The Basic Tools of Finance

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

Present Value

• Finance
• Studies how people make decisions:
• Allocation of resources over time
• Handling of risk
• Present value
• Amount of money today
• That would be needed
• Using prevailing interest rates
• To produce a given future amount of money

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value

• Future value
• Amount of money in the future
• That an amount of money today will yield
• Given prevailing interest rates
• Compounding
• Accumulation of a sum of money
• Interest earned remains in the account
• To earn additional interest in the future

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value

• Present value = $100
• Interest rate = r
• Future value = …
• (1+r) ˣ $100 – after 1 year
• (1+r) ˣ (1+r) ˣ $100 = (1+r)² ˣ $100 – after 2 years
• (1+r)³ ˣ $100 – after 3 years …
• (1+r)^N ˣ $100 – after N years

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value

• Future value = $200 in N years
• Interest rate = r
• Present value = $200/(1+r)^N
• Discounting
• Find present value for a future sum o money

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Present Value

• General formula for discounting:
• r – interest rate
• X – amount to be received in N years (future value)
• Present value = X/(1+r)^N

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk

• Rational response to risk
• Not necessarily to avoid it at any cost
• Take it into account in your decision making
• Risk aversion
• Dislike of uncertainty
• Utility
• A person’s subjective measure of well-being/ satisfaction

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk

• Utility function
• Every level of wealth provides a certain amount of utility
• Exhibits diminishing marginal utility
• The more wealth a person has
• The less utility he gets from an additional dollar

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Utility Function

This utility function shows how utility, a subjective measure of satisfaction, depends on wealth. As wealth rises, the utility function becomes flatter, reflecting the property of diminishing marginal utility. Because of diminishing marginal utility, a $1,000 loss decreases utility by more than a $1,000 gain increases it.

Managing Risk

• The markets for insurance
• Person facing a risk
• Pays a fee to insurance company
• Insurance company
• Accepts all or a part of risk
• Insurance contract – gamble
• You may not face the risk
• Pay the insurance premium
• Receive: peace of mind

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk

• Role of insurance
• Not to eliminate the risks
• Spread the risks around more efficiently
• Markets for insurance – problems:
• Adverse selection
• High-risk person – more likely to apply for insurance
• Moral hazard
• After people buy insurance - less incentive to be careful

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk

• Diversification
• Reduction of risk
• By replacing a single risk with a large number of smaller, unrelated risks
• “Don’t put all your eggs in one basket”
• Risk
• Standard deviation - measures the volatility of a variable

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Managing Risk

• Risk of a portfolio of stocks
• Depends on number of stocks in the portfolio
• The higher the standard deviation
• The riskier the portfolio

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Figure 2

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Diversification Reduces Risk

This figure shows how the risk of a portfolio, measured here with a statistic called the standard deviation, depends on the number of stocks in the portfolio. The investor is assumed to put an equal percentage of his portfolio in each of the stocks. Increasing the number of stocks reduces, but does not eliminate, the amount of risk in a stock portfolio.

Managing Risk

• Diversification
• Can eliminate firm-specific risk
• Cannot eliminate market risk
• Firm-specific risk
• Affects only a single company
• Market risk
• Affects all companies in the stock market

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk

• Risk-return trade-off
• Two types of assets
• Diversified group
• 8% return
• 20% standard deviation
• Safe alternative
• 3% return
• 0% standard deviation
• The more a person puts into stocks
• The greater the risk and the return

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Figure 3

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Trade-off between Risk and Return

When people increase the percentage of their savings that they have invested in stocks, they increase the average return they can expect to earn, but they also increase the risks they face.

Asset Valuation

• Fundamental analysis
• Study of a company’s accounting statements and future prospects
• To determine its value
• Undervalued stock: Price < value
• Overvalued stock: Price > value
• Fairly valued stock:
• Price = value

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Asset Valuation

• The efficient markets hypothesis
• Asset prices reflect all publicly available information about the value of an asset
• Each company listed on a major stock exchange is followed closely by many money managers
• Equilibrium of supply and demand sets the market price

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Asset Valuation

• Debate - frequency & importance of departures from rational pricing
• Market irrationality
• Movement in stock market
• Hard to explain - news that alter a rational valuation
• Efficient markets hypothesis
• Impossible to know the correct/rational valuation of a company

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.