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# basic tools of finance

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### Transcript

• 1. The Basic Tools of Finance Copyright &#xA9; 2004 South-Western 27
• 2. &#x2022; Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk. Copyright &#xA9; 2004 South-Western
• 3. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY &#x2022; 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. Copyright &#xA9; 2004 South-Western
• 4. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY &#x2022; The concept of present value demonstrates the following: &#x2022; Receiving a given sum of money in the present is preferred to receiving the same sum in the future. &#x2022; In order to compare values at different points in time, compare their present values. &#x2022; Firms undertake investment projects if the present value of the project exceeds the cost. Copyright &#xA9; 2004 South-Western
• 5. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY &#x2022; If r is the interest rate, then an amount X to be received in N years has present value of: X/(1 + r)N Copyright &#xA9; 2004 South-Western
• 6. PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY &#x2022; Future Value &#x2022; The amount of money in the future that an amount of money today will yield, given prevailing interest rates, is called the future value. Copyright &#xA9; 2004 South-Western
• 7. FYI: Rule of 70 &#x2022; According to the rule of 70, if some variable 70 grows at a rate of x percent per year, then that variable doubles in approximately 70/x years. years Copyright &#xA9; 2004 South-Western
• 8. MANAGING RISK &#x2022; A person is said to be risk averse if she exhibits a dislike of uncertainty. Copyright &#xA9; 2004 South-Western
• 9. MANAGING RISK &#x2022; Individuals can reduce risk choosing any of the following: &#x2022; Buy insurance &#x2022; Diversify &#x2022; Accept a lower return on their investments Copyright &#xA9; 2004 South-Western
• 10. Figure 1 Risk Aversion Utility Utility gain from winning \$1,000 Utility loss from losing \$1,000 0 \$1,000 loss Current wealth Wealth \$1,000 gain Copyright&#xA9;2004 South-Western
• 11. The Markets for Insurance &#x2022; One way to deal with risk is to buy insurance. insurance &#x2022; The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk. Copyright &#xA9; 2004 South-Western
• 12. Diversification of Idiosyncratic Risk &#x2022; Diversification refers to the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks. Copyright &#xA9; 2004 South-Western
• 13. Diversification of Idiosyncratic Risk &#x2022; Idiosyncratic risk is the risk that affects only a single person. The uncertainty associated with specific companies. Copyright &#xA9; 2004 South-Western
• 14. Diversification of Idiosyncratic Risk &#x2022; Aggregate risk is the risk that affects all economic actors at once, the uncertainty associated with the entire economy. &#x2022; Diversification cannot remove aggregate risk. Copyright &#xA9; 2004 South-Western
• 15. Figure 2 Diversification Risk (standard deviation of portfolio return) (More risk) 49 Idiosyncratic risk 20 Aggregate risk (Less risk) 0 1 4 6 8 10 20 30 40 Number of Stocks in Portfolio Copyright&#xA9;2004 South-Western
• 16. Diversification of Idiosyncratic Risk &#x2022; People can reduce risk by accepting a lower rate of return. Copyright &#xA9; 2004 South-Western
• 17. Figure 3 The Tradeoff between Risk and Return Return (percent per year) 8.3 25% stocks 50% stocks 75% stocks 100% stocks No stocks 3.1 0 5 10 15 20 Risk (standard deviation) Copyright&#xA9;2004 South-Western
• 18. ASSET VALUATION &#x2022; Fundamental analysis is the study of a company&#x2019;s accounting statements and future prospects to determine its value. Copyright &#xA9; 2004 South-Western
• 19. ASSET VALUATION &#x2022; People can employ fundamental analysis to try to determine if a stock is undervalued, overvalued, or fairly valued. &#x2022; The goal is to buy undervalued stock. Copyright &#xA9; 2004 South-Western
• 20. Efficient Markets Hypothesis &#x2022; The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset. Copyright &#xA9; 2004 South-Western
• 21. Efficient Markets Hypothesis &#x2022; A market is informationally efficient when it reflects all available information in a rational way. &#x2022; If markets are efficient, the only thing an investor can do is buy a diversified portfolio Copyright &#xA9; 2004 South-Western
• 22. CASE STUDY: Random Walks and Index Funds &#x2022; Random walk refers to the path of a variable whose changes are impossible to predict. &#x2022; 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. Copyright &#xA9; 2004 South-Western
• 23. Summary &#x2022; Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. &#x2022; A person can compare sums from different times using the concept of present value. &#x2022; The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce the future sum. Copyright &#xA9; 2004 South-Western
• 24. Summary &#x2022; Because of diminishing marginal utility, most people are risk averse. &#x2022; Risk-averse people can reduce risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower returns. &#x2022; 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. Copyright &#xA9; 2004 South-Western
• 25. Summary &#x2022; 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. &#x2022; Some economists question the efficient markets hypothesis, however, and believe that irrational psychological factors also influence asset prices. Copyright &#xA9; 2004 South-Western