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
