Agricultural Economics 330 - Texas A&M University



Agricultural Economics 330

Examination 3

Instructor: Dr. David J. Leatham

Name: Seat Number: Section:

NOTE: SHOW A TIME LINE AND THE PRESENT VALUE OR FUTURE VALUE FORMULAS USED TO SOLVE EACH PROBLEM INVOLVING TIME. NO POINTS WILL BE GIVEN WITHOUT A TIME LINE AND FORMULAS EVEN IF YOU HAVE THE RIGHT ANSWER!

EXAM POINTS ARE IN PARENTHESIS.

1. True or False (Circle the correct answer)

|True |Risk averse means an individual is unwilling to take risk. |

|or | |

|False | |

|True |An increase in debt does not affect business risk, holding everything else constant. |

|or | |

|False | |

|True |Borrowing money helps reduce leverage. |

|or | |

|False | |

|True |The optimal leverage position of farmers who are more risk averse will be lower than for farmers who are less risk |

|or |averse, holding everything else constant. |

|False | |

|True |Government programs that decrease business risk may increase financial risk as farmers adjust their leverage positions. |

|or | |

|False | |

|True |An increase in leverage will decrease the need for liquidity reserves, holding everything else constant. |

|or | |

|False | |

|False |An increase in leverage increases the expected rate of return on equity faster than the increase in firm risk. |

|True |Lease payments on farm equipment are not tax deductible. |

|or | |

|False | |

|True |Mutually exclusive investments are unacceptable. |

|or | |

|False | |

|True |A borrower pays less total interest when equal principal payments are used in calculating periodic payments rather than |

|or |using a fully amortized loan. However, the effective interest rate is same, holding everything else constant. |

|False | |

|True |The loan balance of a loan can be calculated as the market value of the loan. |

|or | |

|False | |

2. Definitions:

A. A form of leasing or rental that combines the hiring of labor services and the use of a tangible asset.

B. The term used in the Truth in Lending Act. It is an actuarial representation of the total financing cost of credit expressed as percent per annum. It is calculated as the actuarial rate times the number of conversion periods per year.

C. A three-party leasing arrangement in which asset-owner finances the asset with funds borrowed from a lender and then leases the asset to a lessee.

D. A form of loan fee generally charged by long-term lenders at origination to cover a portion of the lender’s administrative and funding costs. The fee is typically expressed as a percentage of the total loan.

E. A single period profit maximization objective function is not sufficient for a financial manager because it ignores and .

3. An increase in leverage may decrease the expected rate of return on equity Explain.

4. Explain why it is important to merchandise (increase) your credit even if you do not plan to borrow any additional money.

5. Suppose you wish to buy a car today. You have two choices, buy a new car for $10,000 or buy a used car for $6,000. The new car has an economic life of 6 years and you expect that it can be sold at the end of 6 years for $2,000. If you buy the used car, you plan to sell it in 3 years and expect to receive $600. Also, you expect that the used car will require $300 more a year than the new car for maintenance. Assume your marginal tax rate and inflation are equal to zero. If your opportunity cost of capital is 12%, would you choose the new or used car?

6. Suppose Mr. Agirich wants to borrow $45,000 to buy a tract of land. The Federal Land Bank will make a 5-year loan fully amortized at 9% (monthly payments). A $40 loan fee and stock purchase is required. The borrower stock requirement is the smallest of $1,000 or 2% of loan amount. The stock is non-earning but will be returned to the borrower when the loan is retired. Assume that sufficient money is borrowed to cover the $45,000, the fee and the stock purchase.

A. Calculate the annual percentage rate and the effective interest on this loan.

(Answer: 9.78%)

B. Calculate the remaining loan balance of this loan at the end of the 4th year (after the regularly scheduled payment). (Answer: $10,911.75)

7. Suppose you have been asked to help Mr. Agirich of Agirich Farms determine the expected profitability, measured as the rate of return on equity ( [pic]) and firm risk, measured as the variance of the rate of return on equity ([pic]) for his firm. Mr. Agirich provides you with the following probability distribution for the rate of return on assets (ra). Assume that the cost of debt (i) is 10%, leverage is 0.25 and the tax rate (t) is 15%.

| | |

|ra |Probability |

| | |

|.04 |.20 |

| | |

|.12 |.60 |

| | |

|.20 |.20 |

(A. Calculate ( [pic]), ([pic]), and the coefficient of variation of re.

(Answer: 0.10625, 0.00289, and 0.505)

B. If Mr. Agirich has $100,000 of equity how much money would he have to borrow (total liabilities) if he wants an expected rate of return on equity of 12%?

(Answer: $105,882)

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