Chapter 34 - Financial Economics Chapter 34 Financial Economics QUESTIONS 1. Suppose that the city of New York issues bonds to raise money to pay for a new tunnel linking New Jersey and Manhattan. An investor named Susan buys one of the bonds on the same day that the city of New York pays a contractor for completing the first stage of construction. Is Susan making an economic or a financial investment? What about the city of New York? LO1 Answer: New York is making an economic investment. Recall that an economic investment refers either to paying for new additions to the capital stock or new replacements for capital stock that has worn out. The issuance of bonds is financing the new tunnel, which is an addition to society's capital stock. Susan is making a financial investment. Recall that a financial investment refers to the purchase of an asset using an existing asset. Here Susan exchanges one asset for another, say income out of her checking account for the bond. Susan has only changed her portfolio of assets. 2. What is compound interest? How does it relate to the formula: X dollars today = (1 + i ) t X dollars in t years? What is present value? How does it relate to the formula: X /(1 + i ) t dollars today = X dollars in t years? LO1 Answer: Compound interest describes how quickly an investment increases in value when interest is paid, or compounded, not only on the original amount invested but also on all interest payments that have been previously made. This concept relates to the formula (1+i) t X through the variables i , the interest rate, and t , the amount of years (time) X dollars is invested. The first year X dollars are invested the payoff is (1+i)X . If we allow this investment to 'roll-over' another year and invest (1+i)X we will have (1+i)(1+i)X = (1+i) 2 X at the end of year two. That is we earn interest on the principal and interest from the previous year. After t years we have (1+i) t X . The present value model simply rearranges the equation above to make it easier to transform future amounts of money into present amounts of money. Instead of using the formula (1+i) t X to calculate the 'future value' of X dollars today we can write the formula as X /(1 + i ) t to calculate how much X dollars in the future is worth to us today. For example, assume I offer you $1100 a year from now or $1000 today that you can't spend for a year (you must save the $1000). Also, assume the current interest rate is 10%. Which would you choose? Your answer should be it doesn't matter which I give you. If you take the $1000 today it is worth $1100 a year from now. Thus, the offer of $1100 in the future is equivalent to $1000 (= X /(1 + i ) = $1100/1.1).
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