Questions Set 76: Solution

Solution
Options versus Futures. Explain the difference between foreign currency options and futures and when either might be used most appropriately.
Future Terminology. Explain the meaning and probable significance for international business of the following contract specifications:
Specific – sized contract
Standard method of stating exchange rates
Standard maturity date
Collateral and maintenance margins
Counterparty
Puts and Calls. What is the basic difference between a put on British pounds sterling and a call on sterling?
Buying a European Option. You have the same information as in Question 6, except that the pricing is for a European option. What is different?
Paulo’s Puts. Paulo writes a put option on Japanese yen with a strike of $0.008000/¥ (¥125.00/$) at a premium of 0.0080 cents per yen and with an expiration date six month from now. The option is for ¥12,500,000. What is Paulo’s profit or loss at maturity if the ending spot rates are ¥110/$, ¥115/$, ¥120/$, ¥125/$, ¥130/$, ¥135/$, and ¥140/$.
Black River Investments. Jennifer Magnussen, a currency trader for Chicago-based Black River Investments, uses the future quotes (shown at the bottom of the page) on the British pound to speculate on its value:
If Jennifer buys 5 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of her position?
If Jennifer sells 12 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of her position?
If Jennifer buys 3 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of her position?
If Jennifer sells 12 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of her position?
Madera Capital. Katya Berezovsky is a currency speculator for Madera Capital of Los Angeles. Her latest speculative position is to profit from her expectation that the U.S. dollar will rise significantly against the Japanese yen. The current spot rate is ¥120.00/$. She must choose between the following 90 – day options on the Japanese yen.
Should Katya buy a put on yen or a call on yen?
Using your answer to part a, what is Katya’s break – even price?
Using your answer to part a, what is Katya’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is ¥140/$?
Call Profits. Assume that a call option on euros is written with a strike price of $1.25/€ at a premium of 3.80 cents per euro ($0.0380/€) and with an expiration date three months from now. The option is for €100,000. Calculate your profit or loss should you exercise before maturity at a time when the euro is traded spot at
$1.10/€
$1.15/€
$1.20/€
$1.25/€
$1.30/€
$1.35/€
$1.40/€
Giri the Contrarian. Giri Patel works for CIBC Currency Funds in Toronto. Giri is something of a contrarian – as opposed to most of the forecasts, he believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.6750/C$. Giri may choose between the following options on the Canadian dollar:
Should Giri buy a put on Canadian dollars or a call on Canadian dollars?
Using your answer to part a, what is Giri’s break-even price?
Using your answer to part a, what is Giri’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is indeed $0.7600/C$?
Using your answer to part a, what is Giri’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is indeed $0.8250/C$?

Questions Set 75: Solution

Solution

The economic perspective entails:

irrational behavior by individuals and institutions

a comparison of marginal benefits and marginal costs in decision making

short term but not long term thinking

the rejection of the scientific method



Microeconomics is concerned with

the aggregate or total levels of income, employment, and output.

a detailed examination of specific economic units that make up the economic system.

positive economics, but not normative economics

the establishing of an overall view of the operation of the economic system.



A production possibilities curve shows:

that resources are unlimited

that people prefer one of the goods more than the other

the maximum amount of two goods that can be produced assuming the full and efficient use of available resources

combinations of capital and labor necessary to produce specific levels of output



An increase in the price of a product will reduce that amount of it purchased because:

supply curves are upward sloping

the higher price means that real incomes have risen

consumers will substitute other products for the one whose price has risen

consumers substitute relatively high priced for relatively low priced products



Assume in a competitive market that price is initially above the equilibrium level. We can predict that price will:

decrease, quantity demanded will decrease, and quantity supplied will increase.

decrease and quantity demanded and quantity supplied will both decrease.

decrease, quantity demanded will increase, and quantity supplied will decrease.

increase, quantity demanded will decrease, and quantity supplied will increase



Refer to the below graph. A surplus of 160 units would be encountered if price was:


$1.60,

$1.10, that is $1.60 minus $.50

$1.00

$.50



For a linear demand curve:

demand is elastic at high prices elasticity is constant along the curve

elasticity is unity at every point along the curve

demand is elastic at low prices

elasticity is constant along the curve





0.8

1.0

1.2

2.0





10 and supply is elastic

1 and supply is unit elastic

0.25 and supply is inelastic

2.5 and supply is elastic



We would expect the cross elasticity of demand for Pepsi in relation to other soft drinks to be greater than that for soft drinks generally because:

soft drinks are normal goods

the income effect always exceeds the substitution effect

there are fewer good substitutes for soft drinks generally than for Pepsi

there are more good substitutes for soft drinks generally than for Pepsi



Marginal utility is the:

sensitivity of consumer purchases of a good to changes in the price of that good.

change in total utility obtained by consuming one more unit of a good.

change in total utility obtained by consuming another unit of a good divided by the change in the price of that good.

total utility associated with the consumption of a certain number of units of a good divided by the number of units consumed.



