Chapter 27: The Basic Tools of Finance

Present Value
• Finance is the field that studies how people
make decisions regarding the allocation of
resources over time and the handling of risk.
• Present value is the amount of money today
that would be needed, using prevailing interest
rates, to produce a given future amount of
money.
• The lesson: Money today is more valuable
than the same amount of money in the
future.
• Imagine that someone offers to give you $100
today or $100 in 10 years. Which would you
choose?
• Imagine that someone offers you $100 today
or $200 in 10 years. Which would you choose?
• If you put $100 in a bank account today, how
much will it be worth in N years? That is, what
will be the future value of this $100.
 Present Value
• Future value
– Amount of money in the future
– That an amount of money today will yield given
prevailing interest rates
• Compounding
– Accumulation of a sum of money
• Interest earned remains in the account to earn
additional interest in the future.

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 Present Value
• Present value = $100
– Interest rate = r
– Future value = …
• (1+r) ˣ $100: After 1 year
• (1+r) ˣ (1+r) ˣ $100 = (1+r)2 ˣ $100: After 2
years
• (1+r)3 ˣ $100: After 3 years …
• (1+r)N ˣ $100: After N years
 Present Value
• Future value = $200 in N years
– Interest rate = r
– Present value = $200/(1+r)N
• Discounting
– Find present value for a future sum of
money
 Present Value
• General formula for discounting:
• r – interest rate
• FV – amount to be received in N years
(future value)
– Present value = FV/(1+r)N
 The discount rate (r) takes into account not
just the time value of money, but also the risk
or uncertainty of future cash flows.
 Class Exercise
• Would you rather have $22,000 today, or
$25,000, two years from today?
a. Using an interest rate (r) of 7%.
b. Using an interest rate (r) of 3%.
 Solution
a. PV= $25,000/ (1+0.07)2
= $25,000/ (1.1449)= $21,836
 This implies that collecting $22,000 today is the best
choice.
b. PV= $25,000/ (1+0.03)2 =$25,000/ (1.0609)= $23,565
 This implies that $ 25,000 after two years from today is
preferable than collecting $22,000 today.
 Lesson:- When the discount rate goes up, present values
go down. When the discount rate goes down, present
values go up.
 The greater the uncertainty of future cash flows, the
higher the discount rate.
 Managing Risk
• Risk means you have the possibility of losing
some, or even all, of our original investment.
• Rational people responds to risk.
– Not necessarily to avoid it at any cost
– Take it into account in your decision making
• Risk aversion
– Dislike of uncertainty
How will uncertainty affect people’s behaviour?
The answer is that it depends on their attitudes
towards taking a gamble
 Risk neutral: This is where a person will take a
gamble if the odds are favourable; not take a
gamble if the odds are unfavourable; and be
indifferent about taking a gamble if the odds are fair.
 Risk loving: This is where a person is prepared to
take a gamble even if the odds are unfavourable.
• Risk averse: This is where a person may not be
prepared to take a gamble even if the odds are
favourable.
• For example, suppose a friend offers you the
following opportunity. He will toss a coin. If it comes
up heads, he will pay you $1,000. But if it comes up
tails, you will have to pay him $1,000. Would you
accept the bargain?
• You wouldn’t if you were risk averse. For a risk-
averse person, the pain of losing the $1,000 would
exceed the pleasure from winning $1,000.
• Economists have developed models of risk aversion
using the concept of utility, which is a person’s
subjective measure of well-being or satisfaction.
• The utility function gets flatter as wealth increases.
 Managing Risk
• Utility
– A person’s subjective measure of well-being/
satisfaction
• Utility function
– Every level of wealth provides a certain amount of
utility
– Exhibits diminishing marginal utility
• The more wealth a person has
• The less utility he gets from an additional dollar.
Because of diminishing marginal utility lost from
losing the $1,000 bet is more than the utility gained
from winning it. As a result, people are risk averse.
The Utility Function
Utility
Utility gain from
winning $1,000

Utility loss from

losing $1,000

0 Wealth
$1,000 loss Current $1,000 gain
wealth
This utility function shows how utility, a subjective measure of satisfaction, depends on
wealth. As wealth rises, the utility function becomes flatter, reflecting the property of
diminishing marginal utility. Because of diminishing marginal utility, a $1,000 loss
decreases utility by more than a $1,000 gain increases it.
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 Managing Risk
• There are three risk aversion systems in the economy:
insurance, diversification, and the risk-return trade-off.
• Risk-averse people can reduce risk by buying insurance,
diversifying their holdings, and choosing a portfolio with
lower risk and lower return.
• One way to deal with risk is to buy insurance.
• The general feature of insurance contracts is that a person
facing a risk pays a fee to an insurance company, which in
return agrees to accept all or part of the risk.
• Insurance contract – gamble
– You may not face the risk
– Pay the insurance premium
– Receive: peace of mind
 Managing Risk
• The role of insurance is not to eliminate the risks inherent in life
but to spread the risks around more efficiently.
• The markets for insurance suffer from two types of problems
that impede their ability to spread risk.
 On problem is adverse selection: A high-risk person is more
likely to apply for insurance than a low-risk person because a
high-risk person would benefit more from insurance
protection.
 A second problem is moral hazard: after people buy
insurance, they have less incentive to be careful about their
risky behavior because the insurance company will cover
much of the resulting losses.
 An insurance company cannot monitor all of its customers’
risky behavior.
 Examples of adverse selection include:
• Adverse selection refers to situations in which an insurance company
extends insurance coverage to an applicant whose actual risk is
substantially higher than the risk known by the insurance company.

