Chapter 16/Interest Rates, Investment, and Capital Markets
Chapter 16Interest Rates, Investment, and Capital Markets
MULTIPLE CHOICE
Choose the one alternative that best completes the statement or answers the question.
1)Suppose a person has a discount rate of zero. This implies that she
A) places no value on the future.
B) places no value on the present.
C) values the present and the future equally.
D) would not lend money at any positive interest rate.
Answer: C
Diff: 0
Topic: Comparing Money Today to Money in the Future
2)Suppose two people with the same level of income and wealth have different discount rates. Joe has a very high discount rate and Jim has a very low discount rate. Which one of the following is TRUE?
A) Joe is more likely to borrow than Jim.
B) Joe is less likely to borrow than Jim.
C) Joe and Jim will borrow the same amount.
D) Neither Joe nor Jim would be borrowers.
Answer: A
Diff: 1
Topic: Comparing Money Today to Money in the Future
3)Interest rates are positive mainly because
A) of inflation.
B) people tend to prefer the present to the future.
C) people tend to prefer the future to the present.
D) bankers are greedy.
Answer: B
Diff: 1
Topic: Comparing Money Today to Money in the Future
4) If you place $100 in a bank account that pays 6% at the end of each year, and you
leave your $100 and all your interest in the bank, how much will you have in the bank at the end of 7 years with annual compounding?
A)(106)7.
B) 7 * (106).
C)100 * (1.60)7.
D)100 * (1.06)7.
Answer: D
Diff: 1
Topic: Comparing Money Today to Money in the Future
5) If you invest $500 today, and the value one year from today is $1000, then the
annual interest rate must be
A)10%.
B)50%.
C)100%.
D)200%.
Answer: C
Diff: 1
Topic: Comparing Money Today to Money in the Future
6)For a given rate of interest, the total interest you receive from lending money
A) increases with the frequency of compounding.
B) decreases with the frequency of compounding.
C) is independent of the frequency of compounding.
D) is greatest when there is no compounding.
Answer: A
Diff: 1
Topic: Comparing Money Today to Money in the Future
7)If the interest rate is 10%, then $1 received one year from now is worth how much today?
A) $1.10
B) $1.00
C) $0.91
D) $0.90
Answer: C
Diff: 1
Topic: Comparing Money Today to Money in the Future
8)If the interest rate is 10%, then $1 today is worth how much one year from now?
A) $1.10
B) $1.00
C) $0.91
D) $0.90
Answer: A
Diff: 1
Topic: Comparing Money Today to Money in the Future
9)If savers require a 2% return and inflation is expected to be 3%, what rate will banks offer savers?
A) 1%
B) 3.2%
C) 5%
D) 6%
Answer: C
Diff: 1
Topic: Comparing Money Today to Money in the Future
10)If your bank pays you 6% interest on a savings account and inflation is 2%, your real rate of interest is
A) 2%.
B) 4%.
C) 8%.
D) 12%.
Answer: B
Diff: 1
Topic: Comparing Money Today to Money in the Future
11)If inflation turns out to be higher than was anticipated,
A) debtors are helped.
B) debtors are hurt.
C) debtors are neither helped nor hurt.
D) the effect on debtors cannot be predicted.
Answer: A
Diff: 1
Topic: Comparing Money Today to Money in the Future
12)If inflation turns out to be higher than was anticipated, debtors are helped because
A) the real present value of their payments increases.
B) the real present value of their payments decreases.
C) the nominal present value of their payments increases.
D) the nominal present value of their payments increases.
Answer: B
Diff: 1
Topic: Comparing Money Today to Money in the Future
13)If you agree to a long-term loan at a specified nominal rate of interest and inflation turns out to be higher than was anticipated,
A) the nominal rate of interest falls.
B) the nominal rate of interest rises.
C) the real rate of interest falls.
D) the real rate of interest rises.
Answer: C
Diff: 1
Topic: Comparing Money Today to Money in the Future
14)As the interest rate rises, the present value of a given perpetual stream of income
A) increases.
B) decreases.