An increase in the quantity demanded means that:

the demand curve has shifted to the right.

given supply, the price of the product can be expected to decline.

the demand curve has shifted to the left.

price has declined and consumers therefore want to purchase more of the product.



The price elasticity of demand coefficient measures:

buyer responsiveness to price changes.

the extent to which a demand curve shifts as incomes change.

the slope of the demand curve.

how far business executives can stretch their fixed costs.



If total utility is increasing, marginal utility:

is positive, but may be either increasing or decreasing.

must also be increasing.

may be either positive or negative.

will be increasing at an increasing rate.



Where total utility is at a maximum, marginal utility is:

negative.

positive and increasing.

zero.

positive but decreasing.



Marginal utility:

is equal to total utility divided by the number of units consumed.

is equal to total utility if the demand curve is linear.

increases as more of a product is consumed.

diminishes as more of a product is consumed.



The theory of consumer behavior assumes that

consumers behave rationally, maximizing their satisfactions.

consumers have unlimited money incomes.

consumers do not know how much marginal utility they obtain from successive units of various products.

marginal utility is constant.



An increase in demand means that:

given supply, the price of the product will decline.

the demand curve has shifted to the right.

price has declined and consumers therefore want to purchase more of the product.

the demand curve has shifted to the left.



When product prices change, consumers are inclined to purchase larger amounts of the now cheaper products and less of the now more expensive products. This describes:

the cost effect

the price effect

the income effect

the substitution effect



Assumptions made in conjunction with economic theorizing:

can be unrealistic, if when they are relaxed, the outcome is essentially unchanged.

make the output of economic modeling useless.

must be avoided to the extent possible.

must be realistic and consistent with known real-world conditions if the predictions of the theory are to be useful for practical purposes.



The production possibilities curve illustrates the basic principle that:

an economy's capacity to produce increases in proportion to its population size

more of one good can be produced without a decrease in the production of the other good while holding inputs and technology constant.

the production of more and more of one good will require larger and larger cuts in the production of the other good.

an economy will automatically seek that level of output at which all of its resources are employed.



The concept of opportunity cost:

is irrelevant if the production possibilities curve is shifting to the right.

is irrelevant in socialist economies because of central planning.

suggests that the cost of resources for any particular product is the alternative outputs foregone because these resources are not available for alternative production.

suggests that insatiable wants can be fulfilled only if the opportunity costs for fulfilling them approach zero or are negative while the society continues to pay the prevailing wage.



The Illinois Central Railroad once asked the Illinois Commerce Commission for permission to increase its commuter rates by 20 percent. The railroad argued that declining revenues made this rate increase essential. Opponents of the rate increase argued that the railroad's revenues would fall because of the rate hike. It can be concluded that:

the railroad felt that the demand for passenger service was elastic and opponents of the rate increase felt that it was inelastic.

the railroad felt that the demand for passenger service was inelastic and opponents of the rate increase felt that it was elastic.

elasticity of demand was not at issue, that railroad felt they needed more revenue to continue operations.

none of the above.



If the price elasticity of demand for gasoline is .30 and there is a 10% decrease in the price of gasoline, this will cause the quantity of gasoline demanded to:

increase by 30%.

increase by 3%.

decrease by 3%.

decrease by 30%



What is elasticity of the labor market and what factors determine the elasticity of the market demand and supply of labor.

