WHAT’S NEW IN THE EIGHTH EDITION:
There is a new Ask the Experts feature on “Diversication.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
the relationship between present value and future value.
the eects of compound growth.
how risk-averse people reduce the risk they face.
how asset prices are determined.
CONTEXT AND PURPOSE:
Chapter 27 is the third chapter in a four-chapter sequence on the level and growth of output
in the long run. In Chapter 25, we discuss how capital and labor are among the primary
determinants of output and growth. In Chapter 26, we addressed how saving and investment
in capital goods aect the production of output. In Chapter 28, we will show some of the
tools people and rms use when choosing capital projects in which to invest. Because both
capital and labor are among the primary determinants of output, Chapter 28 will address the
market for labor.
The purpose of Chapter 27 is to introduce the students to some tools that people use
when they participate in nancial markets. We will show how people compare dierent sums
of money at dierent points in time, how they manage risk, and how these concepts
combine to help determine the value of a nancial asset, such as a share of stock.
KEY POINTS:
Because savings can earn interest, a sum of money today is more valuable than the
same sum of money in the future. A person can compare sums from dierent times using
the concept of present value. The present value of any future sum is the amount that
would be needed today, given prevailing interest rates, to produce that future sum.
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.
439
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2
7
THE BASIC TOOLS OF
FINANCE
440 ❖ Chapter 27/The Basic Tools of Finance
The value of an asset equals the present value of the cash Bows the owner will receive.
For a share of stock, these cash Bows include the stream of dividends and the nal share
price. According to the eCcient markets hypothesis, nancial 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 eCcient markets hypothesis,
however, and believe that irrational psychological factors also inBuence asset prices.
CHAPTER OUTLINE:
I. Denition of +nance: the +eld that studies how people make decisions regarding
the allocation of resources over time and the handling of risk.
A. Many of the basic insights of nance are central to understanding how the economy
works.
B. The tools of nance can help us think through some of the decisions that we must
make in our lives.
II. Present Value: Measuring the Time Value of Money
A. Money today is more valuable than the same amount of money in the future.
B. Denition of present value: the amount of money today that would be
needed, using prevailing interest rates, to produce a given future amount
of money.
1. Example: you put $100 in a bank account today. How much will it be worth in N
years?
2. Denition of future value: the amount of money in the future that an
amount of money today will yield, given prevailing interest rates.
a. Denition of 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.
b. If we invest $100 at an interest rate of 5% for 10 years, the future value will
be (1.05)10 × $100 = $163.
c. Example: You expect to receive $200 in N years. What is the present value of
$200 that will be paid in N years?
i) To compute a present value from a future value, we divide by the factor (1
+ r)N.
ii) If the interest rate is 5% and the $200 will be received 10 years from now,
the present value is $200/(1.05)10 = $123.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
If is the interest rate, then an amount $ to be
received in years has a present value of $ /(1+ ) .
N
r X
N X r
Chapter 27/The Basic Tools of Finance ❖ 441
d. The higher the interest rate, the more you can earn by depositing your money
at the bank, so the more attractive having $100 today becomes.
e. The concept of present value also helps to explain why investment is inversely
related to the interest rate.
C. FYI: The Magic of Compounding and the Rule of 70
1. Growth rates that seem small in percentage terms seem large after they are
compounded for many years.
2. Example: Elliott and Darlene both graduate from college at the age of 22 and take
jobs earning $30,000 per year.
a. Elliott lives in an economy where incomes grow at 1% per year.
b. Darlene lives in an economy where incomes grow at 3% per year.
c. Forty years later (when both are 62), Elliott will be earning $45,000 and
Darlene will be earning $98,000.
3. The Rule of 70 can help us understand the eects of compounding:
III. Managing Risk
A. Risk Aversion
1. Most people are risk averse.
a. People dislike bad things happening to them.
b. In fact, they dislike bad things more than they like comparable good things.
c. For a risk-averse person, the pain from losing the $1,000 would exceed the
pleasure from winning $1,000.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Rule of 70: If a variable grows at % per year, then
that variable will double in approximately 70/ years.
X
X
This is a good time to explain to students how important saving can be
while they are young. Show students how the magic of compounding can
turn a small amount of saving (say, $1,000 per year) into a large amount
in 25 or 30 years.
442 ❖ Chapter 27/The Basic Tools of Finance
2. Economists have developed models of risk aversion using the concept of utility,
which is a person’s subjective measure of well-being or satisfaction.
a. A utility function exhibits the property of diminishing marginal utility: the more
wealth a person has, the less utility she gets from an additional dollar.
b. Because of diminishing marginal utility, the utility lost from losing $1,000 is
greater than the utility of winning $1,000.
B. The Markets for Insurance
1. One way to deal with risk is to purchase insurance.
2. From the standpoint of the economy as a whole, the role of insurance is not to
eliminate the risks inherent in life but to spread them around more eCciently.
a. Owning insurance does not prevent bad things from happening to you.
b. However, the risk is shared among thousands of insurance-company
stockholders rather than being borne by you alone.
3. The markets for insurance suer from two types of problems that impede their
ability to spread risk.
a. A high-risk person is more likely to apply for insurance than a low-risk person
because a high-risk person would benet more from insurance protection. This
is adverse selection.
b. 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. This is moral hazard.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 1
Chapter 27/The Basic Tools of Finance ❖ 443
C. Diversication of Firm-Specic Risk
1. Practical advice that nance oers to risk-averse people: “Don’t put all your eggs
in one basket.”
