Investment Strategy

CHAPTER 11

Investment, Strategy, and Economic Rents

Answers to Problem Sets

1. a. False

b. True

c. True

d. False

2. $15

3. First consider whether renting the building and opening the Taco Palace is positive NPV. Then consider whether to buy (instead of renting) based on your optimistic view of local real estate.

4. a. .1 X 3,450/1.005 = $343.3 million

b. The expected rate of return is [pic]= .005 + 1.2(.08 - .005) =

.095 or 9.5%. The expected price is $3,433 X 1.095 = $3,759. The certainty equivalent price is $3,450.

5. The second-hand market value of older planes falls by enough to make up for their

higher fuel consumption. Also, the older planes are used on routes where fuel efficiency is relatively less important.

6. The 757 must be a zero-NPV investment for the marginal user. Unless Boeing can charge different prices to different users (which is precluded with a secondary market), Delta will earn economic rents if the 757 is particularly well suited to Delta’s routes (and competition does not force Delta to pass the cost savings through to customers in the form of lower fares). Thus, the decision focuses on the issue of whether the plane is worth more in Delta’s hands than in the hands of the marginal user.

a. With a good secondary market and information on past changes in aircraft prices, it becomes somewhat more feasible to ignore cash flows beyond the first few years and to substitute the expected residual value of the plane.

b. Past aircraft prices may be used to estimate systematic risk (see Chapter 8).

c. The existence of a secondary market makes it more important to take note of the abandonment option.

7. The key question is: Will Gamma Airlines be able to earn economic rents on the Akron-Yellowknife route? The necessary steps include:

a. Forecasting costs, including the cost of building and maintaining...