Chapter 27: The Basic Tools of Finance

1. All financial decisions involve two concepts .They area. time and money. Incorrect. Money is not a concept but a financial variable.

b. money and risk. Incorrect. Money is one of the measures of financial activity.

c. time and risk. Correct. The length of time and the level of risk are the two key questions in every financial problem.

c. saving and investment. Incorrect. These are the two activities coordinated by the financial system.

2. The financial system coordinates two activities that are central to the macroeconomy:

a. money and wealth. Incorrect. These are measures of financial variables.

b. saving and investment. Correct. These are the two flows that enable productivity growth.

c. consumption and saving. Incorrect. Consumption does not flow through the financial system.

d. taxes and government spending. Incorrect. These variables flow through the government sector not the financial sector.

3. When a person does not consume some of her income, this action is referred to as

a. investing. Incorrect. Investing is the spending by businesses on new equipment.

b. spending. Incorrect. Spending is just another name for consumption expenditures.

c. financing. Incorrect. This refers to the process of borrowing to fund an investment project.

d. saving.

Correct. Saving is the residual amount left after spending out of current income.

4. When making saving and investment decisions, the future is

a. perfectly known. Incorrect. Future conditions are never completely knowable.

b. perfectly predictable. Incorrect. Like weather forecasting, economic forecasting is an inexact science.

c. impossible to know about at all. Incorrect. Past data and economic theory are useful general guides to possible future conditions.

d. risky and uncertain. Correct. No system of theory or forecasting is close to 100% accurate.

5. Compared to $100 next year, $100 this year is

a. of equal value. Incorrect. The same amount is more valuable today.

b. of greater value. Correct. The same amount is always more valuable today than in the future.

c. of lesser value. Incorrect. Money decreases in value the farther into the future it is received.

d. impossible to compare. Incorrect. Present value calculations make precise comparisons possible.

6. As the interest rate increases, the present value of a future sum of money will

a. increase. Incorrect. The present value amount and the interest rate are inversely related.

b. remains the same. Incorrect. The present value and the interest rate must move in opposite directions.

c. decrease.

Correct. The present value and the interest rate are inversely related.

d. increase at an increasing rate. Incorrect. The two variables will always move in the opposite direction at a constant rate.

7. As the interest rate decreases, the present value of a sum of money will

a. increase. Correct. The present value and the interest rate are inversely related.

b. remains the same. Incorrect. The present value and the interest rate must always move in the opposite direction.

c. decrease. Incorrect. As the interest rate falls, money today becomes more valuable in comparison to the future.

d. increase at an increasing rate. Incorrect. The present value and the interest rate will move in opposite directions at a constant rate.

8. If the interest rate rises from 5% to 10%, the promise of $100 in the future becomes

a. less valuable today. Correct. As interest rates rise, it takes less money today to increase in value to $100.

b. more valuable today. Incorrect. Rising interest rates make a sum of money today less valuable.

c. more risky. Incorrect. The level of interest rates affects present value not riskiness.

d. increasingly valuable. Incorrect. Rising interest rates move present value in the opposite direction.

9. If the interest rate falls from 10% to 5%, the promise of $100 in the future becomes

a. less valuable today. Incorrect. As interest rates fall, present values increase.

b. less risky. Incorrect. A change in interest rates does not necessarily change levels of risk.

c. more valuable. Correct. The interest rate and the promise of future payment are inversely related.

d. harder to evaluate. Incorrect. The present value equation can predict values from any interest rate.

10. Rising interest rates will usually make business investment projects

a. more risky. Incorrect. The level of risk does not necessarily change as interest rates change.

b. less risky.Incorrect. Interest rate changes affect present value more closely.

c. more profitable. Incorrect. Rising interest rates reduce the value of a future stream of profits.

d. less profitable. Correct. As the interest rate rises, future levels of profit become less valuable.

11. Present value helps explain the

a. upward slope of loan able funds demand. Incorrect. Loanable funds demand has a downward slope.

b. upward slope of loanable funds supply. Incorrect. Present value is related to the demand for loanable funds.

c. downward slope of loanable funds demand. Correct. At lower interest rates, the quantity of loanable funds demanded increases.

d. downward slope of loanable funds supply. Incorrect. The loanable funds supply curve is upward sloping.

