I.

Suggested end-of-chapter problems for Chapter 3:

#6, #9, #12, #13, #16, #A4 in the appendix

II. Sample Questions for Chapter 3

1) Which of the following statements regarding the valuing of costs and benefits is correct?
A) The first step in evaluating a project is to identify its costs and benefits.
B) Competitive market prices allow us to calculate the value of a decision without worrying
about the tastes or opinions of the decision maker.
C) Because competitive markets exist for most commodities and financial assets, we can use
them to determine cash values and evaluate decisions in most situations.
D) All of the above are true.
Answer: D

2) If the risk-free rate of interest (rf) is 3.5%, then you should be indifferent between receiving
$1000 in one-year or
A) $965.00 today.
B) $966.18 today.
C) $1000.00 today.
D) $1035 today.
Answer: B
Explanation: $1000/1.035 = $966.183575

3)Which of the following statements is incorrect?

A) In general, money today is worth more than money in one year.
B) We define the risk-free interest rate, rf for a given period as the interest rate at which money
can be borrowed or lent without risk over that period.
C) We refer to (1 - rf) as the interest rate factor for risk-free cash flows.
D) For most financial decisions, costs and benefits occur at different points in time.
Answer: C; the future value interest rate factor for risk-free cash flow is (1 + rf)n, where n
represents time, present value interest factor is 1/(1 + rf)n.

4) If the risk-free rate of interest (rf) is 6%, then you should be indifferent between receiving
$250 today or
A) $235.85 in one year.
B) $250.00 in one year.
C) $265.00 in one year.
D) None of the above
Answer: C
Explanation: $250.00 × (1.06) = $265.00

5) A firm needs to order a new machine that will be delivered in one year. The $1,000,000 price
for the machine is due in one year. The machine manufacturer offers the firm a discount of
$50,000 if the firm pays for the furnace now. If the interest rate is 7%, then the NPV of paying
now is closest to:
A) ($15,421)
B) $15,421
C) ($46,729)
D) $46,729
Answer: A
Explanation: Solution: $1,000,000 / 1.07 - $950,000 = -$15,420.56

6) You are offered an investment opportunity in which you will receive $23,750 today in
exchange for paying $25,000 in one year. Suppose the risk-free interest rate is 6% per year.
Should you take this project? The NPV for this project is closest to:
A) Yes; NPV = $165
B) No; NPV = $165
C) Yes; NPV = -$165
D) No; NPV = -$165
Answer: A
Explanation: NPV = 23,750 - 25,000/(1.06) = 165, since NPV > 0 accept the project

7) Which of the following statements regarding arbitrage is correct?

A) Any situation in which it is possible to make a profit without taking any risk or without any
investment is known as an arbitrage opportunity.
B) To arbitrage, one buys an asset with a lower price and simultaneously sells another equivalent
asset with a higher price.
C) The practice of buying and selling equivalent securities or assets in different markets to take
advantage of a price difference is known as arbitrage.
D) All of the above are correct.
Answer: D

8) Walgreen Company (NYSE: WAG) is currently trading at $48.75 on the NYSE. Walgreen
Company is also listed on NASDAQ and assume it is currently trading on NASDAQ at $48.50.
Does an arbitrage opportunity exists and if so how would you exploit it and how much would
you make on a block trade of 100 shares?
A) No, no arbitrage opportunity exists.
B) Yes, buy on NASDAQ and sell on NYSE, make $25.
C) Yes, buy on NYSE and sell on NASDAQ, make $25.
D) Yes, buy on NASDAQ and sell on NYSE, make $250.
Answer: B

9) Which of the following statements regarding arbitrage and security prices is NOT correct?
A) In financial markets it is not possible to sell a security you do not own.
B) When a bond is underpriced, the arbitrage strategy involves borrowing money to buy the
bond.
C) When a bond is overpriced, the arbitrage strategy involves shorting the bond and investing the
proceeds.
D) The general formula for the no-arbitrage price of a security is Price(security) = PV(All cash
flows paid by the security).
Answer: A; it is possible to sell a security you do not already own. We call such selling as short
selling or simply shorting.

10) A bond will give the owner $100 a year later without any uncertainty. If the risk-free rate of
interest is 7.5%, then the value of the bond is closest to:
A) $91.00
B) $92.50
C) $93.00
D) $100.00
Answer: C
Explanation: PV = 100 / 1.075 = 93.02 which is approximately $93.00

The following two questions are related to the material in the appendix:

11) Which one of the following statements is false?

A) When we compute the return of a security based on the average payoff we expect to receive,
we call it the expected return.
B) The notion that investors prefer to have a safe income rather than a risky one of the same
average amount is call risk aversion.
C) Because investors are risk averse, the risk-free interest rate is not the right rate to use when
converting risky cash flows across time.
D) The more risk averse investors are, the higher the current price of a risky asset will be
compared to a risk-free bond.
Answer: D

12) Suppose a risky security pays an average cash flow of $100 in one year. The risk-free rate is
5%, and the expected return on the market index is 13%. If the returns on this security are high
when the economy is strong and low when the economy is weak, but the returns vary by only
half as much as the market index, then the price for this risky security is closest to:
A) $88
B) $92
C) $93
D) $95
Answer: B
Explanation: B) Since the security is half as risky as the market, then the risk-premium for the
security should be half of the market risk premium. The market risk premium is 13% - 5% =
8%, so the risk premium on this security should be half of this or 4%. So the expected return
should be equal to the risk-free rate + the risk premium = 5% + 4% = 9%. Therefore the price =
$100 / 1.09 = $92.