0. © 2007 Thomson South-Western

1. The Basic Tools of Finance
Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk.

2. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
Present value refers to the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money.

3. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
The concept of present value demonstrates the following:
Receiving a given sum of money in the present is preferred to receiving the same sun in the future.
In order to compare values at different points in time, compare their present values.
Firms undertake investment projects if the present value of the project exceeds the cost.

4. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
If r is the interest rate, then an amount X to be received in N years has present value of:
X/(1 + r)N
Because the possibility of earning interest reduces the present value below the amount X, the process of finding a present value of a future some of money is called discounting.

5. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
Future Value
The amount of money in the future that an amount of money today will yield, given prevailing interest rates, is called the future value.

6. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
Examples:
Present Value
You need to put some money in the bank and want to be paid $200 in 10 (N) years…how much will you need to deposit today if the interest rate is 5%?
$200/(1.05)10 = $123
(Assumes interest is paid annually)

7. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
Examples:
Future Value
You put $100 in the bank today…how much will your account be worth in 10 years if the interest rate is 5%?
$100x(1.05)10 = $163

8. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
Examples:
Present Value
The interest rate is 7%. What is the present value of $150 to be received in 2 years?

9. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY
Present / Future Value
Is this concept valuable? What can you use it for?
Lottery winnings
Company build decisions
Etc.

10. FYI: Rule of 70
According to the rule of 70, if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years.

11. Risk Aversion If heads, you win $1000. If tails, you lose $1000.
Risk Aversion
Most people are risk averse – they dislike uncertainty.
Example: You are offered the following gamble. Toss a fair coin.
If heads, you win $1000.
If tails, you lose $1000.
Should you take this gamble?
If you are risk averse, the pain of losing $1000 would exceed the pleasure of winning $1000, and both outcomes are equally likely, so you should not take this gamble.
THE BASIC TOOLS OF FINANCE 11

12. The Utility Function
Utility is a subjective measure of well-being that depends on wealth.
Wealth
Utility
Current utility
As wealth rises, the curve becomes flatter due to diminishing marginal utility:
the more wealth a person has, the less extra utility he would get from an extra dollar.
To help your students understand the concept of diminishing marginal utility, you might ask them:
Would a poor person or a rich person be more excited about finding a $20 bill on the sidewalk? Students will answer the poor person. $20 means more to someone with little wealth than someone with lots of wealth.
But this is exactly the type of reasoning behind the concept of diminishing marginal utility. And, as the next slide shows, it helps explain why people are risk averse.
Current wealth
THE BASIC TOOLS OF FINANCE 12

13. The Utility Function and Risk Aversion
The Utility Function and Risk Aversion
Wealth
Utility
Utility gain from winning $1000
Utility loss from losing $1000
Because of diminishing marginal utility, a $1000 loss reduces utility more than a $1000 gain increases it.
–1000
+1000
THE BASIC TOOLS OF FINANCE 13

14. MANAGING RISK Risk Aversion
Individuals can reduce risk choosing any of the following:
Buy insurance
Diversify
Accept a lower return on their investments

15. Managing Risk With Insurance
How insurance works: A person facing a risk pays a fee to the insurance company, which in return accepts part or all of the risk.
Insurance allows risks to be pooled, and can make risk averse people better off:
E.g., it is easier for 10,000 people to each bear 1/10,000 of the risk of a house burning down than for one person to bear the entire risk alone.
THE BASIC TOOLS OF FINANCE 15

16. Two Problems in Insurance Markets
1. Adverse selection: A high-risk person benefits more from insurance, so is more likely to purchase it.
2. Moral hazard: People with insurance have less incentive to avoid risky behavior.
Insurance companies cannot fully guard against these problems, so they must charge higher prices.
As a result, low-risk people sometimes forego insurance and lose the benefits of risk-pooling.
Example of adverse selection: People with chronic illnesses have more incentive to buy health insurance (provided it covers their treatment) than other people.
Example of moral hazard: People with good fire insurance have less incentive to replace the batteries in their smoke detectors.
THE BASIC TOOLS OF FINANCE 16

17. A C T I V E L E A R N I N G 2 Adverse selection or moral hazard?
Identify whether each of the following is an example of adverse selection or moral hazard.
Joe begins smoking in bed after buying fire insurance.
Both of Susan’s parents lost their teeth to gum disease, so Susan buys dental insurance.
C. When Gertrude parks her Corvette convertible, she doesn’t bother putting the top up, because her insurance covers theft of any items left in the car.
Just a quick check to see if students understand the difference between moral hazard and adverse selection. 17

