Chapter 14 - The Basic Tools of Finance

**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

**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