Chapter 27: The Basic Tools of Finance

Chapter 27: The Basic Tools of Finance

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

Chapter 27.1: Present Value: Measuring the TIme Value of Money

Present value: the amount of money today needed to produce a future amount of money, given prevailing interest rates
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, where the interest earned remains in the account to earn additional interest in the future
(1+r)^N * $x,where r=rate of interest, N=number of years, and x=original total $
Discounting: the process of finding a present value of a future sum of money

Chapter 27.2: Managing Risk

27.2a: Risk Aversion * Risk averse: a dislike of uncertainty * Utility: a person’s subjective measure of well-being or satisfaction * The more money someone has, the less utility earned from the next dollar earned
27.2b: The Markets for Insurance * Buying insurance deals with risk * Insurance is bought for a peace of mind * Adverse selection: a high risk person is more likely to apply for insurance than a low risk person * Moral hazard: after insurance is bought, there is less incentive to be careful about risky behaviors
27.2c: Diversification of Firm-Specific Risk * Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risk * Bought stock bets on the future profitability of that company, which is risky because not all information is known * Standard deviation: risk measured by the volatility of variable * The higher the standard deviation, the more volatile it is, and the riskier it is * Firm-specific risk: risk that affects only a single company * Market risk: risk that affects all companies in the stock market
27.2d: The Trade-Off between Risk and Return * People face trade-offs * Historically, stocks have offered much higher rates of return than bonds, bank savings accounts, and other financial assets

Chapter 27.3: Asset Valuation

27.3a: Fundamental Analysis * Overvalued: a stock whose price is more than its value * Fairly valued: a stock whose price is equivalent to its value * Undervalued: a stock whoswhose price is less than its value * Fundamental analysis: the detailed analysis of a company in order to estimate its value * Stock analysts are hired by firms to conduct a fundamental analysis and give advice on stocks to buy * Dividends: cash payments a company makes to its shareholders * A company’s ability to pay dividends depends on the company’s ability to earn profits
27.3b: The Efficient Markets Hypothesis * Efficient markets hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset * Money managers watch new stories and conduct fundamental analysis to try and determine a stock’s value. Stocks are bought ideally when a price falls below its fundamental value, and sold when the price is above the fundamental value * At market price, number of shares being sold = number of shares being bought * Informational efficiency: the description of asset prices that rationally reflect all available information * Stock prices change when information changes. When good news appears about a company, the price rises, and if bad news appears, the price falls * Random walk: the path of a variable whose changes are impossible to predict
27.3c: Market Irrationality * Speculative bubble: whenever the price of an asset rises above what appears to be its fundamental value * Speculative bubbles may happen because the value of a stock to a stockholder is decided by the stream of dividend payments but also on the final sale price * You need to estimate not only the value of the business, but what other people will think of the business’s worth in the future * If the market were irrational, a rational person would be able to beat the market * Beating the market is nearly impossible