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**

# 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**