Answers to End of Chapter 3 (2
Arbitrage and Financial Decision Making
Honda Motor Company is considering offering a $2000 rebate on its minivan, lowering the vehicle’s
price from $30,000 to $28,000. The marketing group estimates that this rebate will increase sales over
the next year from 40,000 to 55,000 vehicles. Suppose Honda’s profit margin with the rebate is $6000
per vehicle. If the change in sales is the only consequence of this decision, what are its costs and
benefits? Is it a good idea?
The benefit of the rebate is tat Honda will sell more vehicles and earn a profit on each additional vehicle
Benefit = Profit of $6,000 per vehicle × 15,000 additional vehicles sold = $90 million.
The cost of the rebate is that Honda will make less on the vehicles it would have sold:
Cost = Loss of $2,000 per vehicle × 40,000 vehicles that would have sold without rebate = $80 million.
Thus, Benefit – Cost = $90 million – $80 million = $10 million, and offering the rebate looks attractive.
(Alternatively, we could view it in terms of total, rather than incremental, profits. The benefit as
$6000/vehicle × 55,000 sold = $330 million, and the cost is $8,000/vehicle × 40,000 sold = $320 million.)
You are an international shrimp trader. A food producer in the Czech Republic offers to pay you 2
million Czech koruna today in exchange for a year’s supply of frozen shrimp. Your Thai supplier
will provide you with the same supply for 3 million Thai baht today. If the current competitive
market exchange rates are 25.50 koruna per dollar and 41.25 baht per dollar, what is the value of
Czech buyer’s offer = 2,000,000 CZK / (25.50 CZK/USD) = 78,431.37 USD
Thai supplier’s offer = 3,000,000 THB / (41.25 THB/USD) = 72,727.27 USD
The value of the deal is $78,431 – 72,727 = $5704 today.
Suppose the current market price of corn is $3.75 per bushel. Your firm has a technology that can
convert 1 bushel of corn to 3 gallons of ethanol. If the cost of conversion is $1.60 per bushel, at what
market price of ethanol does conversion become attractive?
The price in which ethanol becomes attractive is ($3.75 + $1.60 / bushel of corn) / (3 gallons of ethanol /
bushel of corn) = $1.78 per gallon of ethanol.
Suppose your employer offers you a choice between a $5000 bonus and 100 shares of the company
stock. Whichever one you choose will be awarded today. The stock is currently trading for $63 per
Suppose that if you receive the stock bonus, you are free to trade it. Which form of the bonus
should you choose? What is its value?
Suppose that if you receive the stock bonus, you are required to hold it for at least one year.
What can you say about the value of the stock bonus now? What will your decision depend on?
Stock bonus = 100 × $63 = $6,300
Cash bonus = $5,000
Since you can sell (or buy) the stock for $6,300 in cash today, its value is $6,300 which is better than
the cash bonus.