1.1 Households make four kinds of economic decisions. Suppose you have two households with the same income. Household A has one income earner and Household B has two income earners.
How would the four types of economic decisions differ between these two otherwise identical households?
1.2 Three friends have just graduated, each with a B.Mgt. degree. One wants to start a restaurant and another wants to work as a subcontractor in a building trade. The third friend wants to put together a firm with a couple of other graduates to provide several kinds of complementary financial services including insurance, financial planning, and bookkeeping.
What form of business organization (textbook, pp. 8-9) would you suggest each of the three friends should use, and why?
2.1 Adam Smith is often called the father of economics. His famous book, The Wealth of Nations, talks about an "invisible hand" which automatically allocates goods to the persons most able to put them to good use. The invisible hand operates through the price mechanism for goods and services, so that individuals who trade on the market, while seeking only their own good, are actually efficiently allocating society's resources.
His ideas, if applied to modern capital markets, imply that these markets would efficiently allocate investment capital to the firms that would use the capital most efficiently in producing goods and services for society. But this would happen only if markets were left to operate without state intervention.
Do you think modern governments should leave capital markets unregulated? Why or why not?
2.2 Consider a business firm, organized as a proprietorship, which has $100,000 invested in assets-a bank loan of $80,000 and $20,000 personal capital invested by the proprietor. If the firm becomes insolvent, who is at risk? Why?
2.3 In each of the following situations, moral hazard or adverse selection may be present. Indicate which you think is present, if any, and explain your choice.
a. An insurance company is thinking about issuing health insurance to a firm's employees.
b. An insurance company has issued health insurance to a firm's employees on the basis of their medical histories.
c. An investor is asking for a bank loan to support a new business she wants to operate. She is unwilling to submit to a credit check.
d. An investor has purchased shares in a new software company. He is just a shareholder, and is not going to be involved in the daily operations of the firm.
e. A grandfather has just given his grandson $100 as a birthday present.
2.4 In each of the situations considered in question 2.3, what could be done to overcome the problem?
3.1 Use the information in the following table to calculate the following ratios. Use the results to discuss and compare the financial positions of the two firms.
Ratios:
Total Shareholder Return
Return on Sales
Return on Assets
Return on Equity
Asset Turnover
Times Interest Earned
Debt Ratio (You'll need to calculate the average debt during the year.)
Spaling Preston
EBIT (Earnings before Interest and Taxes) 300,000 190,000
Interest Expense 10,000 15,000
Net income 200,000 100,000
Dividend payout ratio 35% 40%
Retention ratio 65% 60%
Sales 3,000,000 2,000,000
Average assets during the year 2,500,000 1,500,000
Average shareholders' equity during the year 1,800,000 1,000,000
Market price per share
Beginning of year 20 18
End of year 15 20
Number of shares outstanding 150,000 50,000
3.2 Assume you have put $1,000 in a savings account at 10% annually compounded interest.
a. How much could you take out each year and still have the original $1,000 in the account?
b. If you left half of the interest earnings in the account, at what rate would the balance grow from year to year?
c. If you took out 80% of the interest earnings in the account, at what rate would the balance grow each year?
3.3 Imagine a corporation with $1,000,000 of assets and a debt ratio of 40%. ROE (return on equity) is expected to be 20% for the foreseeable future. Assume the firm keeps the same amount of debt indefinitely (as opposed to keeping the same debt ratio).
a. What do you expect the firm's earnings to be for the next 3 years if the firm doesn't pay out any dividends or re-purchase any shares?
b. If the firm doesn't pay any dividends or re-purchase any shares, at what rate would the firm grow from year to year?
c. If the firm pays 50% of its earnings as dividends, at what rate would the firm grow from year to year?
d. If the firm uses 80% of its earnings to re-purchase shares from its shareholders, at what rate would the firm grow from year to year?
e. If the firm pays 50% of its earnings as dividends, and uses an additional 20% of its earnings to re-purchase shares from its shareholders, at what rate would the firm grow from year to year?
f. What does the term "Sustainable Growth Rate" mean? Would the amounts you have calculated in parts b. to d. equal the Sustainable Growth Rate for the firm?
4.1 Assume that the correct discount rate for the following cash flows is 8%. What is the present value of the following cash flows?
a. $50 at the end of 3 years
b. $50 at the end of 100 years
c. $50 received at the end of each year for 20 years
d. $50 received at the beginning of each year, totaling 20 payments
4.2 Assuming an 8% discount rate, what is the future value of the following cash flows?
a. future value in 3 years of $50 received now
b. future value in 100 years of $50 received now
c. future value at the end of 20 years of $50 received each year at the end of the year
d. future value at the end of 20 years of $50 received each year at the beginning of the year, again totaling 20 payments
4.3 Calculate the following values, assuming a discount rate of 8%:
a. present value of a perpetuity (also called a perpetual annuity) of $50 received each year at the end of each year
b. present value of an annuity of $50 received at the end of each year for 5 years
c. present value of an annuity of $50 received at the end of each year for 10 years, with the first payment to be received at the end of the 6th year
d. present value of an annuity of $50, with the first payment received at the end of the 16th year
4.4
a. Show (with a time line, for example) that the perpetuity in 4.3a. is exactly the same as the sum of the annuities and perpetuities in 4.3b. to 4.3d.
b. Show that their present values add up to the same amount.
4.5 a. Jane is 20 years old today. Jane is going to put $1,000 into her savings account on her 21st birthday and again on every birthday for 20 payments (i.e., till her 40thbirthday). She will earn 5%, paid annually. How much money will be in the account after she collects her interest and makes her 20th payment?
b. Calculate how much money she could take out each year for the 20 years from her 41st birthday till her 60th birthday, assuming she still earns 5% and takes out the same amount each year, leaving exactly $0 in the account after removing her 20th payment.