12. Loanable funds demand refers to the use of money for

a. savings accounts. Incorrect. Saving is a source or supply of loanable funds.

b. buying stocks and bonds. Incorrect. Both of these activities are a form of saving.

c. business investment spending. Correct. Business firms borrow money to finance investment expenditures.

d. earning interest income. Incorrect. Loanable funds demanders will pay interest for the funds they borrow.

13. If you win the lottery and are given a choice of $1,000,000 today or $2,000,000 in ten years, you will need to consider

a. how much you want the money. Incorrect. This may be important but will not help you decide between the two amounts.

b. the price level. Incorrect. It may be valuable to know the future rate of inflation.

c. the interest rate. Correct. This will tell you how fast $1,000,000 will turn into $2,000,000.

d. the stock market index. Incorrect. This will tell you how much stock you can buy now.

14. If you anticipate your salary increasing at 2% a year, how long will it take your salary to double?

a. Two years. Incorrect. The two percent refers to growth rate not number of years.

b. Twenty years. Incorrect. It will take even longer than this to double.

c. Thirty five years. Correct. This is the answer obtained from the rule of 70.

d. Fifty years. Incorrect. This would be right if there were no compounding effect.

15. According to the rule of 70, if a country's population is growing at 5%, it will double in size in

a. Five years. Incorrect. The 5 is the percent growth not the number of years.

b. Fourteen years. Correct. This is the answer using the number 70 in the numerator.

c. Twenty years. Incorrect. This would be correct if there were no compound effects.

d. Seventy years. Incorrect. Seventy is the rule not necessarily the answer.

16. If Monica's income grows at 3% a year and Chandler's income grows at 4% a year, how many more years will it take Monica's income to double compared to Chandler's?

a. Seventy years. Incorrect. This is the rule of 70 number not the answer.

b. Three years. Incorrect. The 3% growth rate does not directly indicate the number of years.

c. Four years. Incorrect. The 4% growth rate does not directly affect the number of years.

d. Six years. Correct. It will take approximately 23 years for Monica's income to double and 17 years for Chandler's to double.

17. The formula for the rule of 70 can be expressed mathematically as

a. 70 x X. Incorrect. 70 must be divided by X.

b. 70/X. Correct. The number of years must be divided into 70.

c. X/70. Incorrect. This is the inverse of the correct expression.

d. 70 x 70. Incorrect. The rule requires 70 to be divided by the percent growth number.

18. Most people are assumed by economists to be

a. risk lovers. Incorrect. Most people tend to avoid risk if possible.

b. risk averse. Correct. Most people do not like to take risks, especially with money.

c. compulsive gamblers. Incorrect. This is similar to being a risk lover.

d. confident of the future. Incorrect. People have difficulty forecasting the future.

19. Additional income is less valuable than previous income because of the principal of

a. diminishing marginal utility. Correct. Additional dollars are less valuable because additional goods add less to total utility.

b. comparative advantage. Incorrect. This is an important principal in foreign trade.

c. increasing costs. Incorrect. This is an important concept in business costs.

d. variable costs. Incorrect. This is a factor in business profit decisions.

20. As the level of wealth increases the utility function will

a. get steeper. Incorrect. This implies that additional wealth is more valuable than previous wealth.

b. shift upward. Incorrect. The function will not shift only change slope.

c. shift downward. Incorrect. The function will not shift only change slope.

d. get flatter. Correct. This means that additional wealth is not as valuable as lower levels of wealth.

21. Because most people are risk averse, they will value

a. winning $100 more than losing $100. Incorrect. Loss involves lower income which is more valuable dollar for dollar than higher income.

b. winning $100 equal to losing $100. Incorrect. Losing implies a lower income and a loss of more marginal utility.

c. winning $100 less than losing $100. Correct. The loss reduces more valuable income and winning increases less valuable income.

d. winning $50 more than losing $100. Incorrect. This would only be true if people were risk lovers.