• For example, a smoker who successfully manages to obtain health

insurance coverage as a nonsmoker.
• By concealing his behavioral choice to smoke, an applicant is leading
the insurance company to make decisions on coverage or premium costs
that are adverse to the insurance company's management of financial
risk.

• Another example of adverse selection is the provision of auto

insurance is a situation in which the applicant obtains insurance
coverage based on providing a residence address in an area with a very
low crime rate when the applicant actually lives in an area with a very
high crime rate.
 Examples of moral hazard include:
• Comprehensive insurance policies decrease incentive to take
care of your possessions.

• Governments promising to bail out loss-making banks can

encourage banks to take greater risks.

• It is argued that membership of the Euro can cause a type of

moral hazard.
• For example, when Greece joined the Euro, it benefited from
low-interest rates. This encouraged Greece to keep increasing
public sector debt–until markets realized too late that they
actually had high, unsustainable debts.
 Moral hazard refers to “any situation in which one person
makes the decision about how much risk to take, while
someone else bears the cost if things go badly”- Krugman, Paul
(2009).
 Managing Risk
• Diversification implies that the reduction of risk by
replacing a single risk with a large number of
smaller, unrelated risks.
– “Don’t put all your eggs in one basket”
 When people use their savings to buy financial assets,
they can also reduce risk through diversification.
• Risk is measured with a statistic called the standard
deviation.
– Standard deviation - measures the volatility of a
variable-that is, how much the variable is likely to
fluctuate.
 Managing Risk
• The higher the SD of a portfolio’s return, the more
volatile its return is likely to be, and the riskier it is
that someone holding the portfolio will fail to get the
return that he or she expected.

• Risk of a portfolio of stocks

– Depends on number of stocks in the portfolio
– The higher the standard deviation, the riskier the
portfolio.
 Diversification Reduces Risk
Risk (standard
deviation of 1. Increasing the number of stocks
portfolio return) in a portfolio reduces firm-specific
(More risk) risk through diversification . . .
49

2. . . . but
20
market risk
remains.
(Less risk)
0 1 4 6 8 10 20 30 40
Number of Stocks in Portfolio
This figure shows how the risk of a portfolio, measured here with a statistic called
the standard deviation, depends on the number of stocks in the portfolio. The
investor is assumed to put an equal percentage of his portfolio in each of the
stocks. Increasing the number of stocks reduces, but does not eliminate, the
22
amount of risk in a stock portfolio.
 Managing Risk
• Diversification can eliminate firm-specific risk-the uncertainty
associated with the specific companies.

• But, diversification cannot eliminate market risk-the uncertainty

associated with the entire economy, which affects all companies
traded on the stock market.

• For example, when the economy goes into a recession, most

companies experience falling sales, reduced profit, and low stock
returns.

• Hence, diversification reduces the risk of holding stocks, but it

does not eliminate it.
 Class Exercise
• Diversification implies that the reduction of risk by
replacing a single risk with a large number of smaller,
unrelated risks. Therefore, does a stockholder get
more diversification going from 1 to 10 stocks or
going from 100 to 120 stocks?
 Managing Risk
Risk-return trade-off
• Historically, stocks have offered much higher rates of
return than alternative financial assets, such as bonds
and bank savings accounts.
– Two types of assets
• Diversified group of risky stocks
– 8% return and 20% standard deviation
• Safe alternative such as a bank savings account
or a government bond.
– 3% return and 0% standard deviation
– The more a person puts into stocks, the greater
the risk and the return.
 Figure 3
The Trade-off between Risk and Return
Return
(percent per
100%
year) 75% stocks
50% stocks
8
25% stocks
stocks
No
stocks

0 5 10 15 20
Risk (standard deviation)