C) does not change.
D) approaches infinity.
Answer: B
Diff: 1
Topic: Comparing Money Today to Money in the Future
15)As the interest rate increases, the present value of a future payment
A) increases.
B) decreases.
C) does not change.
D) approaches infinity.
Answer: B
Diff: 1
Topic: Comparing Money Today to Money in the Future
16)The Net Present Value approach to investment results in an investment being undertaken only if
A) its net present value is positive.
B) its net present value is zero.
C) it has positive cash flow.
D) its internal rate of return equals the rate of interest.
Answer: A
Diff: 1
Topic: Choices Over Time
17)Suppose a new cost-saving device will generate $1,000 net savings per year to a firm. The device costs $10,000. Should the firm purchase the device?
A) Definitely.
B) Absolutely not.
C) The firm is indifferent between buying the device and not.
D) More information is required to answer.
Answer: D
Diff: 1
Topic: Choices Over Time
18)Suppose a new cost-saving device will forever generate $1,000 net savings per year to a firm. The device costs $10,000. Using the Internal Rate of Return approach, the firm will make the investment
A) definitely.
B) definitely not.
C) if the interest rate exceeds 10%.
D) if the interest rate is less than 10%.
Answer: D
Diff: 1
Topic: Choices Over Time
19)In using the Internal Rate of Return approach, one must first calculate the discount rate on the investment that makes
A) the net present value equal zero.
B) the interest rate equal zero.
C) the interest rate equal the discount rate.
D) the first year's return positive.
Answer: A
Diff: 1
Topic: Choices Over Time
20)Using the Internal Rate of Return approach to investment, one would undertake an investment if the internal rate of return
A) equals zero.
B) equals the interest rate.
C) exceeds the interest rate.
D) is less than the interest rate.
Answer: C
Diff: 1
Topic: Choices Over Time
21)To calculate the internal rate of return on a factory that would yield a perpetual future stream of income, one would divide
A) the annual future payment by the cost of the factory.
B) the sum of the future payments by the cost of the factory.
C) the cost of the factory by the rate of interest.
D) the cost of the factory by the annual future payment.
Answer: A
Diff: 1
Topic: Choices Over Time
22)A bond issuer agrees to pay a stated nominal amount each year. An increase in the nominal interest rate will cause
A) the price of the bond to fall.
B) the price of the bond to rise.
C) the nominal value of the bond's coupon to rise.
D) the nominal value of the bond's coupon to fall.
Answer: A
Diff: 1
Topic: Choices Over Time
23)If a bond's coupon adjusts to pay a constant real rate of return, then an increase in inflation would cause
A) the nominal coupon payment to rise.
B) the nominal coupon payment to fall.
C) the nominal coupon payment to remain unchanged.
D) the bond's price to fluctuate wildly.
Answer: A
Diff: 1
Topic: Choices Over Time
24)If a firm needs one machine to produce a product, and must replace the machine
when it wears out, then the firm should pick a durability level of the machine that
A)minimizes the expense today.
B)minimizes the present discounted cost of having the machine forever.
C)maximizes the future value of the machine.
D)minimizes the future value of the machine.
Answer: B
Diff: 1
Topic: Choices Over Time
25)At age 40, Joe is considering quitting his job and going back for a college degree. He needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A college degree would raise his annual income by $10,000 per year. He will retire at age 70. His cost of going back to college is
A) .
B) .
C) .
D) .
Answer: D
Diff: 1
Topic: Choices Over Time
26)At age 40, Joe is considering quitting his job and going back for a college degree. He needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A college degree would raise his annual income by $10,000 per year. He will retire at age 70. His benefit of a degree would be
A) .
B) .
C) 10,000/r.
D) .
Answer: D
Diff: 1
Topic: Choices Over Time
27)At age 40, Joe is considering quitting his job and going back for a college degree. He needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A college degree would raise his annual income by $10,000 per year. He will retire at age 70. If these are real amounts (adjusted for inflation), then the discount rate to be used should be
A) the nominal rate of interest.
