 300 thousand $.
2. A company has an investment project that would cost $10 million today and yield a
payoff of $15 million in 4 years.
a. Should the firm undertake the project if the interest rate is 11 percent? 10 percent? 9
percent? 8 percent?
- Interest rate is 11 percent:
The money which the company receive when they investment is:
10(1+0.11)^4= 15.18 (million $) > 15 (m)
=> They should NOT undertake the project
- Interest rate is 10 percent:
The money which the company receive when they investment is:
10(1+0.1)^4= 14.641 (million $) <15 (m)
=> They should undertake the project
- Interest rate is 9 percent:
The money which the company receive when they investment is:
10(1+0.09)^4= 14.116 (million $) <15 (m)
=> They should undertake the project
- Interest rate is 8 percent:
The money which the company receive when they investment is:
10(1+0.08)^4= 13.6 (million $) <15 (m)
=> They should undertake the project
b. Can you figure out the exact interest rate at which the firm would be indifferent
between undertaking and forgoing the project? (This interest rate is called the project’s
internal rate of return.)
The project’s internal rate of return (ir) is:
(1+ir)^4=15:10 => 1+ir = 1.1067
=> ir = 0.1067 = 10.67%
3. Bond A pays $8,000 in 20 years. Bond B pays $8,000 in 40 years. (To keep things
simple, assume that these are zero-coupon bonds, meaning the $8,000 is the
only payment the bondholder receives.)
a. If the interest rate is 3.5 percent, what is the value of each bond today? Which bond
is worth more? Why? (Hint: You can use a calculator, but the rule of 70 should make
the calculation easy.)
The formal:
● FV = Future value (the payment amount, $8,000)
● r = Annual interest rate (3.5%, or 0.035)
● n = Number of years until payment
Bond A: PVA = 8000/(1+0.035)^20 = 4020.53 $
Bond B: PVB = 8000/(1+0.035)^40 = 2020.58 $
Using the Rule of 70:
The Rule of 70 approximates how long it takes for money to double at a given interest
rate. The formula is:
At 3.5%, the doubling time is: 70/3.5=20 years
=> This means:
● In 20 years, the present value will roughly double.
● In 40 years, the present value will double twice .
Bond A (20 years):
Since the doubling time is 20 years, the present value is roughly half of $8,000:
PVA ≈ 8000/2 = 4000
Bond B (40 years):
Since the doubling time is 20 years, in 40 years the present value will roughly double
twice. Thus, the present value is roughly one-fourth of $8,000:
PVB ≈ 8000/4 = 2000
=> Bond A is worth more today because its payment is received earlier and is
therefore discounted less.
b. If the interest rate increases to 7 percent, what is the value of each bond? Which
bond has a larger percentage change in value?
At 7%, the doubling time is: 70/7=10 years
=> This means:
● In 10 years, the present value will roughly double.
● In 20 years, the present value will double twice (i.e., quadruple).
● In 40 years, the present value will double four times (i.e., 16×).
Bond A (20 years):
Since the doubling time is 10 years, in 20 years, the present value will roughly
quadruple.
Thus, the present value is roughly one-fourth of $8,000:
PVA ≈ 8000/4 = 2000
Bond B (40 years):
Since the doubling time is 10 years, in 40 years, the present value will roughly double
four times (16×).
Thus, the present value is roughly one-sixteenth of $8,000:
PVB ≈ 8000/16 =500
Exact Calculation
Bond A: PVA = 8000/(1+0.07)^20 = 2067.35 $
Bond B: PVB = 8000/(1+0.07)^40 = 534.24 $
Conclusion:
● Bond A's present value: ~$2067.35
● Bond B's present value: ~$534.24
● Bond B has a larger percentage change in value because its longer maturity
makes it more sensitive to interest rate changes.
c. Based on the example above, complete the two blanks in this sentence: “The value
of a bond [rises/falls] when the interest rate increases, and bonds with a longer time to
maturity are [more/less] sensitive to changes in the interest rate.”
