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Essentials of Economics

N. Gregory Mankiw

Chapter 19

The Basic Tools of Finance - all with Video Answers

Educators

Chapter Questions

00:53

Problem 1

According to an old myth, Native Americans sold the island of Manhattan about 400 years ago for s24 If they had invested this amount at an interest rate of 7 percent per year, how much, approximately, would they have today?

Kaylee Mcclellan
Kaylee Mcclellan
Numerade Educator
05:58

Problem 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?
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.

Md.Daniyal Arshad
Md.Daniyal Arshad
Numerade Educator
04:12

Problem 3

Bond A pays $\$ 8,000$ in 20 years. Bond $B$ pays 88,000 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.)
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?
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."

Jesse Neumann
Jesse Neumann
Numerade Educator
08:44

Problem 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 $85 .$ You expect to sell the stock after 3 years for $\$ 120 .$ Is XYZ a good investment? Support your answer with calculations

Md.Daniyal Arshad
Md.Daniyal Arshad
Numerade Educator
02:44

Problem 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
b. car insurance
c. life insurance

Jesse Neumann
Jesse Neumann
Numerade Educator
01:04

Problem 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?

Jesse Neumann
Jesse Neumann
Numerade Educator
01:34

Problem 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?

Jesse Neumann
Jesse Neumann
Numerade Educator
01:42

Problem 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.
b. Those who trade stocks based on inside information usually earn very high rates of return. Does this fact violate the efficient markets hypothesis?
c. Insider trading is illegal. Why do you suppose that is?

Jesse Neumann
Jesse Neumann
Numerade Educator
03:35

Problem 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.
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.)
c. Does $\underline{\text { A }}$ or $\underline{\mathrm{B}}$ offer Jamal the higher expected utility? Again, show your calculations.
d. Should Jamal pick A or B? Why?

Jesse Neumann
Jesse Neumann
Numerade Educator