22. From the standpoint of macroeconomics, insurance coverage will

a. eliminate risks. Incorrect. Insurance will spread the risk around and reduce individual costs of loss.

b. reduce risk to the economy. Incorrect. Insurance will only reduce risk to individuals in the economy.

c. spread the costs of risk. Correct. Individual risk will be reduced and each household will face less total risk.

d. increase risks. Incorrect. On a macroeconomic basis, insurance will neither increase nor reduce risk.

23. The probability that more accident prone individuals will apply for insurance is an example of

a. adverse selection. Correct. More risky individuals face a higher probability of loss.

b. moral hazard. Incorrect. This refers to practice after insurance is obtained.

c. diversification.

Incorrect. This is a principal in stock market selection.

d. appreciation. Incorrect. This is the result of an increase in stock market prices.

24. When a person with auto insurance starts to drive more recklessly, this is an example of

a. adverse selection. Incorrect. This is the label for pre-existing negative characteristics.

b. moral hazard. Correct. The reckless driver is creating a hazard for the insurance company.

c. diversification. Incorrect. This is a principal in stock market finance decisions.

d. idiosyncratic risk. Incorrect. This is the term for the possibility of loss from a stock market purchase.

25. When you use all your available funds to buy stock in only one company, you are putting yourself in jeopardy of

a. adverse selection. Incorrect. This refers to the negative behavior of individuals as parties to a contract.

b. moral hazard. Incorrect. This describes irresponsible behavior by a party to an agreement.

c. diversification. Incorrect. This is the opposite of buying only on stock.

d. idiosyncratic risk. Correct. You are risking all your funds on the performance of one company.

26. One common method of reducing the risk of owning corporate stocks is to employ

a. unanimity. Incorrect. This might mean owning only a single company's stock.

b. adverse selection. Incorrect. This refers to pre-existing negative qualities.

c. diversification. Correct. This is the practice of spreading risk by owning stocks in several different companies.

d. idiosyncratization. Incorrect. This may refer to putting all your eggs in one basket.

27. The major loss of the average worker at Enron after Enron collapsed was the loss of

a. a job which they will never get back. Incorrect. Most workers are able to move to jobs at other companies.

b. nationalized health care. Incorrect. There is no nationalized health care in the United States.

c. residence permits allowing them to live in Houston. Incorrect. The City of Houston does not require residence permits.

d. pension assets. Correct. Most workers had the majority of their pension fund's savings only in Enron stock.

28. One method of measuring the risk of a stock is to use statistics to calculate

a. diversification. Incorrect. This is the practice of buying several stocks to reduce risk.

b. standard deviation. Correct. This is the measure of how volatile a stock price has been.

c. adverse selection. Incorrect. This is not a statistic but rather a behavioral practice.

d. portfolio return. Incorrect. This is the measure of the net gains of owning a group of stocks.

29. As more stocks are added to an individual's portfolio, what happens?

a. Idiosyncratic risk decreases.

Correct. The risks associated with owning only one company's stock can be eliminated.

b. Idiosyncratic risk increases. Incorrect. Diversification is a key method of reducing the total risk of a portfolio.

c. Aggregate risk decreases. Incorrect. Aggregate risk refers to the entire economy and this is not affected by individual decisions.

d. Aggregate risk increases. Incorrect. Aggregate risk reflects the macroeconomy and does not change with individual decisions.

30. Diversification cannot reduce which kind of risk associated with owning stocks?

a. Idiosyncratic risk. Incorrect. Buying several different stocks will reduce the risks associated with owning only one company's stock.

b. Aggregate risk. Correct. Buying more stocks does not affect the performance of the overall economy.

c. Adverse selection. Incorrect. This term is not relevant to stock ownership risk.

d. Moral hazard. Incorrect. This is another term not relevant to stock market ownership.

31. One of the key Ten Principals of Economics that is relevant to financial decisions involves the tradeoff between

a. inflation and unemployment. Incorrect. This is a macroeconomic tradeoff relevant to the entire economy.

b. exports and imports. Incorrect. This refers to the potential gains for foreign trade.

c. risk and return. Correct. All financial decisions involve both potential gain and potential loss.

d. taxes and spending. Incorrect. This involves the role of government in the economy.

