1. Chapter 27
The Basic Tools of
Finance
Part 2

2. Finance
Decisions about
money, time, and risk

3. Present Value
The amount of money
need today, using an
interest rate, to
produce a future
amount

4. Future Value
The amount of money
in the future, using an
interest rate, that a
present amount will
produce

5. Compounding
Formula
N
(1+r)

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

7. Risk Aversion
A dislike of uncertainty

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

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

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

12. Insurance Problems
Asymmetric Information
Adverse Selection
Moral Hazard

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

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

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

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

17. Three Risks
Firm Risk
Industry Risk
Market Risk

18. Firm Risk
Risk that affects only a
single company

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

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

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

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