Econ 479/592 STUDY QUESTIONS FOR ECONOMICS 479 Prof. Thornton

Below are 10 study questions. Six of these questions will appear on the exam. You will answer a total of four questions. One question will be required. You will then choose any 3 of the remaining 5 questions. Keep in mind that you will have one hour and fifteen minutes to answer 4 test questions. This gives you about 19 minutes per question. Make sure you keep this time constraint in mind when preparing your questions. You will be allowed to bring to the test a “crib sheet” with the calculations for questions 6, 7, and 9. However, this crib sheet must contain only numbers, it cannot have any words.

1.  What is financial economics? How does financial economics pertain to households and business firms in the economy? Discuss.

2.  Most of the theories and models in financial economics are based on the assumption that the objective of the firm is to maximize stockholder wealth. Many financial economists argue that this should be the objective of the firm and that this is the objective of the firm. Discuss the nature of this assumption and the normative and positive arguments for it. Do you agree with these arguments? Yes/no. Explain.

3.  Two important types of securities traded on the nation’s money market are treasury bills and commercial paper. Compare and contrast these two money market instruments. Briefly explain how the primary and secondary market for each of these securities is organized.

4.  The financial system performs 6 important functions. Three of these functions are to transfer funds, transfer risk, and provide information. Carefully explain these 3 functions. Provide examples of how the financial system performs each of these functions.

5.  What is a derivative? What are two purposes for which derivatives can be used? Compare and contrast a forward contract and a futures contract. How are they similar? How do they differ? Why are both of these contracts classified as “derivatives”?

6.  You are currently age 51 and employed as a high school teacher making $40,000 per year. You plan to retire permanently from work at age 55. You are thinking about making a career change. To do so you would quit your current job, attend law school full time for two years and get your law degree. Law school will cost you $30,000 per year. A law firm has agreed to hire you after you finish law school and pay you a salary of $120,000 per year for 2 years until you retire at age 55. Assume that the annual interest rate for this 4 year period is 10%. Is this decision a financial decision? Yes/no. Explain. Is this decision an investment decision? Yes/no. Explain. If your objective is to maximize your wealth, would you make the career change? Carefully explain the logic of your decision process and show your work.

7.  You buy 100 shares of Equifax stock at $50 per share and hold it for 3 years. At the end of years 1, 2, and 3, the price of Equifax is $55, $47.50, and $50.25 respectively. Each year Equifax pays a dividend of $2 per share. The inflation rate for year 1, 2, and 3 is 3%, 1%, and 4% respectively. The interest rate on Treasury bills for each year is the same as the inflation rate. You want to measure the performance of your investment in Equifax. Calculate the nominal rate of return for each year. Calculate the real rate of return for each year. Show your work. Interpret these measures. Which measure is the best measure of your yearly performance? Explain. Now calculate the best measure of the average annual rate of return for the 3 year period. Show your work. Interpret this measure of performance. Did your investment in Equifax stock perform better or worse than T-bills over this 3 year period? Justify your answer.

8.  Woodco Corporation, a large furniture producer, has just hired a new Chief Executive Officer (CEO). In an interview with the Wall Street Journal he states: “Financial decisions made by Woodco management in the recent past, such as the acquisition of a firm that sells kitchen supplies, and the production of a new line of furniture for the low end of the market, have done nothing but destroy value. We need to find ways to increase the value of this firm and create value for stockholders.” Given what you know about business firm analysis of investment projects, interpret this statement. Explain how Woodco’s financial decisions may have “destroyed value” in the past, and how management might “create value” in the future.

9.  You have been recently hired as the manger of product development for Thornton Sports Gear Inc., a large producer of athletic goods. You come up with an idea for producing a new type of running shoe: the T2000. You are aware that this is a risky investment project, but after doing a discounted cash flow analysis you decide that the project is worth adopting. To convince the CEO, J. Thornton, that he should expand the firm’s product line and produce the T2000, you must make a formal presentation of your project analysis. You know that Thornton wants to maximize stockholder wealth (especially since he owns 40% of the firm’s stock), but he knows very little about financial economics. Carefully explain to Thornton the logic of your analysis and why the firm should expand its product line and produce the T2000. To do this, make-up your own numbers, but keep the example simple. (There is no need to make-up an example that has the level of detail of the example given in class). What is important is the logic and clarity of your explanation. Keep in mind you will have limited time to answer this question if it is asked on the exam.

10.  You are given the following information about Digital Computer Corporation stock, a large manufacturer of personal computers whose stock is actively traded on the N.Y. Stock Exchange and followed by a number of stock market analysts.

Price per share: $42

Earnings per share for most recent year: $3

Average price/earnings ratio for comparable computer firms: 10

Estimated cash flow per share for current year: $2

Estimated annual growth rate of cash flow: 7%

Estimated required rate of return (discount rate) for stock: 11%

Estimate the true value of the stock using the discounted cash flow valuation approach,

relative valuation approach, and efficient market hypothesis approach. When necessary show

your work and explain. According to each approach, is the stock undervalued, overvalued, or

fairly priced? Which approach do you believe is the best approach to value this stock? Why?

Justify your answer.

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