4. E , = + (0.08)(20, 000) 5. D. Course 2 Solutions 51 May a

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1 . D According to the semi-strong version of the efficient market theory, prices accurately reflect all publicly available information about a security. Thus, by this theory, actively managed portfolios should not be able to consistently outperform the rest of the market. All available information has already been incorporated into the current market price. 2. A The private market does not usually provide public goods since it is impossible to exclude non-paying customers. This often makes it impossible for a private firm to collect sufficient revenue to cover the cost.. E An increase in business inventories indicates that demand is not as high as businesses anticipated, resulting in inventory accumulation. The decrease in demand is a reflection of the downturn in economic activity. 4. E X = = 85. a , = + (0.08)(20, 000) S20 j S = j j = 4.8% 5. D X B= X a = 0.4 n i n C = v Xan 2n X J = v i 0.4 n a = v = 0.6 n i X J = 0.6 i Course 2 Solutions 5 May 200

2 6. E The licensing fee works the same as an increase in fixed costs; it shifts the market supply upward, increasing price and decreasing quantity demanded. At the firm level, however, it increases average costs without changing marginal costs; therefore, the representative firm increases output. This apparent paradox is resolved by the fact that in the long run some firms will go out of business. 7. D Seth = = = Janice = 5000 ( 0.06)( 0) = Lori = P(0) 5000 = where P= = a The sum is C Additional paid-in capital will be $,200,000 (($ per share $ par value) 00,000 shares = $200,000 increase). 9. D For a normal good, a price decline results in a positive income effect and a quantity increase larger than would be the case for a compensated price decline. 0. C Project X: Annual cash flows of (immediate annuity at 0% with PV = 4000). Payback 4000 in 6 th year. NPV discount rate = (0.07) = 0.06 Annuity at 6% of cash flows of 4000, ,, = Project Y: Payback in 5 th year IRR is interest rate such that: 4000 = 6600v 5 IRR = 0.5% NPV = /(.06) 5 = % Course 2 Solutions 52 May 200

3 . B decl bal 0 X d = ( ) ( d ) = ( 0.25) 7 X 8 /0 ( ) Depr = X X 0.25 = X 7/0 sum of yrs digits 0 i = first 7 yrs depr = 55 7 X 49 Depr = Y X X = Y X = Y 2. E Bruce's interest, year : 00 0 = X ( d) ( d) Robbie's interest, year 7: ( d ) 6 = X = d ( d ) 0 d ( d) 6 = d = 0.9% 2 X = 00 = ( ) 0. D If you assume: Annual repayments of interest and principal repayments are level. Year (t + ) principal repaid = v n t Year t interest repaid = i an + = v n t+ t Total = v n t+ + v n t = v n t (v ) = v n t ( ( v)) = + v n t (d) 4. B Real wages can grow only when there is labor productivity growth or labor s share of product increases. The latter has remained relatively constant for long periods so the former is the primary source of real wage growth. Course 2 Solutions 5 May 200

4 5. D Currently Tom is making a profit of 5 a day. If he outsources delivery, Tom could double output and earn a profit of 50 excluding the delivery cost. Hence Tom could pay the delivery service up to 45 without decreasing his profit. 6. B An increase in market interest rates will result in banks lending out excess reserves which lowers free reserves and increases the money supply. 7. B 0 v = 2; 0v = 2 ( + i) 2 + ( i) ( i) ( i) = 0 2 ± 204 ( + i) = = i = 7.72% X = = / = 9.84 ( + i).0772 ( ) 8. A At the competitive price, a natural monopoly cannot cover its costs because price is below average cost at this point. 9. A Economic income = Cash flow plus change in NPV NPV = 628.4/ /(.2) 2 = 960. NPV 2 = 628.4/.2 = 52.7 Economic income = ( ) = B The relationship between money, velocity, prices, and real output is such that if real output is rowing at 2.75% per year, and velocity is increasing at.00% per year, and the inflation target is 0 to.00%, then in order to maintain the identity M + v = P + Y, where each variable is a growth rate, then it must be that money growth is between.75% and 2.75%. Course 2 Solutions 54 May 200

