Basic Tools of Finance

1. Chapter 27
Basic Tools
of
Finance

2. Survey
Question 1
What would you prefer?
A.Win 1,000 riyals
B. Flip a coin:
50 percent chance you win 2,000 riyals
50 percent chance you win nothing.

3. Survey
Question 2
What would you prefer?
A. Lose 1,000 riyals
B. Flip a coin:
50 percent chance you lose 2,000 riyals
50 percent chance you lose nothing.

4. Survey
Most people avoid risk
on gains
but prefer to take risks
to avoid loss

5. Key Terms
finance
present value
future value
compounding
discounting
risk aversion
diversification
firm-specific risk
market risk
fundamental analysis
efficient market
hypothesis
information efficiency
random walk

6. Key Formulas
(1+r)
N
r = rate
N = number of periods
Compounding
FutureValue or FV
multiplying
Discounting
PresentValue or PV
dividing
(1+r)N
1

7. Finance
Time and Risk

8. Tomorrow
OneYear
TenYears

9. Discount the future
Today is worth
more than
tomorrow

10. Grow
in the
Future
Today
One year
TenYears

11. Promissory Note
Trading paper for paper
I.O. U.
10 SAR
Dr. Gale

12. Rates
and
Compounding
Linear
versus
Exponential

13. 0
8
16
24
32
40
48
56
64
1 2 3 4 5 6
2
4
8
16
32
64
2
4
6
8
10
12
Linear versus Exponential
Adding versus Compounding
+
^

14. 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

15. Grow by a percentage
each year,
not a fixed amount
Compounding

16. Compounding
The process of finding
the future value of a
present sum of money
multiplying

17. Discounting
The process of finding
the present value of a
future sum of money
dividing

18. compounding is the
inverse of discounting
discounting is the
inverse of compounding

19. 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

20. 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

21. Compounding
8%
4%
2%
time
amount

22. 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

23. FutureValue
The amount of money
in the future, using an
interest rate, that a
present amount will
produce

24. Key Formula 1
(1+r)
N
r = rate
N = number of periods
FutureValue or FV

25. (1+r)
N
r = 10%
FV =?
1 1.100
2 1.210
3 1.331
4 1.464
5 1.611
N FV

26. PresentValue
The amount of money
need today, using an
interest rate, to
produce a future
amount

27. Key Formula 2
(1+r)N
r = rate
N = number of periods
PresentValue or PV
1 Reciprocal
of the
FV formula

28. (1+r)N
r = 10%
N = 5
PV =?
1 .909
2 .826
3 .751
4 .683
5 .621
3.791
N PV
1

29. 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 0.544
10 0.508
7% discount

30. Insurance
Sharing risk
Does not eliminate risk
Spread around risk

32. Risk Aversion
A dislike of uncertainty

33. Scenario
Cost: 1000
Risk: 1 in 100
Expected cost =
cost x risk =
1000 x .01
=10

34. Scenario
Expected cost =10
Total Cost = 1000
Get 100 people to give
10 each to fund the
account
10 x 100 = 1000

35. Insurance Problems
Asymmetric Information
Adverse Selection
Moral Hazard

36. Asymmetric Information
Parties to a trade do
not have the same
information
Not Equal

37. Adverse Selection
Making a bad choice
due to asymmetric
information

38. Moral Hazard
Changing behavior after
an agreement
Temptation to abuse
the other party

39. Diversification
Replace one large risk
with lots of smaller
unrelated risks

40. Three Risks
Firm Risk
Industry Risk
Market Risk

41. Firm Risk
Risk that affects only a
single company

42. Industry Risk
Risk that affects all the
companies in an
industry

43. Market Risk
Risk that affects all the
companies in the stock
market

44. Valuation
What is it worth?
Analyze financial
statements and future
prospects

45. Speculative Bubble
Price is greater than
fundamental value
Buy because everyone
else is buying