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Chapter 2

Multiple-Choice Questionsand

Answers

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1. Which of the following cannot be used as a discount rate?

(a) The nominal rate of interest(b) The real rate of interest(c) The after-tax nominal rate of interest(d) The after-tax real rate of interest(e) All of the above can be used as discount rate,

depending on the situation

The answer is (e)

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2. Mr. Lazrak wants to invest $1,000 for one year. Which of the following bank accounts offers the best deal?

(a) 7.00% interest with annual compounding(b) 6.85% interest with semi-annual compounding(c) 6.75% interest with quarterly compounding(d) 6.55% interest with monthly compounding(e) 6.45% interest with daily compounding

The answer is (a).

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Why?

0666.1365

0645.1)e(

0675.112

0655.1)d(

0692.14

0675.1)c(

0697.12

0685.1)b(

07.107.1)a(

365

12

4

2

Because (a) provides the highest EAR

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3. Janet Jopper owes her friend some money. She is given the following alternatives of payment. If the current rate of interest, 6%, is used as the discount rate, which of the following alternatives of payment is the best for her?

(a) pay $9,750 now(b) $2,000 per year for 5 years, each payable at the end of

the year(c) $1,950 per year for 5 years, each payable at the

beginning of the year(d) $1,800 per year for 6 years, each payable at the end of

the year(e) $2,000 at the end of year 1, $5,000 at the end of year

2, $3,000 at the end of year 3, and $1,200 at the end of year 4

The answer is (b).

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Why?

14.806,9)06.1(

200,1

)06.1(

000,3

)06.1(

000,5

06.1

000,2PV)e(

18.851,8)06.1(06.

1

06.

1800,1PVA)d(

96.706,806.1)06.1(06.

1

06.

1950,1PVAD)c(

73.424,8)06.1(06.

1

06.

1000,2PVA)b(

750,9PV)a(

432

6

5

5

Because (b) is the lowest in terms of payment.

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4. If the rate of interest (the discount rate) increases, which of the following statements is false?

(a) The future value of an investment will increase.(b) The present value of an annuity will decrease.(c) The present value of an annuity due will increase.(d) The present value of an uneven stream of cash-flow

will decrease.(e) All the above statements are false.

The answer is (c).

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5. If the nominal rate of interest is positive, theoretically which of the following cannot be negative?

(a) The before-tax real rate of interest(b) The after-tax real rate of interest(c) the rate of return on a stock (d) The after-tax nominal rate of interest(e) All of the above can theoretically be negative.

The answer is (d). Note: If the rate of inflation is high, all real rates will be negative.