Questions Set 74: Solution

Solution
Grace Hesketh is the owner of an extremely successful dress boutique in downtown Chicago. Although high fashion is Grace’s first love, she’s also interested in investments, particularly bonds and other fixed income securities. She actively manages her own investments and over time has built up a substantial portfolio of securities. She’s well versed on the latest investment techniques and is not afraid to apply those procedures to her own investments.
Grace has been playing with the idea of trying to immunize a big chunk of her bond portfolio. She’d like to cash out this part of her portfolio in seven years and use the proceeds to buy a vacation home in her home state of Oregon. To do this, she intends to use the $ 200,000 she now has invested in the following four corporate bonds (she currently has $ 50,000 invested in each one).
1. A 12 year, 7.5% bond that’s currently priced at $ 895.
2. A 10 year, zero coupon bond priced at $ 405.
3. A 10 year, 10% bond priced at $ 1,080.
4. A 15 year, 9.25% bond priced at $ 980. (Note: These are all noncallable, investment grade, nonconvertible / straight bonds.)
Questions
a. Given the information provided, find the current yield and the promised yield for each bond in the portfolio. (Use annual compounding.)
b. Calculate the Macaulay and modified durations of each bond in the portfolio and indicate how the price of each bond would change if interest rates were to rise by 75 basis points. How would the price change if interest rates were to fall by 75 basis points?
c. Find the duration of the current four bond portfolio. Given the seven year target that Grace has, would you consider this to be an immunized portfolio? Explain.
d. How could you lengthen or shorten the duration of this portfolio? What’s the shortest portfolio duration you can achieve? What’s the longest?
e. Using one or more of the four bonds described above, is it possible to come up with a $ 200,000 bond portfolio that will exhibit the duration characteristics Grace is looking for? Explain.
f. Using one or more of the four bonds, put together a $ 200,000 immunized portfolio for Grace. Because this portfolio will now be immunized, will Grace be able to treat it as a buy and-hold portfolio one she can put away and forget about? Explain.

Questions Set 73:

Solution

1. The Wall Street Journal reported the following spot and forward rates for the Swiss franc ($/SF) in june of 2009:

Spot……………………$0.8466
30-day forward………………$0.8504
90-day forward………………..$0.8540
180-day forward………………$0.8587

• Was the Swiss franc selling at a discount or premium in the forward market?
• What was the 30-day forward premium (or discount)?
• What was the 90-day forward premium (or discount)?
• Suppose you executed a 90-day forward contract to exchange 100,000 Swiss francs into U.S. dollars. How many dollars would you get 90 days hence?
• Assume a Swiss bank entered into a 180-day forward contract with Citicorp to buy $100,000. How many francs will the swiss bank deliver in six months to get U.S. Dollars?

Questions Set 72:

Solution

1) Five years ago, a pharmaceutical company bought a machine that produces pain-reliever medicine at a cost of $2 million. The machine has been depreciated over the past five years, and the current book value is $1,100,000. The company decides to sell the machine now at its market price of $1 million. The marginal tax rate is 34 percent.
What is the relevant cash flow for the machine project?
What is the relevant cash flow if the market price of the machine is $600,000 instead?


2)Healthy Potions, Inc., is considering investing in a new production line of eye drops. Other than investing in the equipment, the company needs to increase its cash and cash equivalents by $10,000, increase the level of inventory by $50,945, increase accounts receivable by $25,000, and increase accounts payable by $5,000 at the beginning of the investment. Healthy Potions will recover these changes in working capital at the end of the project 9 years later. If the appropriate discount rate is 14.9 percent what is the net effect on the today's value of the project?


3Given the soaring price of gasoline, Ford is considering introducing a new production line of gas-electric hybrid sedans. The expected annual sales number of such hybrid cars is 21,000; the price is $22,000 per car. Variable costs of production amount to $13,000 per car. The fixed overhead including salary of top executives is $80 million per year. However, the introduction of the hybrid sedan will decrease Ford’s sales of regular sedans by 7,000 cars per year; the regular sedans have a unit price of $20,000 and unit variable cost of $12,000, and fixed costs of $250,000 per year. Depreciation costs of the production plant are $50,000 per year. The marginal tax rate is 40 percent. What is the incremental annual cash flow from operations?
The incremental annual cash flow from operations is $


4)FITCO is considering the purchase of new equipment. The equipment costs $250,000, and an additional $90,000 is needed to install it. The equipment will be depreciated straight-line to zero over a five-year life. The equipment will generate additional annual revenues of $220,000, and it will have annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years. An inventory investment of $73,000 is required during the life of the investment. FITCO is in the 40 percent tax bracket and its cost of capital is 11 percent.
(Round your intermediate calculations to four decimal places and round your final answer to the nearest dollar. If the answer is negative number then put "-" before answer, i.e. -10,000.)
The project's NPV is


5)Archers Daniels Midland Company is considering buying a new farm that it plans to operate for 10 years. The farm will require an initial investment of $13,250,000. The investment will consist of $2,000,000 for land and $11,250,000 for trucks and other equipments. The land, all trucks, and all other equipment are expected to be sold at the end of 10 years at a price of $5 million, $2 million above book value. The farm is expected to produce revenue of $2,000,000 each year, and an after tax annual cash flow from operations of $1,720,000. The marginal tax rate is 35 percent, and the appropriate discount rate is 14.00 percent. NPV = $

