Fi 410 Ch 2
Chapter 2
The Time Value of Money and Net Present Value
Solutions to Questions 2.1 to 2.43 appear in the text.
2.44 What is a perfect market? What were the assumptions made in this chapter that were not part of the perfect market scenario?
Answer: A perfect market is one with no taxes, no transaction costs, no differences in opinion, and many buyers and sellers. In this chapter, we also are assuming no uncertainty and no inflation.
2.45 What is the difference between a bond and a loan?
Answer: No difference really. A bond is a loan.
2.46 In the text, I assumed you received the dividend at the end of the period. In the real world, if you received the dividend at the beginning of the period instead of the end of the period, could this change your effective rate of return? Why?
Answer: Yes, because dividends could then be reinvested and earn extra returns themselves.
*2.47 Your stock costs $100 today, pays $5 in dividends at the end of the period, and then sells for $98. What is your rate of return?
Answer: ($98 + $5)/$100 − 1 ’ 3%.
2.48 The interest rate has just increased from 6% to 8%. How many basis points is this?
Answer: 200 basis points.
*2.49 Assume an interest rate of 10% per year. How much would you lose over 5 years if you had to give up interest on the interest—that is, if you received 50% instead of compounded interest?
Answer: You would lose 11.1%.
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2.50 Over 20 years, would you prefer 10% per annum, with interest compounding, or 15% per annum but without interest compounding? (That is, you receive the interest, but it is put into an account that earns no interest, which is what we call simple interest.)
Answer: Over 20 years, you would receive a rate of return of 1.120 − 1 ( 573%. The uncompounded rate earns 15% ( 20 ’ 300%. You would prefer the compounded lower interest rate.
*2.51 A project returned +30%, then −30%. Thus, its arithmetic average rate of return was 0%.
The Time Value of Money and Net Present Value
Solutions to Questions 2.1 to 2.43 appear in the text.
2.44 What is a perfect market? What were the assumptions made in this chapter that were not part of the perfect market scenario?
Answer: A perfect market is one with no taxes, no transaction costs, no differences in opinion, and many buyers and sellers. In this chapter, we also are assuming no uncertainty and no inflation.
2.45 What is the difference between a bond and a loan?
Answer: No difference really. A bond is a loan.
2.46 In the text, I assumed you received the dividend at the end of the period. In the real world, if you received the dividend at the beginning of the period instead of the end of the period, could this change your effective rate of return? Why?
Answer: Yes, because dividends could then be reinvested and earn extra returns themselves.
*2.47 Your stock costs $100 today, pays $5 in dividends at the end of the period, and then sells for $98. What is your rate of return?
Answer: ($98 + $5)/$100 − 1 ’ 3%.
2.48 The interest rate has just increased from 6% to 8%. How many basis points is this?
Answer: 200 basis points.
*2.49 Assume an interest rate of 10% per year. How much would you lose over 5 years if you had to give up interest on the interest—that is, if you received 50% instead of compounded interest?
Answer: You would lose 11.1%.
[pic]
2.50 Over 20 years, would you prefer 10% per annum, with interest compounding, or 15% per annum but without interest compounding? (That is, you receive the interest, but it is put into an account that earns no interest, which is what we call simple interest.)
Answer: Over 20 years, you would receive a rate of return of 1.120 − 1 ( 573%. The uncompounded rate earns 15% ( 20 ’ 300%. You would prefer the compounded lower interest rate.
*2.51 A project returned +30%, then −30%. Thus, its arithmetic average rate of return was 0%.