32. If you are give a choice of two financial assets and one has a potential return of 10% and the other has a potential return of only 3%, you might reasonably conclude that the asset with a potential return of 10% is

a. a better deal. Incorrect. It is also probably more risky and susceptible to loss.

b. more secure. Incorrect. The higher the potential return the less safe the return.

c. less secure. Correct. Higher rates of return are necessary to compensate for higher risks of loss.

d. less risky. Incorrect. Higher rates of return are usually signals of higher risk.

33. Which of the following assets would probably have the lowest expected return?

a. a U.S. government bond. Correct. It would also have the lowest expected risk.

b. a stock issued by the government of Argentina. Incorrect. The recent financial troubles in Argentina would make this more risky.

c. a stock issued by a start-up web design company. Incorrect. This would be very high risk and would have to promise a potential high return.

d. a bond issued by United Airlines. Incorrect. A company in bankruptcy is very risky and would have to pay a high return.

34. Judging the value of a stock by looking at the real factors determining the value of the stock is called

a. diversification. Incorrect. This term refers to the process of buying several stocks to reduce risk.

b. efficient analysis. Incorrect. This term is more relevant to the view that the price is the only important factor.

c. fundamental analysis. Correct. This uses data relevant to the particular company and its market.

d. risk analysis. Incorrect. This is the process of using standard deviation to determine statistical changes in stock prices.

35. The theory that the market price reflects all knowable information is called the

a. diversification theory. Incorrect. This theory states only that you should buy several different stocks.

b. efficient markets hypothesis. Correct. This theory says that analyzing individual companies is a waste of time.

c. fundamental analysis theory. Incorrect. This view believes that something can be learned by professional analysis.

d. portfolio risk theory. Incorrect. This is another way of labeling the process of diversification

36. If the stock market is informationally efficient, then stock prices should behave

a. as professional analysts predict. Incorrect. Fundamental analysis does not add any additional information to market prices.

b. as the Fed moves interest rates. Incorrect. The stock market reacts in random ways to monetary policy.

c. like a random walk. Correct. Stock prices contain all necessary information and no one has any additional valuable information.

d. like a smooth time line. Incorrect. Stock prices are very volatile and follow no specific patterns.

37. If you believe that stock prices are informationally efficient, you can save money by buying only

a. government bonds. Incorrect. You would lose the higher returns of stock ownership.

b. managed funds. Incorrect. Informational efficiency means there is nothing to be gained from professional advice.

c. index funds.Correct. These funds do not pay for professional managers.

d. foreign stock funds. Incorrect. These funds may be quite risky for several reasons.

38. Most financial market research suggests that professional fund managers often

a. beat the market. Incorrect. They usually fail to achieve the returns of a market average.

b. under perform indexes. Correct. Index funds, which are not managed, usually do better than professionally managed funds.

c. are worth the expense. Incorrect. They fail to beat index funds which employ no professional managers.

d. smarter than uninformed investors. Incorrect. Monkeys throwing darts are often as "profitable" as professional fund managers.

39. Behavioral economics may suggest that when it comes to stock market purchases, people are often

a. motivated by greed. Incorrect. Greed would imply that they behave rationally but in their own interest.

b. rationally. Incorrect. Most behavioral studies suggest that stock purchases are often based on whims or "animal spirits."

c. irrational.

Correct. This contradicts the usual economist's assumption of consumer rationality.

d. too focused on the future. Incorrect. Research actually suggests too much emphasis on the present.

40. If you as an employee of a large corporation are given a choice of financial asset plans, which one should you choose based on the material in Chapter 27?

a. A government bond only fund. Incorrect. You will miss out on higher returns from stock ownership.

b. A professionally managed fund. Incorrect. Professional managers may not be worth the expenses they add to the costs of the fund.

c. An indexed mutual fund. Correct. This will be the least costly and highest potential gain fund at relatively low risk.

d. An amount of the company's stock equal in value to the other funds. Incorrect. You would make the same mistake as the Enron employees of not diversifying.