Chapter 27. The Basic Toolsof money management. Problems and Applications (1-4) Gregory Mankiw. Principles of Economics 7th Edition.
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 finance charge rate of 7 percent per year, how much, approximately, would they have today?
2. A firm has an capital 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 finance charge rate is 11 percent? 10 percent? 9 percent? 8 percent?
b. Can you figure out the exact cutoff for the finance charge rate between profitability and non profitability?
3. Bond A pays $8,000 in 20 years. Bond B pays $8,000 in 40 years. (To keep things simple, assume these are zero-coupon securities, which means the $8,000 is the only payment the bondholder receives.)
a. If the finance charge 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 finance charge 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 finance charge rate increases,and securities with a longer time to maturity are [more/less] sensitive to changes in theinterest rate.”
4. Your lender account pays an finance charge 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 $5. You expect to sell the stock after 3 years for $120. Is XYZ a good capital? Support your answer with calculations.
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