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

Questions and Problems:


4.1 Potential consumption next year is: $108,000 – ($135,000 – $85,000) (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 Potential consumption next year is: $38,000 + ($55,000 – $20,000) (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 a. Ben’s consumption next year = ($4,000 – $2000 – $1,000) (1+ r) +$3000= $4,150

Solving these equations gives r = 0.15 or 15%


b. If interest rate increases, Ben’s consumption increases for this year.

Ben is better off than before the interest rises.


4.4 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 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 a. Since the PV of labour income is $70, 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 a. Market interest rate = (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


4.8 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 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.