PROBLEMS AND APPLICATIONS

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PROBLEMS AND APPLICATIONS

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 would they have today?

2. A company has an investment project that would cost $15 million today and yield a payoff of $20 million in five years.

a. Should the firm undertake the project if the interest rate is 8 percent? 7 percent? 6 percent? 5 percent?

b. Can you figure out the exact cutoff for the interest rate between profitability and non profitability?

3. For each of the following kinds of insurance, give an example of behavior that can be called moral hazard and another example of behavior that can be called adverse selection.

a. health insurance

b. car insurance

4. Imagine that the U.S. Congress, recognizing the importance of being well dressed, started giving preferential tax treatment to “clothing insurance.” Under this new type of insurance, you would pay the insurance company an annual premium, the insurance company would then pay for 80 percent of your clothing expenses (you pay the remaining 20 percent), and the tax laws would partly subsidize your insurance premiums.

a. How would the existence of such insurance affect the amount of clothing that people buy? How would you evaluate this change in behavior from the standpoint of economic efficiency?

b, Who would choose to buy clothing insurance?

c. Suppose that the average person now spends $2,000 a year on clothes. Would clothing insurance cost more or less than $2,000? Explain.

d. In your view, is this congressional action a good idea? How would you compare this idea. with the current tax treatment of health insurance?

5. Imagine that you intend to buy a portfolio 0{ ten stocks with some of your savings. Should the stocks be of companies in the same industry? could the stocks be of companies located in the same country? Explain ..

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?

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?

8. You have two roommates who m vest in the stock market.

a. One roommate says that he buys stock only in companies that everyone believes will experience big increases in profits in the future. How do you suppose the price-earnings ratio of these companies compares to ..the price-earnings ratio of other companies? What might be the disadvantage of
buying stock in these companies?
b. An other roommate says he only buys stock in companies that are cheap, which he measures by a low price-earnings ratio. How do you suppose the earnings prospects of these companies compare to those of other companies? What might be the disadvantage of buying stock in these companies?

9. When company executives buy and sell stock based on private information they obtain as part of their jobs, they are engaged 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?

10. Find some information on an index fund (such as the Vanguard 500 Index, ticker symbol VFINX). How has this fund performed compared with other; stock mutual funds over the past 5 or 10 years? (Hint: One place to look for data on mutual funds is htt.p:/www.morninLtstar.com.) What do you learn from this comparison?

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PROBLEMS AND APPLICATIONS