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Chapter

19
The Basic Tools
of Finance
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
TENTH EDITION Eastern Illinois University
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part. 1

IN THIS CHAPTER
• What is “present value”? How can we use
it to compare sums of money from different
times?
• Why are people risk averse?
How can risk-averse people use insurance
and diversification to manage risk?
• What determines the value of an asset?
What is the “efficient markets hypothesis”?
Why is beating the market nearly
impossible?
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2

Finance
• The financial system
– Coordinates saving and investment
• Participants in the financial system
– Make decisions regarding the allocation of resources over time
and the handling of risk
• Finance
– Studies how people make decisions regarding the allocation of
resources over time and the handling of risk

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Present Value
• The present value of a future sum:
– The amount of money today (PV) needed to produce a
future amount of money (FV), given prevailing interest
rates
• The future value of a sum:
– The amount of money in the future (FV) that an amount of
money today (PV) will yield, given prevailing interest rates

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4

EXAMPLE 1: Grandma’s Gift

Demarcus received $200 from grandma for
his birthday. He wants to deposit the money in
the bank at 5% interest.
What is the future value (FV) of this amount?
• Present value, PV = $200
• Interest rate, r = 0.05
• In one year, FV = $200×(1 + 0.05) = $210.00
• In two years, FV = $200×(1 + 0.05)2 = $220.50
• In three years, FV = $200×(1 + 0.05)3 = $231.53
• In N years, future value FV = PV×(1 + r)N
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5

EXAMPLE 2: How much to save?

Amaia inherited money from her aunt’s estate.
She wants to travel for now, but also to save
some of the money to pay for grad school in 4
years.
If the interest rate is 8%, how much does she
need to deposit today to have $20,000 in 4
years?
• We need to find PV of $20,000 (FV), r = 0.08, N = 4
• We know FV = PV×(1 + r)N so, PV = FV / (1 + r)N
• PV = $20,000 / (1+0.08)4 = $14,700.60

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6

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Compounding and the Rule of 70

• Compounding:
– The accumulation of a sum of money where the interest earned
on the sum earns additional interest
• Because of compounding
– Small differences in interest rates lead to big differences over
time.
• The Rule of 70:
– If an amount grows at a rate of x % per year, that amount will
double in about 70/x years.

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7

EXAMPLE 3: Compounding and the rule of 70

You buy $1,000 worth of Microsoft stock and hold it
for 30 years.
• If rate of return = 0.08,
• FV = PV×(1 + r)N = $1,000×(1 + 0.08)30 = $10,063
• The $1,000 will double in 70/8 = 8.75 years
• If rate of return = 0.10,
• FV = $1,000×(1 + 0.10)30 = $17,450
• The $1,000 will double in 70/10 = 7 years
• Thus, a 2 percentage points difference in the rate
of return (from 8% to 10%) leads to over $7,000 of
additional interest earned over the 30 years.
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8

EXAMPLE 4: Investment decision

Pacific Gas & Electric wants to build a new power
plant that will generate $800 million in ten years.
The plant costs $400 million to build. Should PG&E
build the plant if:
a) Interest rate is 4%? Why?
b) Interest rate is 8%? Why?
We need to find PV of $800 million in 10 years:
a) PV = ($800 million)/(1.04)10 = $540,451.30
• Since cost < PV, PG&E should build it
b) PV = ($800 million)/(1.08)10 = $370,544.80
• Since cost > PV, PG&E should NOT build it
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9

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Active Learning 1: Buying land to sell later

Makayla is thinking of purchasing a twelve-
acre lot for $70,000. The lot will be worth
$120,000 in ten years.
A. Should Makayla buy the lot if r = 0.03?
B. Should Makayla buy it if r = 0.07?