5 2. E The increase in the price of an input, in this case labor, drives up the marginal cost of producing chips; therefore, it leads to a decrease in the supply of chips and an increase in the price of chips. Similarly, since chips are used to make computers, the supply of computers falls, the equilibrium price of computers increases, and the quantity exchanged decreases. 22. E Let i = after-tax WACC 000 a 5 i 20,000 = a 5 i = i = 0.25%. After-tax WACC = 0.25 = r E (0.4) + r D ( T x )(0.6) = 0.4 r E + ½ r E ( 0.25)(0.6) = 0.4r E r E r E = 6.4%. 2. D An increase in government spending shifts the IS curve to the right and increases both income and interest rates. 24. C Year Year 2 Year Year 4 Dollar deductions,0 44,450 4,80 7,40 Tax shields,666 5,558 5,84 2,594 After tax rate = 0.2(0.65) = Present value =,666/ ,558/ ,84/ ,594/ = 0, C II is not true A firm will not shut down unless Marginal Costs are less than Average VARIABLE costs. 26. C Z = 00 s 6 66% Accumulated Value = X = 00( ( Is) ) = % 0.06 = (2.2) = s % Y = 00( ( Is) ) = % (02.877) = Y/X = 2.0. Course 2 Solutions 55 May 200

6 27. B ( P0 760) P0(0.06).0P0 760 Chris s return = = 0.5P0 0.5P0 ( P0 760) P0(0.06) 2.0P0 792 Jose s return = = 0.5P0 0.5P0 Chris s return = 2 [Jose s return].0p [.0P0 792] = 0.5 P0 0.5 P0.0P 0 = 824 P 0 = 800.0P (800) 760 i = = = 64/400 = 6%. 0.5P 0.5(800) 28. C Set up table: 0 Q P TR MR MC Monopolist will produce the largest quantity such that MR MC. At a quantity of, the demand curve produces a price of 7. Solution is the same if you assume Q is continuous. 29. B With net exports set to zero, the government expenditure multiplier is equal to y C ( T ) = 0.7( 0.) = 0.7(0.7) = 0.49 = = B (p 20) + ( p) ( 5) =.25 p = 0.75 Put value if exercised now = X ( X ) Put value if not exercised now =.25 Equate the above two, we get X = 75. Course 2 Solutions 56 May 200

7 . A Time-weighted return = 0% means: 2 X = => 2X = X 0 (2 + X ) X = 60 Dollar-weighted return: I = X X 0 = Y = = = 25% 0 + (60) E As a result of the factor-price effect, the marginal cost curves of the firms do not shift down but up.. E Assets = Liabilities + Shareholder Equity = = Net income = EBIT Interest Taxes = = 290. (Note depreciation has already been subtracted to get EBIT) Payout Ratio = 0.l0 = dividends = dividends net income 290 Dividends = 29. Retained Earnings = Net Income dividends = Retained Earnings 26 Internal Growth Rate = = = 0.875%. Assets D Competitive equilibrium occurs at Q = 0, P = 2 Consumer surplus = ½ ( 4 2) 0 = 0 Producer surplus = ½ (2 0) 0 = 0 Total surplus = 20 At constrained P = producers will only supply Q = 5 so producer surplus = ½ ( 0) 5 = 2.5 The full price to consumer (including waiting time, etc.) will be bid up to P = to eliminate excess demand. So consumer surplus = ½ (4 ) 5 = 2.5 Total surplus = 5 Deadweight loss = 20 5 = 5. Course 2 Solutions 57 May 200

