Post on 15-Jul-2015
transcript
Chapter 27
Basic Tools of
Finance
SurveyQuestion 1
What would you prefer?
A. Win 1,000 riyals
B. Flip a coin: 50 percent chance you win 2,000 riyals50 percent chance you win nothing.
SurveyQuestion 2
What would you prefer?
A. Lose 1,000 riyals
B. Flip a coin: 50 percent chance you lose 2,000 riyals50 percent chance you lose nothing.
SurveyMost people avoid risk
on gains
but prefer to take risks to avoid loss
Key Termsfinancepresent valuefuture valuecompoundingdiscountingrisk aversiondiversification
firm-specific riskmarket riskfundamental analysisefficient market hypothesisinformation efficiencyrandom walk
Key Formulas
(1+r)N
r = rate N = number of periods
Compounding Future Value or FVmultiplying
Discounting Present Value or PVdividing
(1+r)N1
Finance
Time and Risk
Tomorrow
One Year
Ten Years
Discount the future
Today is worth more than tomorrow
Growin the Future
Today
One year
Ten Years
Promissory Note
Trading paper for paper
I.O. U.
10 SARDr. Gale
Rates and
Compounding Linear versus
Exponential
0
8
16
24
32
40
48
56
64
1 2 3 4 5 62
48
16
32
64
24
68
1012
Linear versus ExponentialAdding versus Compounding
+
^
N Start Add End
0 100.00 7.00 107.00
1 107.00 7.00 114.00
2 114.00 7.00 121.00
3 121.00 7.00 128.00
4 128.00 7.00 135.00
5 135.00 7.00 142.00
Fixed Amount
Grow by a percentage each year,
not a fixed amount
Compounding
Compounding
The process of finding the future value of a
present sum of money
multiplying
Discounting
The process of finding the present value of a future sum of money
dividing
compounding is the inverse of discounting
discounting is the inverse of compounding
7%
N Start Add End
0 100.00 7.00 107.00
1 107.00 7.49 114.49
2 114.49 8.01 122.50
3 122.50 8.58 131.08
4 131.08 9.18 140.26
5 140.26 9.82 150.07
Compounding
Fixed 7%
N Start Add End Start Add End
0 100.00 7.00 107.00 100.00 7.00 107.00
1 107.00 7.00 114.00 107.00 7.49 114.49
2 114.00 7.00 121.00 114.49 8.01 122.50
3 121.00 7.00 128.00 122.50 8.58 131.08
4 128.00 7.00 135.00 131.08 9.18 140.26
5 135.00 7.00 142.00 140.26 9.82 150.07
Fixed vs. Compounding
Compounding8%
4%
2%
time
amount
Rate Amount in 30 years
1% 136.13
2% 184.76
4% 337.31
8% 1,086.77
16% 9,958.59
32% 546,753.87
Future ValueThe amount of money in the future, using an interest rate, that a present amount will
produce
Key Formula 1
(1+r)N
r = rate N = number of periods
Future Value or FV
(1+r)N
r = 10% FV =?
1 1.1002 1.2103 1.3314 1.4645 1.611
N FV
Present ValueThe amount of money need today, using an
interest rate, to produce a future
amount
Key Formula 2
(1+r)N
r = rate N = number of periods
Present Value or PV1 Reciprocal
of the FV formula
(1+r)N
r = 10% N = 5PV =?
1 .9092 .8263 .7514 .6835 .621 3.791
N PV
1
Worth less and less due to time and risk
1 0.935
2 0.873
3 0.816
4 0.763
5 0.713
6 0.666
7 0.623
8 0.582
9 0.54410 0.508
7% discount
Insurance
Sharing risk
Does not eliminate riskSpread around risk
Risk Aversion
A dislike of uncertainty
ScenarioCost: 1000
Risk: 1 in 100Expected cost =
cost x risk = 1000 x .01
=10
ScenarioExpected cost =10Total Cost = 1000
Get 100 people to give 10 each to fund the
account10 x 100 = 1000
Insurance Problems
Asymmetric InformationAdverse Selection
Moral Hazard
Asymmetric Information
Parties to a trade do not have the same
information
Not Equal
Adverse Selection
Making a bad choice due to asymmetric
information
Moral Hazard
Changing behavior after an agreement
Temptation to abuse the other party
Diversification
Replace one large risk with lots of smaller
unrelated risks
Three Risks
Firm RiskIndustry RiskMarket Risk
Firm Risk
Risk that affects only a single company
Industry Risk
Risk that affects all the companies in an
industry
Market Risk
Risk that affects all the companies in the stock
market
Valuation
What is it worth?
Analyze financial statements and future
prospects
Speculative Bubble
Price is greater than fundamental value
Buy because everyone else is buying