Chapter 14: The Basic Tools of Finance

14.1: Present Value: Measuring the Time Value of Money

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

• Present value- the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money

• 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 in, say, a bank account, where the interest earned remains in the account to earn additional interest in the future

14.2: Managing Risk

Risk Aversion:

• Risk aversion- A dislike of uncertainty

The Markets for Insurance:

• Buying insurance is one way to deal with risk

Diversification of Firm-Specific Risk:

• Diversification- The reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks

• 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:

• The choice of a particular combination of risk and return depends on a person’s risk aversion, which reflects a person’s own preferences

  • It is important for stockholders to recognize that the higher average return that they enjoy comes at the price of higher risk

Chapter 14.3: Asset Valuation

Fundamental Analysis:

• Fundamental analysis- The study of a company’s accounting statements and future prospects to determine its value

The Efficient Markets Hypothesis:

• Efficient markets hypothesis- The theory that asset prices reflect all publicly available information about the value of an asset

• Informational efficiency- the description of asset prices that rationally reflect all available information

• Random walk- the path of a variable whose changes are impossible to predict

Market Irrationality:

• Fluctuating stock prices

• It is impossible to know the correct, rational valuation of a company