A. PV = ($120,000)/(1.03)10 = $89,291.27
• Since price < PV, Makayla should buy it
B. PV = ($120,000)/(1.07)10 = $61,001.92
• Since price > PV, Makayla should NOT buy it
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10

10

Risk Aversion
• Most people are risk averse: dislike uncertainty.
– People dislike bad things happening to them
• Utility
– A person’s subjective measure of well-being or
satisfaction.
– Diminishing marginal utility help explain why most people
are risk adverse

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11

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The Utility Function and Risk Aversion

Utility
Utility gain from
winning $1,000

Utility loss from

losing $1,000
Diminishing marginal
utility: the $1,000 loss
reduces utility more
than the $1,000 gain
increases it. –$1,000 +$1,000
Wealth
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12

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The Markets for Insurance

• How insurance works:
– A person facing a risk pays a fee to the insurance
company, which in return agrees to accept all or part of
the risk.
– Insurance allows risks to be pooled and can make risk
averse people better off.

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13

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Two Problems in Insurance Markets

1. Adverse selection:
– A high-risk person benefits more from insurance,
so is more likely to purchase it.
– People with chronic illnesses have more
incentive to buy health insurance (provided it
covers their treatment) than other people
2. Moral hazard:
– People with insurance have less incentive to
avoid risky behavior.
– People with good fire insurance: less incentive to
replace the batteries in their smoke detectors.
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14

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Active Learning 2: Adverse selection or moral hazard?

Identify whether each of the following is an example of

adverse selection or moral hazard.
A. Jeremiah begins smoking in bed after buying fire insurance.
B. Both of Chloe’s parents lost their teeth to gum disease, so
Chloe buys dental insurance.
C. When Aliyah parks her Corvette convertible, she doesn’t bother
putting the top up, because her insurance covers theft of any
items left in the car.

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15

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Diversification of Firm-Specific Risk

• Standard deviation
– Measures the volatility of a variable
• Diversification
– The reduction of risk achieved by replacing a single risk with a
large number of smaller, unrelated risks.
– Can eliminate firm-specific risk (affecting a single company),
but not market risk (affecting all companies in the stock
market)

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16

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Reducing Risk Through Diversification

More risk Increasing the number of stocks in a portfolio
reduces firm-specific risk through diversification
50
RISK: Standard dev. of

40
portfolio return

30

20
But market
10 risk
remains.
0
0 10 20 30 40
Less risk
# of stocks in portfolio
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17

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Trade-Off Between Risk and Return

• Trade-off:
– Riskier assets pay a higher return, on average, to
compensate for the extra risk of holding them.
– Over the past 200 years, average real return:
• On stocks, 8% (riskier asserts)
• On short-term government bonds, 3%.

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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EXAMPLE 4: The risk-return trade-off

Return Portfolio with two asset
(percent
per year)
classes:
• A diversified group of
75%
risky stocks with an
8 stocks average return = 8%,
100%
25% stocks standard dev. = 20%
stocks 50% • A safe asset with a
3
stocks return = 3%, standard
No
stocks dev. = 0%
Increasing the share of
0 5 10 15 20 stocks in the portfolio
Risk (standard deviation) increases the average
return but also the risk.
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19

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Asset Valuation – 1
• When deciding whether to buy a company’s stock:
– You compare the price of the shares to
the value of the company.
• Stocks are:
– Undervalued if Price < Value
– Overvalued if Price > Value
– Fairly valued if Price = Value

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20

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Active Learning 3: Valuing a share of stock

If you buy a share of AT&T stock today (r = 0.1), you
will be able to sell it in 3 years for $30. You will receive
a $1 dividend at the end of each of those 3 years.
• What is the value of a share of AT&T stock today?
= sum of all PV = $25.03

Amount you will When you will Present Value of the

receive (FV) receive it amount
$1 In 1 year $1/(1.1) = $ .91
$1 In 2 years $1/(1.1)2 = $ .83
$1 In 3 years $1/(1.1)3 = $ .75
$30 In 3 years $30/(1.1)3 = $22.54
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Asset Valuation – 2
• Value of a share
= PV of any dividends the stock will pay
+ PV of the price you get when you sell the share
• Problem:
– When you buy the share, you don’t know what
future dividends or prices will be.
• Fundamental analysis (one way to value a stock)
– The study of a company’s accounting
statements and future prospects to determine
its value
Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22

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Active Learning 4: Show of hands survey

You have a brokerage account with Merrill Lynch Wealth
Management. Your broker calls you with a hot tip about a
stock: new information suggests that the company will be
highly profitable.
Should you buy stock in the company?
A. Yes
B. No
C. Not until you read the prospectus.
D. What’s a prospectus?