The value of a bond [rises/falls] when the interest rate increases, and bonds
with a longer time to maturity are [more/less] sensitive to changes in the interest rate.
4. Your bank account pays an interest rate of 8 percent. You are considering buying a
share of stock in XYZ Corporation for $110. After 1, 2, and 3 years, it will pay a
dividend of $5. You expect to sell the stock after 3 years for $120. Is XYZ a good
investment? Support your answer with calculations.
The Cash FlowToday:
- Pay $110 to buy the stock.
- Year 1: Receive $5 dividend.
- Year 2: Receive $5 dividend
- Year 3: Receive 5 dividend+120 from selling the stock.
The Net Present Value (NPV)
We discount future cash flows at the 8% opportunity cost (your bank’s interest rate).
NPV= (−Initial Cost) +D1/(1+r)^1+D2/(1+r)^2+ (D3+P3)/(1+r)^3
- D1=D2=D3=$5 (dividends)
- P3=$120 (sale price in Year 3)
- r=8%=0.08
NPV=−110 + 4.63 + 4.29 + 99.23 = −110 + 108.15 = −1.85
NPV = -$1.85 (Negative → Not a good investment)
Step 3: Compare to the Bank’s 8% Return
Alternatively, calculate the Internal Rate of Return (IRR) and compare it to 8%.
0= −110 + 5/(1+IRR) + 5/(1+IRR)^2 + 125/(1+IRR)^3
=> IRR ≈ 7.4% (less than 8%)
Conclusion:
● NPV is negative (-$1.85) → Investing in XYZ stock destroys value compared
to keeping money in the bank.
● IRR (7.4%) < Bank’s 8% return → The stock underperforms the bank.
=> No, XYZ is not a good investment.
5. For each of the following kinds of insurance, give an example of behavior that
reflects moral hazard and another example of behavior that reflects adverse selection.
a. health insurance
- Moral Hazard Example: A person with health insurance avoids exercise and
eats unhealthily, knowing insurance will cover future medical costs.
- Adverse Selection Example: Someone with a family history of chronic illness is
more likely to buy comprehensive coverage, while healthy people opt out.
b. car insurance
- Moral Hazard Example: A driver speeds recklessly because they know
insurance will pay for accident damages.
- Adverse Selection Example: A high-risk driver is more likely to seek full
coverage, while safe drivers may choose minimal plans.
c. life insurance
- Moral Hazard Example: A smoker refuses to quit because they already have a
life insurance policy covering smoking-related deaths.
- Adverse Selection Example: Someone with a terminal illness hides their
condition to buy a large policy, while healthy individuals underinsure.
6. Which kind of stock would you expect to pay the higher average return: stock in an
industry that is very sensitive to economic conditions (such as an automaker) or stock
in an industry that is relatively insensitive to economic conditions (such as a water
company)? Why?
- In my point of view, I will choose to buy stock in an industry that is very
sensitive to economic conditions. The reasons are:
+ Risk-Return Tradeoff: Cyclical industries (autos, travel, luxury goods) see big
swings in profits with economic booms and busts. Investors demand higher
returns to compensate for this extra risk. Stable industries (utilities, healthcare,
groceries) generate steady cash flows regardless of the economy, so investors
accept lower returns for safety.
+ Market Pricing Sensitive stocks are more volatile, so their prices drop sharply
in recessions. Investors require a risk premium (higher expected return) to hold
them. Insensitive stocks act like "bond substitutes," trading at higher valuations
(lower yields) due to their defensive nature.
=> Higher sensitivity to the economy = Higher risk = Higher expected returns.
Investors pay less for volatile stocks today, boosting future returns if the economy
thrives.
7. A company faces two kinds of risk. A firm-specific risk is that a competitor might
enter its market and take some of its customers. A market risk is that the economy
might enter a recession, reducing sales. Which of these two risks would more likely
cause the company’s shareholders to demand a higher return? Why?