B) the real rate of interest.
C) the rate of inflation.
D) zero.
Answer: B
Diff: 2
Topic: Choices Over Time
28)At age 40, Joe is considering quitting his job and going back for a college degree. He needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A college degree would raise his annual income by $10,000 per year. He will retire at age 70. From an investment standpoint, Joe will go back full-time if
A) .
B) .
C) .
D) .
Answer: D
Diff: 1
Topic: Choices Over Time
29)At age 40, Joe is considering quitting his job and going back for a college degree. He needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A college degree would raise his annual income by $10,000 per year. He will retire at age 70. Which of the following makes it more likely that Joe will decide to go back to college full-time?
A) The rate of interest increases.
B) The rate of interest decreases.
C) The government enacts mandatory retirement at age 60.
D) tuition increases.
Answer: B
Diff: 2
Topic: Choices Over Time
30)At age 40, Joe is considering quitting his job and going back for a college degree. He needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A college degree would raise his annual income by $10,000 per year. He will retire at age 70. Which of the following makes it less likely that Joe will decide to go back to college full-time?
A) The extra income due to a college degree rises.
B) The rate of interest decreases.
C) The government enacts mandatory retirement at age 60.
D) Tuition decreases.
Answer: C
Diff: 2
Topic: Choices Over Time
31)The real internal rate of return on a college education is about
A) 0%.
B) 2.5%.
C) 6.9%.
D) 15%.
Answer: C
Diff: 1
Topic: Choices Over Time
32)If an exhaustible resource is scarce, has constant marginal cost over time, and is sold in a competitive market, then
A) its price increases over time.
B) its price will not be a function of the interest rate.
C) its price moves independently of past prices.
D) its price equals marginal cost.
Answer: A
Diff: 1
Topic: Exhaustible Resources
33)If an exhaustible resource is priced at marginal cost that remains constant over time, then
A) all owners of that resource earn rent.
B) the price will stay constant over time.
C) the percent price increase each year equals the rate of interest.
D) the good is relatively scarce.
Answer: B
Diff: 1
Topic: Exhaustible Resources
34) Suppose an exhaustible resource can be sold only this period or next period. The
resource owner is considering selling 100 tons of the resource this period. The future value of the resource when 100 tons are sold this period is less than the present value of the 100 tons sold this period multiplied by one plus the interest rate. What should the resource owner do?
A)She should sell more than 100 tons this period.
B)She should sell only 100 tons this period.
C)She should sell less than 100 tons this period.
D)She should not sell any of the resource in either period.
Answer: A
Diff: 1
Topic: Exhaustible Resources
35)Technological improvements in coal mining will
A) increase the price of coal.
B) decrease the price of coal.
C) increase the interest rate.
D) decrease the interest rate.
Answer: B
Diff: 1
Topic: Exhaustible Resources
36)The growth over time in the spread between price and marginal cost of an exhaustible resource is equal to
A) zero.
B) one.
C) the interest rate.
D) the present value of the reserves.
Answer: C
Diff: 1
Topic: Exhaustible Resources
37)The spread between price and marginal cost of an exhaustible resource must grow by the rate of interest so that
A) resource owners earn a profit.
B) resource owners are willing to sell some of the resource in the future.
C) the price of the resource remains constant in real terms.
D) the marginal cost of extracting the resource declines.
Answer: B
Diff: 1
Topic: Exhaustible Resources
38)Investment demand is downward sloping because
A) an increase in investment demand causes interest rates to fall.
B) at lower interest rates, firms will undertake more investment.
C) at lower interest rates, firms will undertake less investment.
D) an increase in investment demand causes interest rates to rise.
Answer: B
Diff: 1
Topic: Capital Markets, Interest Rates, and Investments
39)Investment demand is downward sloping because as the interest rate decreases
A) each project's internal rate of return decreases.
B) each project's internal rate of return increases.
C) more projects will have an internal rate of return that exceeds the interest rate.
D) more projects will have an internal rate of return that is less than the interest rate.
