Chapter 3
Financial Decision Making and the Law of One Price
I. Chapter Outline
The chapter outline below is correlated to the PowerPoint Lecture Slides. The PowerPoint slides are
referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
3.1 Valuing Decisions (Slide 6)
• Analyzing Costs and Benefits (Slides 7–10)
• Using Market Prices to Determine Cash Values (Slide 11)
• Example 3.1 Competitive Market Prices Determine Value (Slides 12–13)
• PowerPoint Alternative Example 3.1 (Slides 14–15)
• Example 3.2 Applying the Valuation Principle (Slides 16–17)
• PowerPoint Alternative Example 3.2 (Slides 18–19)
3.2 Interest Rates and the Time Value of Money (Slide 20)
• The Time Value of Money (Slide 20)
• The Interest Rate: An Exchange Rate Across Time (Slide 21)
– Value of Investment in One Year (Slides 22–23)
– Value of Investment Today (Slides 24–25)
– Present Versus Future Value (Slides 26–27)
– Discount Factors and Rates (Slide 28)
3.3 Present Value and the NPV Decision Rule (Slide 34)
• Net Present Value (Slide 34)
• The NPV Decision Rule (Slide 35)
– Accepting or Rejecting a Project (Slide 36)
• Table 3.1 Cash Flows and NPVs for Web Site Business Alternatives (Slide 44)
• PowerPoint Alternative Example 3.5 (Slides 45–48)
• NPV and Cash Needs (Slide 49)
• Table 3.2 Cash Flows of Hiring and Borrowing Versus Selling and Investing (Slide 50)
10 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
II. Learning Objectives
3-1 Assess the relative merits of two-period projects using net present value.
3-2 Define the term “competitive market,” give examples of markets that are competitive and some
3-4 Define arbitrage, and discuss its role in asset pricing. How does it relate to the Law of One
Price?
3-5 Calculate the no-arbitrage price of an investment opportunity.
3-7 Describe the Separation Principle.
3-9 Describe the relationship between a security’s risk premium and its correlation with returns of
other securities.
3-10 Describe the effect of transactions costs on arbitrage and the Law of One Price.
III. Chapter Overview
The chapter begins by discussing Microsoft’s decision to enter into a bidding war for Facebook. It
turned out to be a very good decision. In this chapter, the authors use that acquisition as a springboard
to introduce time value of money concepts. In particular, they focus on how to compare costs and
benefits that occur at different points in time. That part of the analysis is kept very simple because
3.1 Valuing Decisions
The most accurate way to identify costs and benefits is to use the market value of the cash flows—the
3.2 Interest Rates and the Time Value of Money
Usually, cash inflows and outflows do not occur at the same time. We must convert them to the
equivalent cash value at a particular point in time, in order to be able to compare them. We typically
12 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 3 have spreadsheet versions of the problems available: 6, 9, 10,
15, 17, and 19.