Review Questions

1. Provide an example of an investment.

   Investment is defined as the purchase of capital now with the intent of reaping future benefits from that capital. Examples of investment include the purchase of stocks and bonds, as well as economic transactions such as a retail firm’s investment in a new store or a manufacturing company’s purchase of a new production technology.

2. What is the benefit of using present discounted value analysis?

   Present discounted value (PDV) analysis uses interest rates and compounding to put all payments in terms of equivalent present-period dollars. The advantage of PDV analysis is that it enables us to compare payments that occur across different time periods.

3. How can you calculate the interest rate associated with a given set of assets?

   The interest rate is calculated as the interest paid on assets as a fraction of the principal, or size of the assets.

4. Describe the two main parts that make up a bond’s payment stream.

   A typical bond consists of a regular periodic payment that recurs over the bond’s entire life, or until the bond has matured. This is calculated as the bond’s coupon rate multiplied by the second part of a bond’s payment stream—its face value. A bond’s face value is the lump-sum payment paid out to the bondholder when a bond matures.

5. When will an investment’s net present value be positive? Given its sign, should you invest in this project?

   An investment’s net present value will be positive when the PDV of its benefits outweighs the PDV of its costs. This suggests that the investment is worthwhile.

6. What advantage does net present value analysis have over the use of payback periods to evaluate investment decisions?

   While payback periods are a relatively simple way to compare an investment’s initial costs to its future benefits, they do not discount an investment’s future payouts by an interest rate. As a result, payback period analysis is less reliable than NPV analysis, which considers the present-day value costs and benefits of an investment.

7. What is the approximate relationship between an investment’s nominal interest rate and its real interest rate?

   An investment’s nominal interest rate expresses rates of return in raw currency values, while the real interest rate expresses rates of return in terms of purchasing power. The real interest rate approximately equals the nominal interest rate minus the inflation rate.

8. How is the equilibrium interest rate determined in the market for capital? Who are the suppliers and demanders of capital?

   The equilibrium interest rate, like any market price, occurs at the intersection of the supply and demand of capital. In the market for capital, the demand for capital consists of firms and households making investment decisions, and the suppliers of capital, or investors, are people with the funds available to make investments.

9. How can expected value be used to evaluate risky investments?

   Expected value takes into account the uncertainty associated with an investment by using the probability that an investment payout will occur. More specifically, it is equal to the sum of the product of each possible payout and the probability that such a payout will occur.

10. What is the value of insurance to a risk-averse consumer?

    Insurance benefits a risk-averse consumer because it reduces the uncertainty associated with a given investment or situation. This reduction in uncertainty increases the policyholder’s expected utility.

11. Why do we consider diversification a key function of insurance markets?

    Because insurance companies insure many consumers, the companies can rely on diversification to reduce their own risk, as well as to earn net profits on their insurance policies. Diversification reduces the risk to an insurer by combining uncertain (and unrelated) outcomes across all policyholders. As a result, the insurer will most likely only have to pay claims on a portion of its insurance policies, while collecting premiums from all those remaining.