Questions Set 71:

Solution

Cash Flow DOL: The law firm of Dewey, Cheatem, and Howe has monthly fixed costs of $115,000, EBIT of $278,000, and depreciation charges on its office furniture and computers of $7,700. The firm’s Cash Flow DOL is



EBIT: WalkAbout Kangaroo Shoe Stores forecasts that it will sell 7,930 pairs of shoes next year. The firm buys its shoes for $50 per pair from the wholesaler and sells them for $75 per pair. The firm will incur fixed costs plus depreciation and amortization of $100,000 per year. If actual sales next year are 9,746 pairs of shoes, EBIT will increase by





EBIT: Specialty Light Bulbs anticipates selling 3,000 light bulbs this year at a price of $16 per bulb. It costs Specialty $10 in variable costs to produce each light bulb, and the fixed costs for the firm are $10,000. Specialty has an opportunity to sell an additional 1,000 bulbs next year at the same price and variable cost, but by doing so the firm will incur an additional fixed cost of $5,000 if it chooses to sell the additional bulbs. The additional sales would change Specialty’s EBIT by $___, and therefore Specialty Should or Should not produce and sell the additional bulbs.





Pretax operating cash flow break-even: Dandle’s Candles will be producing a new line of dripless candles in the coming years and has the choice of producing the candles in a large factory with a small number of workers or a small factory with a large number of workers. Each candle will be sold for $10. If the large factory is chosen, the cost per unit to produce each candle will be $2.50, while the cost per unit will be $7.30 for the small factory. The large factory would have fixed cash costs of $2 million and a depreciation expense of $300,000 per year, while those expenses would be $500,000 and $100,000 in the small factory. The pretax operating cash flow breakeven point for the large factory is ____. The pretax operating cash flow breakeven point for the small factory is _____.





Profitability index: Suppose that you faced the following projects but had only $30,000 to invest. You should invest in project(s)



A. A and B only
B. B and C only
C. A, B, and C only
D. B, C and D only
C. C and D only

Project



Cost ($)



NPV($)



A



$8,000



$4,000



B



11,000



7,000



C



9,000



5,000



D



7,000



4,000



Accounting operating profit break-even: Dandle’s Candles will be producing a new line of dripless candles in the coming years and has the choice of producing the candles in a large factory with a small number of workers or a small factory with a large number of workers. Each candle will be sold for $10. If the large factory is chosen, the cost per unit to produce each candle will be $2.32, while the cost per unit will be $7.47 for the small factory. The large factory would have fixed cash costs of $2.1 million and a depreciation expense of $300,000 per year, while those expenses would be $470,000 and $100,000 in the small factory. If Dandle uses the small factory, the accounting break-even point is ___ units. If Dandle uses the large factory, the accounting break-even point is ____units.





Cash Flow DOL: The Vinyl CD Co. is going to take on a project that will increase its EBIT by $81,000 next year. The firm’s fixed cost cash expenditures are expected to increase by $82,000, and depreciation and amortization will increase by $74,000 next year. If the project yields an additional 10 percent in revenue, the percentage increase in pretax operating cash flow driven by the additional revenue will be____%





Silver Polygon, Inc., has determined that if its revenues were to increase by 10 percent, then EBIT would increase by 27 percent to $140,000. The fixed costs (cash only) for the firm are $102,000. Given the same 10 percent increase in revenues, EBITDA would change by___%



You are analyzing two proposed capital investments with the following cash flows:



Year



Project X ($)



Project Y ($)



0



$(20,000)



$(20,000)



1



12,617



6,375



2



5,797



6,375



3



5,663



6,375



4



1,840



6,375



The cost of capital for both projects is 10 percent. The PI for project X is ___ and the PI for project Y is ____. If you have unlimited funds you should invest in both projects, project X, project Y, or neither projects. If they are mutually exclusive you should invest in project Y, neither project, or project X.

Profitability index: Suppose that you faced the following projects but had only $25,000 to invest. You should invest in project(s)



Project



Cost ($)



NPV($)



A



$8,000



$4,000



B



11,000



7,000



C



9,000



5,000



D



7,000



4,000





A. A, B, and C only
B. A and B only
C. B and D only
D. A, C and D only
E. B and C only