8 5. A I. Only if correlations are zero. II. Beta doesn t measure correlation, it is an estimated first derivative. III. Flatter 6. C The change in the real exchange rate is equal to the change in the nominal rate times the ratio of the inflation rates. [.5/.25.0/.02] = 2%. 7. A B = = Pa = P.08 P = X = Pa X = PR = v 4 = B Year Starting Book equity ROE 20% 20% 5% 5% 5% Earnings Dividends Plowback Free C-F Starting in year Dividend growth rate g = Plowback ROE = (0.5)(0.5) = t = 2 of future dividends = t = 2 of free cash-flow = 08/( ) = 440 t = 0 of free cash-flow = 440(.5) Course 2 Solutions 58 May 200

9 9. C Since the project is to expand the firm s existing operations, the risk of the new project is the same as that of the firm s existing operations. According to MM capital structure theory, to compute the asset beta, which measures the risk of the firm s existing assets in place, we add the equity beta and the debt beta, each weighted by its proportion in the firm s capital structure. β project = 0.60 β E β D = 0.60(.5) (0.75) =.2. Then, the CAPM may be applied to find the cost of capital: R = ( ) = = E st, calculate Present value(exercise Price) (or PV[EX]): Current Share Price Since ln = -0.08, at the risk-free rate, Present Value of the Exercise Price and the Current Share Price = 00, the PV(EX) = 08.. In addition: t = 0.25, and σ = 0.4. Note that [σ * Square Root (t)] = 0.2 Based on these inputs, it is easy to calculate d and d 2 : d = -0., and d 2 = -0.5 (Exactly) Black-Scholes: N(d)*(Current Price) N(d2)*(PV[EX]) = N( 0.)*00 N( 0.5)*08. = 00(0.82) 08.(0.085) = B Price of bond = 000 ( + i) ( i) 0 ( ) S ( i) = S /2 20 /2 = = i = 9.75% / A The correct answer follows from the definition of the price elasticity of demand. The percentage change in price from the initial equilibrium is /9, and the percentage change in quantity demanded is /; hence the price elasticity of demand is.00. One can also solve the problem directly using the differential calculus: elasticity = (dq/dp)(p/q). Course 2 Solutions 59 May 200

10 4. C I. Cost of capital remains at 4% false. II. β C = D/V β D + E/V β E = / (0.) + 2/ (.65) =.2. β C =.20 >.05 Project is less risky false. III. r c = r f + β C (r m r f ) 0.4 = X X = 0.05 = 5% true. 44. D EBIT,560 Int 6,000 = 00, ,560 Tax,946 = 5, ,64 = Amount available to shareholders 45. B ROE =, ,92. 5 t 2 dt k e = 2 t 5 k 0 e = k e = k = k = B Slope of indifference curve is dy/dx = Y/X Budget line is of form 5X + Y = I Y = (/)I (5/)X Slope of budget line = 5/ = Y/X Y = (5/)X (5/)X*X = 2 X 2 = 7.2 X = A Monetarists believe that in the long run, real output is not affected by monetary growth, but is affected by technology and the growth of inputs. Course 2 Solutions 60 May 200

11 48. A Current capitalization rate is: P 0 = DIV /(r g) = 0.50/(r 0.075) r = 0.50/28.50 = r = When the long-run growth rate changes, current price should adjust to reflect this change, and to keep the expected rate of return constant. P 0 = 0.50/( ) = B ann eff 2 i = (.05) = Tawny: δ = ln (.025) = Y At t = 5, = δ t = 5 = Y = Y Z = ( ) = A = a = a 50 j n j j = 7.00%, soa =.79 n 6% n = 0.2 Course 2 Solutions 6 May 200

12 Course 2 May 200 Answer Key D 26 C 2 A 27 B E 28 C 4 E 29 B 5 D 0 B 6 E A 7 D 2 E 8 C E 9 D 4 D 0 C 5 A B 6 C 2 E 7 A D 8 B 4 B 9 C 5 D 40 E 6 B 4 B 7 B 42 A 8 A 4 C 9 A 44 D 20 B 45 B 2 E 46 B 22 E 47 A 2 D 48 A 24 C 49 B 25 C 50 A Course 2 Solutions 62 May 200

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