18. A C T I V E L E A R N I N G 2 Answers
Identify whether each of the following is an example of adverse selection or moral hazard.
A. Joe begins smoking in bed after buying fire insurance.
moral hazard
B. Both of Susan’s parents lost their teeth to gum disease, so Susan buys dental insurance.
adverse selection
C. When Gertrude parks her Corvette convertible, she doesn’t bother putting the top up, because her insurance covers theft of any items left in the car. 18

19. Diversification of Firm-Specific Risk
Diversification refers to the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks.
Firm-specific risk is risk that affects only a single company.
Market risk is risk that affects all companies in the stock market.
Diversification cannot remove market risk.

20. Figure 2 Diversification
Risk (standard
deviation of
1. Increasing the number of stocks in a portfolio reduces firm-specific
risk through diversification…
portfolio return)
(More risk) 49
2. …but market risk remains. 20
(Less risk) 1 4 6 8 10 20 30 40
Number of
Stocks in
Portfolio

21. Diversification of Firm-Specific Risk
People can reduce risk by accepting a lower rate of return.

22. Figure 3 The Trade-off between Risk and Return
(percent
100%
stocks
per year)
75%
stocks
50%
stocks
8.0
25%
stocks No
stocks
3.0
Risk 5 10 15 20
(standard
deviation)

23. If share price > value, the stock is overvalued.
Asset Valuation
When deciding whether to buy a company’s stock, you compare the price of the shares to the value of the company.
If share price > value, the stock is overvalued.
If price < value, the stock is undervalued.
If price = value, the stock is fairly valued.
It’s easy to look up the price. But how does one determine the stock’s value?
THE BASIC TOOLS OF FINANCE 23

24. A C T I V E L E A R N I N G 3 Valuing a share of stock
If you buy a share of AT&T stock today,
you will be able to sell it in 3 years for $30.
you will receive a $1 dividend at the end of each of those 3 years.
If the prevailing interest rate is 10%, what is the value of a share of AT&T stock today?
The objective of this exercise is to help students see for themselves that the value of a share of stock equals the present value of dividends received plus the present value of the final sale price.
Some students may need a hint to get started. 24

25. A C T I V E L E A R N I N G 3 Answers
amount you will receive
when you will receive it
present value of the amount
$1/(1.1) = $
in 1 year $1
$1/(1.1)2 = $
in 2 years $1
$1/(1.1)3 = $
in 3 years $1
$30/(1.1)3 = $22.54
in 3 years
$30
The value of a share of AT&T stock equals the sum of the numbers in the last column: $25.03 25

26. ASSET VALUATION
Fundamental analysis is the study of a company’s accounting statements and future prospects to determine its value.
People can employ fundamental analysis to try to determine if a stock is undervalued, overvalued, or fairly valued.
The goal is to buy undervalued stock.

27. The Efficient Markets Hypothesis
The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset.
A market is informationally efficient when it reflects all available information about the value of an asset in a rational way.
If markets are efficient, the only thing an investor can do is buy a diversified portfolio.

28. CASE STUDY: Random Walks and Index Funds
Random walk refers to the path of a variable whose changes are impossible to predict.
If markets are efficient, all stocks are fairly valued and no stock is more likely to appreciate than another. Thus stock prices follow a random walk.

29. Is the stock market really rational?
Market Irrationality
Is the stock market really rational?
Keynes suggested asset prices are driven by “animal spirits” of investors
Fed Chairman Alan Greenspan, in the 1990s, questioned the “irrational exuberance” of the booming stock market
A person might be willing to pay more than a stock is worth today, if it is expected to increase in value tomorrow

30. Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future.
A person can compare sums from different times using the concept of present value.
The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce the future sum.

31. Because of diminishing marginal utility, most people are risk averse.
Risk-averse people can reduce risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower returns.

32. The value of an asset, such as a share of stock, equals the present value of the cash flows the owner of the share will receive, including the stream of dividends and the final sale price.

33. According to the efficient markets hypothesis, financial markets process available information rationally, so a stock price always equals the best estimate of the value of the underlying business.
Some economists question the efficient markets hypothesis, however, and believe that irrational psychological factors also influence asset prices.