Homework 2 begins (question 1 – 5)
Question 1. Can the nominal interest rate ever be negative? Can the real interest rate
ever be negative? Explain.
The real rate can be negative but not the nominal, as no one is going to invest at 0% or negative interest rate. If nominal interest rate is 2% and inflation is 3%, then the real rate is negative by 1%
Question 2. What is a sunk cost? Should it be included in the incremental cash flows
for a project? Why or why not?
Sunk cost which can not be recovered, such as depreciation, it is not included in the incremental cash flow as it is irrelevant to the decision making.
Question 3. What is an opportunity cost? Should it be included in the incremental cash flows for a project? Why or why not?
Opportunity cost is the sacrifice of benefit for an alternative for the use of another
alternative. It should be included as it is a relevant cost for decision making purpose
Question 4 Briefly describe the four characteristics of IPOs that puzzle financial economists.
a. The pricing of the shares, may be at par, discount and premium.
b. The underwriting of issue.
c. The cost involve in issuing the securities.
d. The listing requirement for different agencies within the country and if issued outside the country.
Question 5. You are purchasing a new home and need to borrow $325,000 from a mortgage lender. The mortgage lender quotes you a rate of 6.5% APR for a 30-year fixed rate mortgage (with payments made at the end of each month). The mortgage lender also tells you that if you are willing to pay 1 point, they can offer you a lower rate of 6.25% APR for a 30-year fixed rate mortgage. One point is equal to 1% of the loan value. So if you take the lower rate and pay the points you will need to borrow an additional $3,250 to cover the points you are paying the lender. Assuming that you do not intend to prepay your mortgage (pay off your mortgage early), are you better off paying the 1 point and borrowing at 6.25% APR or just taking out the loan at 6.5% without any points?
Payment at 6.5% per month will be 2054 per month but at 6.25% it will be 2021 therefore
the loan at 6.25% should be taken due to lower monthly payment.
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