Chapter 27 - The Basic Tools of Finance

Finance: the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk

27-1 Present Value: Measuring the Time Value of Money

Present value: the amount of money today needed to produce a future amount of money, given prevailing interest rates
Future value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates
Compounding: the accumulation of a sum of money, where the interest earned remains in the account to earn additional interest in the future
(1+r)^N * $x,where r=rate of interest, N=number of years, and x=original total $
Discounting: the process of finding a present value of a future sum of money

Risk-averse: a dislike of uncertainty
Utility: a person’s subjective measure of well-being or satisfaction
The more money someone has, the less utility earned from the next dollar earned

Buying insurance deals with risk
Insurance is bought for peace of mind
Adverse selection: a high-risk person is more likely to apply for insurance than a low-risk person
Moral hazard: after insurance is bought, there is less incentive to be careful about risky behaviors

Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risk
Bought stock bets on the future profitability of that company, which is risky because not all information is known
Standard deviation: risk measured by the volatility of variable
The higher the standard deviation, the more volatile it is, and the riskier it is
Firm-specific risk: the risk that affects only a single company
Market risk: the risk that affects all companies in the stock market

People face trade-offs
Historically, stocks have offered much higher rates of return than bonds, bank savings accounts, and other financial assets

Overvalued: a stock whose price is more than its value
Fairly valued: a stock whose price is equivalent to its value
Undervalued: a stock whose price is less than its value
Fundamental analysis: the detailed analysis of a company in order to estimate its value
Stock analysts are hired by firms to conduct fundamental analysis and give advice on stocks to buy
Dividends: cash payments a company makes to its shareholders
A company’s ability to pay dividends depends on the company’s ability to earn profits

Efficient markets hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset
Money managers watch new stories and conduct fundamental analyses to try and determine a stock’s value. Stocks are bought ideally when a price falls below its fundamental value and sold when the price is above the fundamental value
At market price, number of shares being sold = number of shares being bought
Informational efficiency: the description of asset prices that rationally reflect all available information
Stock prices change when information changes. When good news appears about a company, the price rises, and if bad news appears, the price falls
Random walk: the path of a variable whose changes are impossible to predict

Speculative bubble: whenever the price of an asset rises above what appears to be its fundamental value
Speculative bubbles may happen because the value of a stock to a stockholder is decided by the stream of dividend payments but also on the final sale price
You need to estimate not only the value of the business but what other people will think of the business’s worth in the future
If the market were irrational, a rational person would be able to beat the market
Beating the market is nearly impossible