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23

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Efficient Markets Hypothesis – 1

• Efficient Markets Hypothesis (EMH):
– The theory that asset prices reflect all publicly available
information about the value of an asset
– Each company listed on a major stock exchange is
followed closely by many money managers
– The equilibrium of supply and demand sets the market
price

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Efficient Markets Hypothesis – 2

• Stock market exhibits informational efficiency:
– Each stock price reflects all available information about the value
of the company.
• Stock prices should follow a random walk:
– The path of a variable whose changes are impossible to predict.
• If prices reflect all available information
– No stock is a better buy than any other. The best you can do is to
buy a diversified portfolio

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25

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Diversified Investing

“In general, absent any inside information, an equity

investor can expect to do better by holding a well‐
diversified, low‐fee, passive index fund than by holding a
few stocks.”

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26

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Market Irrationality – 1
• Many believe that stock price movements are partly
psychological:
– J.M. Keynes, 1930s: stock prices are driven by “animal
spirits” of investors; irrational waves of pessimism and
optimism
– Alan Greenspan: 1990s stock market boom due to
“irrational exuberance”

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Market Irrationality – 2
• Speculative bubbles
– The price of an asset rises above what appears to be its
fundamental value
• Possibility of speculative bubbles
– Value of the stock to a stockholder depends on:
• Stream of dividend payments
• Final sale price

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28

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Market Irrationality – 3
• Debate: frequency and importance of departures from
rational pricing
– Market irrationality
• Movement in stock market is hard to explain - news that alter a
rational valuation
– Efficient markets hypothesis
• Impossible to know the correct/rational valuation of a company

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THINK-PAIR-SHARE
When your parents visit you at the college, they find you
throwing darts at stock pages on your bulletin board. You
received an enormous signing bonus from the company you
will work after graduation. You are now in the process of
picking the stocks in which you plan to invest. Your father
says, “There’s got to be a better way to choose stocks. I can
give you the phone number of my stock analyst or you could
at least buy a well-known, well-managed mutual fund.”

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THINK-PAIR-SHARE
A. What is the stock valuation method to which your father is
referring, and what is its goal?
B. Explain the efficient markets hypothesis to your parents. If it is true,
can your father’s method for picking stocks achieve its goal?
C. If the efficient markets hypothesis is true, what is the only goal of
your dart-throwing exercise? Explain.
D. If the efficient markets hypothesis is true, which of the following will
likely provide the greater return in the long run: your dart-throwing
exercise or an actively managed mutual fund? Why?

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31

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CHAPTER IN A NUTSHELL
• Because savings can earn interest, a sum of money today is more
valuable than the same sum in the future. The present value of any
future sum is the amount that would be needed today, given
prevailing interest rates, to produce that future sum.
• Because of diminishing marginal utility, most people are risk averse.
Risk can be reduced by buying insurance, diversifying holdings, and
choosing a portfolio with lower risk and lower return.

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32

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CHAPTER IN A NUTSHELL
• The value of an asset equals the present value of the cash flows the
owner will receive. For a share of stock, these cash flows include the
stream of dividends and the final sale price.
• According to the efficient markets hypothesis, financial markets
process available information rationally, so a stock price always
equals the best estimate of the value of the underlying business.
Some economists question the efficient markets hypothesis,
however, and say that irrational psychological factors influence asset
prices.

Mankiw, Essentials of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33

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