The market risk (e.g., a recession that reduces overall sales) would more likely
cause the company’s shareholders to demand a higher return. Here's why:
- Diversification Eliminates Firm-Specific Risk: Investors can reduce (or even
eliminate) firm-specific risks—like a competitor stealing customers—by
holding a diversified portfolio of stocks. Since these risks don’t affect the entire
market, shareholders don’t require extra compensation for them.
- Market Risk Is Unavoidable: Recessions hurt all stocks, so diversification
doesn’t help. Since investors can’t escape this risk, they demand a higher return
to compensate for bearing it.
8. When company executives buy and sell stock based on private information that they
obtain as part of their jobs, they are engaging in insider trading.
a. Give an example of inside information that might be useful for buying or selling
stock.
A tech company’s CFO discovers that next quarter’s earnings will fall 50%
below forecasts due to a major production defect (before the public announcement).
How This Inside Information Could Be Used:
- Selling Stock: The CFO dumps their shares before earnings are reported,
avoiding massive losses when the stock plummets.
- Short Selling: A board member could bet against the stock (short selling)
knowing the price will crash.
Why This Is Insider Trading:
- Earnings reports are material information that directly affect stock prices.
- Trading on undisclosed financial results cheats investors who lack access to the
same data.
c. Insider trading is illegal. Why do you suppose that is?
Insider trading is illegal because it:
- Creates an unfair playing field: Insiders (like executives or employees) have
access to non-public, material information. If they trade on that before the
public knows, they gain an unfair advantage over regular investors — who are
making decisions without the same info.
- Damages investor confidence: If people believe the stock market is "rigged" or
that insiders can cheat and win, investors will lose confidence and might stop
investing altogether. That would reduce market participation and hurt the
economy.
- Violates ethical and legal duties: Corporate insiders often have a duty to act in
the best interest of shareholders. Using inside info for personal gain violates
that trust and duty.
- Disrupts market efficiency: Public trust and timely disclosure of information
help markets reflect true value. If inside info is secretly exploited, markets
become less efficient, and prices may no longer reflect all publicly available
info.
9. Jamal has a utility function U=W^1/2, where W is his wealth in millions of dollars
and U is the utility he obtains from that wealth. In the final stage of a game show, the
host offers Jamal a choice between (A) $4 million for sure and (B) a gamble that pays
$1 million with probability 0.6 and $9 million with probability 0.4.
a. Graph Jamal’s utility function. Is he risk averse? Explain.
- The utility function is concave (opening downward), which means Jamal
exhibits risk aversion. A risk-averse individual prefers a sure outcome over a
gamble with the same expected value because the diminishing marginal utility
of wealth makes potential losses hurt more than equivalent gains please.
b. Does A or B offer Jamal the higher expected prize? Explain your reasoning with
appropriate calculations. (Hint: The expected value of a random variable is the
weighted average of the possible outcomes, where the probabilities are the weights.)
Option A: 4 million(certain)
Option B:
Gamble (0.6×1 m + 0.4 × $9m)
Calculating expected value (EV) of B:
EV(B) = (0.6 × 1) + (0.4 × 9) = 0.6 + 3.6 = $4.2 million
=> B offers the higher expected prize
c. Does A or B offer Jamal the higher expected utility? Again, show your calculations.
Calculate utility for each outcome:
● U(1) = √1 = 1
● U(4) = √4 = 2
● U(9) = √9 = 3
Option A's utility: U(4) = 2 (certain)
Option B's expected utility (EU):
EU(B) = (0.6 × U(1)) + (0.4 × U(9)) = (0.6 × 1) + (0.4 × 3) = 0.6 + 1.2 = 1.8
A offers the higher expected utility .
d. Should Jamal pick A or B? Why?
Jamal should pick Option A ($4 million sure) because:
1. He's risk-averse (concave utility function).
2. Even though B has a higher expected monetary value (4.2m> 4m), its expected
utility (1.8) is lower than A's (2.0).
3. For risk-averse individuals, the certainty of A is more valuable than the chance
at a higher payoff in B.