Answer: C
Diff: 2
Topic: Capital Markets, Interest Rates, and Investments
40)Government policies that encourage savings
A) reduce interest rates.
B) increase interest rates.
C) have no effect on interest rates.
D) lower the net present value of all investments.
Answer: A
Diff: 1
Topic: Capital Markets, Interest Rates, and Investments
41)Which of the following is most likely to cause interest rates to fall?
A) Government borrows to finance a war.
B) All firms project higher future revenue streams for all of their projects.
C) All firms project lower future revenue streams for all of their projects.
D) Government institutes a high tax on savings.
Answer: C
Diff: 1
Topic: Capital Markets, Interest Rates, and Investments
42)Which of the following is most likely to cause the savings supply curve in the market for loanable funds to shift leftward?
A) Government borrows to finance a war.
B) All firms project higher future revenue streams for all of their projects.
C) All firms project lower future revenue streams for all of their projects.
D) Government institutes a high tax on savings.
Answer: D
Diff: 1
Topic: Capital Markets, Interest Rates, and Investments
43)Which of the following is most likely to cause the demand curve in the capital market to shift leftward?
A) Government borrows to finance a war.
B) All firms project higher future revenue streams for all of their projects.
C) All firms project lower future revenue streams for all of their projects.
D) Government institutes a high tax on savings.
Answer: C
Diff: 1
Topic: Capital Markets, Interest Rates, and Investments
TRUE/FALSE/EXPLAIN
1)Suppose $100 is deposited in a bank account paying 5% compounded annually. If the interest earned is X after 5 years, then the interest earned will be 2X after 10 years.
Answer: False. Because of compounding, the balance on which interest is earned grows over time. Thus, the interest earned in years 6 to 10 will exceed the interest earned in years 1 to 5.
Diff: 2
Topic: Comparing Money Today to Money in the Future
2)Interest rates are positive because inflation makes purchases more expensive in the future than today.
Answer: False. Even if inflation were zero, interest rates would be positive since people prefer present consumption to future consumption.
Diff: 2
Topic: Comparing Money Today to Money in the Future
3)A recent purchaser of a bond that agrees to pay an annual nominal amount would hope that interest rates do not rise.
Answer: True, for two reasons. First, the person is locked into a lower interest rate. Second, if the person needs to sell the bond, he will incur a loss since at higher interest rates, bond prices fall.
Diff: 1
Topic: Choices Over Time
4)An investment is profitable as long as its internal rate of return is equal to the rate of interest.
Answer: False. Such an investment has profit of zero. The investment is profitable if the internal rate of return exceeds the interest rate.
Diff: 1
Topic: Choices Over Time
5)Government debt increases the interest rate and private investment.
Answer: False. The interest rate does increase; however, this causes the level of private investment to decrease.
Diff: 1
Topic: Capital Markets, Interest Rates, and Investments
PROBLEMS
1)Jerry wishes to retire in 5 years with $1 million in his bank account. If the account pays 4% and his current balance is $500,000, how much must he deposit at the beginning of each of the next five years for his wish to come true? The amount must be the same each year.
Answer: His current accumulation will grow to $608,326.45, leaving him $391,673.55 short. To get this, he will save X at the beginning of each of the next five years so that
$391,673.55 = X[(1.04) + (1.04 )2 + (1.04 )3 + (1.04 )4 + (1.04 )5] = X[5.63292]. X = $69,532.95.
Diff: 1
Topic: Comparing Money Today to Money in the Future
2) In an economy with no inflation, explain why interest rates are positive.
Answer: Because most people prefer consumption today relative to consumption tomorrow, they must be compensated for delaying consumption. Interest is the compensation for the delay in consumption.
Diff: 1
Topic: Comparing Money Today to Money in the Future
3)A state lottery has a Million Dollar Lottery game that pays $1,000 a week for life. Assuming a 6% nominal rate of interest and generously assuming an infinite lifetime, can this game be called a "Million Dollar Lottery”?
Answer: Assuming that the payments last forever, the present value of the payments is roughly 52,000/.06 = $866,667. Not really a million dollars.