Solution of 3 Practice Problems on Financial Economics - Exam 2 | ECN 134, Exams of Economics

Download Solution of 3 Practice Problems on Financial Economics - Exam 2 | ECN 134 and more Exams Economics in PDF only on Docsity! ECN 134 SOLUTION KEY #2 1. i) The firm must invest today the amount x which solves the equation x× (1.08)27 = 1, 500, 000, i.e. x = $ 187, 780 . ii) PV of the Smiths’ offer: $ 115,000. PV of the Joneses offer: 11.13 150000 = $112, 700. You should choose the Smiths’ offer. iii) a) PV = 10000.1 = 10, 000 . b) PV = 11.1 500 0.1 = 4, 545 . c) PV = 11.12 2420 0.1 = 20, 000 . 1 2. r = 0%: Add the stream of payments: -150 + 8×(-10) + 12×(50 × 0.6) = 130 . Perfect competition implies free entry and exit. Therefore, as long as positive profits exist in nut trees, the price of trees will be bid up (or the price of the final product will be bid down through increasing supply). This drives the net present value of the nut tree to zero. -150 + 8×(-10) + 12×(50×p) = 0 has solution p = 23/60 = 0.383 . r = 4%: Use the annuity formula for each of the three streams: -150 + [-10/0.04×(1-1/1.048)] + 1/1.048×[50×0.6/0.04×(1 - 1/1.0412)] = -11.6 . The equilibrium price has to be higher since the NPV is currently less than zero. To find the equilibrium price, set NPV equal zero and solve for p: -150 + [-10/0.04×(1 - 1/1.048)] + 1/1.048 × [50×p/0.04×(1-1/1.0412)] = 0. Then the equilibrium price is: 0.63 . -150 + [-10/0.04×(1 - 1/1.048)] + 1/1.048 × [50×p/0.04×(1-1/1.04120)] = 0. Thus, if the trees bear fruit for 120 years, the equilibrium price is: 0.24 . Because we value future payments less than current payments - the higher the interest rate or the further into the future, the greater the discount. Ten times as productive does not mean ten times the ”value”. An imperfect analogy might be to diminishing marginal returns: since each increase in the tree’s productivity comes further off, each increase must be worth less and less. 2