Question

3A) A junk bond promises to pay 16% interest, but it is expected to default (be worthless and thus, have a negative 100% rate of return) with a probability equal to 0.1. The expected rate of return is (in percent):

answer: ___________

3B) An investment costs $2.5 million today and is expected to be worth $3 million in one year. What is the maximum interest rate that the investor would be willing to pay for a loan to finance this investment? That is, what is its internal rate of return? (in percent)

answer:____________

3C) An investment pays $210,000 next year. The interest rate is 5%. The present value of this investment is (in dollars)

answer:_____________

3D) When the wage of a worker rises

a. works more due to the substitution effect. There is no income effect.

b. works more due to the income effect. There is no substitutiion effect.

c. works more due to the substitution effect but less due to the income effect.

d. works more due to the income effect but less due to the subsitution effect.

e. works more due to the substitution and the income effect.

3E) When non-wage income rises, the worker

a. works more due to the substitution effect. There is no income effect.

b. works more due to the income effect. There is no substitution effect.

c. works less due to the substitution effect. There is no income effect.

d. works less due to the income effect. There is no substitution effect.

e. works more due to both the substitution and income effects

Answer 1

Do rate the answer if you find it satisfactory.

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3A) A junk bond promises to pay 16% interest, but it is expected to default (be worthless and thus, have a negative 100% rate of return) with a probability equal to 0.1. The expected rate of return is (in percent):

Answer: 4.4%

probablity of earning 16% return= 0.9

probablity of a -100 return = 0.1

Expected rate of return= 0.9 * 16 + 0.1 * (-100)

= 14.4 -10

= 4.4%

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3B) An investment costs $2.5 million today and is expected to be worth $3 million in one year. What is the maximum interest rate that the investor would be willing to pay for a loan to finance this investment? That is, what is its internal rate of return? (in percent)

PV = FV(1+i)n

Answer: 20%

IRR is the rate at which NPV is zero

so, 2,500,000 = 3,000,000/(1+i)1

1+i = 3,000,000/2,500,000 = 1.2

i = 1.2 -1 = 0.2

or 20%

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3C) An investment pays $210,000 next year. The interest rate is 5%. The present value of this investment is (in dollars)

Answer: $200,000

PV = 210,000/(1+0.05)1 = 210,000/1.05 = $200,000

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3D) When the wage of a worker rises:

Answer: c. works more due to the substitution effect but less due to the income effect.

If wages increase, then work becomes relatively more profitable than leisure. (substitution effect)

However, with higher wages, he can maintain a decent standard of living through less work. (income effect)

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3E) When non-wage income rises, the worker:

Answer: d. works less due to the income effect. There is no substitution effect.

There is no substitution effect as the wage has not risen, but non-wage income has risen, as a result of income effect the worker can maintain a decent standard of living through less work

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