When people increase the percentage of their savings that they have invested
in stocks, they increase the average return they can expect to earn, but they
also increase the risks they face.
• A common misconception is that higher risk equals
greater return.
• The risk/return tradeoff tells us that the higher risk
gives us the possibility of higher returns. There are
no guarantees.
 Asset Valuation
• Fundamental analysis
– Study of a company’s accounting statements and future prospects
to determine its value.
– A stock that tends to trade at a lower price relative to it's
fundamentals (i.e. dividends, earnings, sales, etc.) and thus
considered undervalued by a value investor.
– Common characteristics of such stocks include a low price-to-
earnings ratio.
• Undervalued stock: Price < value
• Overvalued stock: Price > value
• Fairly valued stock:
– Price = value
 If price at which the shares are being sold is less than the value of
that share of the business, you are getting a bargain by paying less
than the business is worth.
• There are many ways to value a company.  The simplest of
these is the price to earnings ratio often referred to as the PE
ratio. 
• This ratio is calculated by dividing the price by the earnings
per share (EPS).
• Example:- if the closing price of a share is $4.00 and
earnings per share for the past year was 25 cents, then the PE
ratio will be 16.  
• PE Ratio = Price / EPS
• The “EPS” represents earnings per share -- the total profit
divided by the number of shares out there on the market
• On average the market PE ratio is 15, so a share with a PE
ratio less than 15 is considered undervalued and a PE ratio
higher than 15 is considered overvalued.
• Generally speaking, a high P/E ratio indicates that
investors expect higher earnings.

• However, a stock with a high P/E ratio is not necessarily a

better investment than one with a lower P/E ratio, as a
high P/E ratio can indicate that the stock is being
overvalued.
 Asset Valuation
• Learning the price is easy: You can just look it up in the
newspaper.
• However, determining the value of the business is the hard
part.
• If you want to rely on fundamental analysis to pick a stock
portfolio, there are three ways to do it.
– Do all the necessary research yourself.
– Rely on the advice of Wall Street analysts.
– Buy a mutual fund, which has a manager conducts
fundamental analysis and makes the decision for you.
 Mutual fund managers buy a stock when its price falls below
its fundamental value and to sell it when its price rises above
its fundamental value.
 Asset Valuation

• 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 market hypothesis,
however, and believe that irrational psychological factors also
influence asset prices.
• The efficient markets hypothesis explains 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.
– Equilibrium of supply and demand sets the market price,
i.e., at the market price, the number of shares being offered
for sale exactly equals the number of shares that people want
to buy.
 Asset Valuation
• According to the efficient markets hypothesis, security
prices are seldom far above or below their justified level.
• Stock markets exhibits informational efficiency: it reflects
all available information about the value of the asset.
• When good news about the company’s prospects becomes
public, the value and the stock price both rise, and vice
versa.
• Informational efficiency implies the description of asset
prices that rationally reflect all available information.
 Random walks and index funds
• Random walk hypothesis refers to changes in stock prices are
impossible to predict from available information.
• According to this theory, the only thing that can move stock
prices is news that changes the market’s perception of the
company’s value.
• But news must be unpredictable-otherwise, it wouldn’t really
be news.
• The efficient markets hypothesis
– Theory about how financial markets work
– Probably not completely true
• Evidence
– Stock prices – very close to a random walk
– Future price changes are uncorrelated with past price
changes
 Random walks and index funds
• Index fund is a mutual fund that buys all stocks in a
given stock index.
• Active funds
– Actively managed mutual funds
• Professional portfolio manager
– Buy only the best stocks
 In essence, an index fund buys all stocks, where as
active funds are supposed to buy only the best stocks.
• Performance of index funds better than active
funds
 Random walks and index funds
• Active portfolio managers
– Lower return than index funds
– Trade more frequently
– Incur more trading costs
– Charge greater fees
– Only 25% of managers beat the market
 Asset Valuation
• Efficient markets hypothesis
– Assumes that people buying & selling stock are
rational
• Process information about stock’s underlying value
• Fluctuations in stock prices
– Partly psychological
 Asset Valuation
• When price of an asset
– Above its fundamental value
– Market - experiencing a speculative bubble
• Possibility of speculative bubbles
– Value of the stock to a stockholder depends on:
• Stream of dividend payments
• Final sale price
 Asset Valuation
• Debate - frequency & importance of departures from
rational pricing
– Market irrationality
• Movement in stock market
– Hard to explain - news that alter a rational
valuation
– Efficient markets hypothesis
• Impossible to know the correct/rational valuation of a
company
 Summary
• The concept of present value reminds us that a dollar in the
future is less valuable than a dollar today, and it gives us a way
to compare sums of money at different points in time.

• Because of diminishing marginal utility, most people are risk-

averse.

• Risk-averse people can reduce risk by buying insurance,

diversifying their holdings, and choosing a portfolio with lower
risk and lower return.

• The theory of risk management reminds us that the future is

uncertain and that risk-averse people can take precautions to
guard against this uncertainty.
• The study of asset valuation tells us that the stock price of any
company should reflect its expected future profitability.

• 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 market hypothesis,

however, and believe that irrational psychological factors
also influence asset prices.

• Behavioral Finance is the study of how psychology affects

financial decision making and financial markets.