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

27-2 Managing Risk

Risk Aversion

• 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

The Markets for Insurance

• 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 of Firm-Specific Risk

• 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

The Trade-Off Between Risk and Return

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

27-3 Asset Valuation

Fundamental Analysis

• 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

The Efficient Markets Hypothesis

• 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

Market Irrationality

• 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

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