Chapter 4: Financial Markets and Net Present Value: First Principles of Finance

Questions and Problems:

4.1 Currently, Jack Morris makes $85,000 per annum. Next year his income will be $108,000. Jack is a
big spender and he wants to consume $135,000 a year. The equilibrium interest rate is 7 percent. What
will be Jack’s consumption potential next year if he consumes $135,000 this year?
Potential consumption next year is: $108,000 – ($135,000 – $85,000) x (1.07) = $54,500
In order to consume $135,000 this year Jack will borrow $50,000 and pay $53,500 ($50,000
principal and $3,500 interest) next year, leaving him $54,500 potential consumption next year.

4.2 Rachel Pettit is a miser. Her current income is $55,000; next year she will earn $38,000. She plans
to consume only $20,000 this year. The current interest rate is 9 percent. What will Rachel’s
consumption potential be next year?
Potential consumption next year is: $38,000 + ($55,000 – $20,000) x (1.09) = $76,150
Rachel will earn $3,150 interest on the $35,000 she lends out this year, which will increase her
potential consumption by $38,150 to $76,150 next year.

4.3 Ben Netanyahu earns $4,000 this year and zero income the next year. Ben also has an investment
opportunity in which he can invest $2,000 and receive $3,000 next year. Suppose Ben consumes
$1,000 this year, invests in the project, and consumes $4,150 next year. A. What is the market
rate? B. Suppose the interest rate increases. What will happen to Ben’s consumption for this year?
Is Ben better or worse off than before the interest rate rise?

a. Ben’s consumption next year = ($4,000 – $2000 – $1,000) x (1+ r) +$3000= $4,150
Solving these equations gives r = 0.15 or 15%

b. If the interest rate increases, Ben’s consumption increases for this year. With a consumption
of $4,150 next year, Ben will have to invest less than $2,000 in the project and lend out less
than $1,000 this year, so that he has more than $1,000 to consume this year. Ben is better off
than before the interest rises.

4.4 What is the basic reason that financial markets develop?

Financial markets arise to facilitate borrowing and lending between individuals. By borrowing and
lending, people can adjust their patterns of consumption over time to fit their particular preferences.
This allows corporations to accept all positive NPV projects, regardless of the inter–temporal
consumption preferences of the shareholders.

4.5 Suppose that the equilibrium interest rate is 5.3 percent. What would happen in the market if a
group of financial intermediaries attempted to control interest rates at 4 percent?
There would be too much borrowing and there would be insufficient lending at 4%. The borrowers would
have to be given limited access to the market. This would also be an irresistible arbitrage
opportunity that could not last long and a new equilibrium would be set,
this would occur if arbitrageurs borrow at 4% and then lend at 5.3%.

4.6 The following figure depicts the financial situation of Jane Fawn. In period 0, her labour income
and current consumption are $50; later, in period 1, her labour income and consumption will be
$44. She has an opportunity to make the investment represented by point D. By borrowing and
lending, she will be able to reach any point along the line FDE. A. What is the market rate of

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 interest? (Hint: The new market interest rate line EF is parallel to AH.) B. What is the NPV of
point D ? C. If Jane wishes to consume the same quantity in each period, how much should she
consume in period 0? Assume the investment represented by point D is undertaken.

a. Since the PV of labour income is $70 (point A), and $70 = $50 + $44/(1 + r), r must be equal to
120%.

b. NPV = $85 – $70 = $15

c. Her wealth is $85. Letting C denote consumption, she wants

$85 = C + C/(1 + r) where r = 120%. Solve for C; C = $58.44

4.7 Enrique Rodrigues has $54,300 this year, as represented by point A. He has the opportunity to make
an investment in productive assets represented by point B in the following figure. He wants
to consume $25,000 this year and $60,000 next year. This pattern of consumption is
represented by point F. By borrowing or lending, he will be able to reach any point along the
line DBC.
A. What is the market interest rate? B. How much must Enrique invest in financial assets and productive
assets today if he follows an optimum strategy? C. What is the stand-alone NPV of the
investment at point B ?

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

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a. The market interest rate, r, is such that: $65,000 = $97,500/(1 + r)
r = (97,500/65,000) – 1 = 0.5 = 50%

b. Investment in productive asset = $54,300– $30,200 = $24,100

Investment in financial assets = $54,300 (how much he has today) – $24,100 (investment cost
above) – $25,000 (consumption today) = $5,200

c. NPV = – $24,100 (investment cost) + ($52,200 – $16,050)/1.5 = $0

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

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4.8 To answer this question, refer to the figure below. The Badvest Corporation is an all-equity firm
with BD in cash on hand. It has an investment opportunity at point C, and it plans to invest AD in real
assets today. Thus, the firm will need to raise AB by a new issue of equity. A. What is the NPV of the
investment? B. What is the rate of return on the old equity? Measure this rate of return from before the
investment plans are announced to afterward. C. What is the rate of return on the new equity?
j

a. The PV of the investment is AE. The NPV of the investment is DE.

b. CF / BD – 1. The equity will appreciate to BE on the announcement.

c. AF / AB – 1.

4.9 Assume that capital markets do not exist. Ryan has $70,000 today (t = 0) and will receive $90,000
in exactly one year (t = 1) . The graph below illustrates point Y: having $70,000 now and
receiving $90,000 next year. Here, if no capital or financial market exists, then Ryan must
consume $70,000 now and $90,000 next year. Next consider this case when borrowing and
lending at r = 10% are available in the financial markets; Ryan now has a real investment
opportunity, or business project. If Ryan decides to accept this opportunity, it will cost $20,000
now ( t = 0 and will offer a risk-free payoff of $25,000 next year. Now, revisit the point Y where
Ryan has $70,000 now and will receive $90,000 next year, but this time the real asset project
exists. Assume that he still wants to consume $70,000 now (t = 0) , and answer the following.
A. How much more can Ryan consume next year, with the investment opportunity, compared to when
there was no borrowing or lending opportunity? B. Calculate the NPV of the project.

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

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a. Ryan can consume $3,000 [(115,000 – 90,000) – 20,000x1.1] more assuming that the
investment opportunity is undertaken.

b. NPV = – $20,000 + $25,000/1.1 = $2,727.

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