2. Denition of diversi+cation: the reduction of risk achieved by replacing a
single risk with a large number of smaller unrelated risks.
a. A person who buys stock in a company is placing a bet on the future
protability of that company.
b. Risk can be reduced by placing a large number of small bets rather than a
small number of large ones.
3. Risk can be measured by the standard deviation of a portfolio’s return.
a. Standard deviation measures the volatility of a variable.
b. The higher the standard deviation of a portfolio’s return, the riskier it is.
c. The risk of a stock portfolio falls as the number of stocks increases.
4. It is impossible to eliminate all risk by increasing the number of stocks in the
portfolio.
a. Denition of +rm-speci+c risk: risk that a4ects only a single economic
actor.
b. Denition of market risk: risk that a4ects all economic actors at once.
c. Diversication can eliminate rm-specic risk, but will not aect market risk.
D. The Trade-o between Risk and Return
1. Principle #1: People face trade-os.
2. Risk-averse people are willing to accept the risk inherent in holding stock because
they are compensated for doing so.
3. When deciding how to allocate their savings, people have to decide how much
risk they are willing to undertake to earn a higher return.
4. The choice of a particular combination of risk and return depends on a person’s
risk aversion, which reBects her own preferences.
IV. Asset Valuation
A. The price of a share of stock is determined by supply and demand.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 2
Figure 3
444 ❖ Chapter 27/The Basic Tools of Finance
B. To understand stock prices, we need to understand what determines a person’s
willingness to pay for a share of stock.
C. Fundamental Analysis
1. Denition of fundamental analysis: the study of a company’s accounting
statements and future prospects to determine its value.
2. If the price of a share of stock is less than the value, the stock is said to be
undervalued.
3. If the price of a share of stock is greater than its value, the stock is said to be
overvalued.
4. If the price of a share of stock is equal to its value, the stock is said to be fairly
valued.
5. The value of a stock to a shareholder is what she receives from owning it, which
includes the present value of dividend payments and the nal sale price.
a. Both of these are highly related to the rm’s ability to earn prots.
b. The rm’s protability depends on a large number of factors that aect the
demand for its product and its costs of doing business.
6. There are three ways to rely on fundamental analysis to select a stock portfolio.
a. Do all of the necessary research yourself.
b. Rely on the advice of Wall Street analysts.
c. Buy shares in a mutual fund.
D. The ECcient Markets Hypothesis
1. Denition of the e5cient markets hypothesis: the theory according to
which asset prices re6ect all publicly available information about the
value of an asset.
2. Each company listed on a major stock exchange is followed closely by money
managers who monitor news stories and conduct fundamental analysis to
determine a stock’s value.
3. At the equilibrium market price of a share of stock, the number of shares being
oered for sale is exactly equal to the number of shares that people want to buy.
a. At the market price, the number of people who think that the stock is
overvalued exactly balances the number of people who think it is
undervalued.
b. As judged by the typical person in the market, all stocks are fairly valued all of
the time.
4. Denition of informationally e5cient: re6ecting all available information
in a rational way.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 27/The Basic Tools of Finance ❖ 445
a. Stock prices change when information changes.
b. When the good (bad) news about a company’s prospects becomes public, the
value and the price of the stock will rise (fall).
5. Denition of random walk: the path of a variable whose changes are hard
to predict.
a. Changes in stock prices are impossible to predict from available information.
b. The only thing that can move stock prices is news that changes the market’s
perception of the company’s value.
c. Because news is unpredictable, changes in stock prices should be
unpredictable.
6. Case Study: Random Walks and Index Funds
a. Some of the best evidence in favor of the eCcient markets hypothesis comes
from the performance of index funds.
b. In practice, funds that are actively managed by a professional rarely beat
index funds and often do worse.
7. Ask the Experts: Diversi)cation
a. 95 percent of economic experts agreed that an equity investor can expect to
do better buying a well-diversied low-cost index fund than by picking a few
stocks.
E. Market Irrationality
1. The eCcient markets hypothesis assumes that people buying and selling stock
rationally process all of the information they have about the stock’s underlying
value.
2. There is a long tradition suggesting that Buctuations in stock prices are partly
psychological.
a. In the 1930s, John Maynard Keynes suggested that asset markets are driven
by the “animal spirits” of investors.
b. In the 1990s, Federal Reserve Chairman Alan Greenspan questioned whether
the stock market boom was due to “irrational exuberance.”
3. The value of a stock depends on the nal sale price expected in the future.
a. A person may be willing to pay more than a stock is worth today if he believes
that another person will pay even more in the future.
b. Therefore, to evaluate a stock, you have to estimate not only the value of the
business but also what other people may believe the business is worth in the
future.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
446 ❖ Chapter 27/The Basic Tools of Finance
4. There is much debate among economists about whether departures from rational
pricing are important or rare.
a. Believers in market irrationality point out that the stock market often moves in
ways that are hard to explain on the basis of news that might alter a rational
valuation.
b. Believers in the eCcient markets hypothesis point out that it is diCcult to
know the correct, rational valuation of a company so it is hard to tell if any
particular valuation is irrational.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.