236
WHAT’S NEW IN THE SEVENTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ the relationship between present value and future value.
➢ the effects of compound growth.
➢ how risk-averse people reduce the risk they face.
➢ how asset prices are determined.
CONTEXT AND PURPOSE:
Chapter 14 is the third chapter in a four-chapter sequence on the level and growth of output in the long
run. In Chapter 12, we discuss how capital and labor are among the primary determinants of output and
growth. In Chapter 13, we addressed how saving and investment in capital goods affect the production
of output. In Chapter 15, we will show some of the tools people and firms use when choosing capital
projects in which to invest. Because both capital and labor are among the primary determinants of
output, Chapter 15 will address the market for labor.
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 different 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.
14
THE BASIC TOOLS OF
FINANCE
Chapter 14/The Basic Tools of Finance ❖ 237
• 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.
• The value of an asset equals the present value of the cash flows the owner will receive. For a share
of stock, these cash flows include the stream of dividends and the final share price. According to the
efficient markets hypothesis, financial 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 efficient markets hypothesis, however, and believe that irrational psychological factors
also influence asset prices.
CHAPTER OUTLINE:
I. Definition of finance: the field 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 finance are central to understanding how the economy works.
B. The tools of finance 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. Definition 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?
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
.
238 ❖ Chapter 14/The Basic Tools of Finance
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: Finn and Quinn both graduate from college at the age of 22 and take jobs earning
$30,000 per year.
a. Finn lives in an economy where incomes grow at 1% per year.
3. The Rule of 70 can help us understand the effects of compounding:
III. Managing Risk
A. Risk Aversion
1. Most people are risk averse.
a. People dislike bad things happening to them.
Rule of 70: If a variable grows at % per year, then
that variable will double in approximately 70/ years.
X
X
Chapter 14/The Basic Tools of Finance ❖ 239
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 efficiently.
3. The markets for insurance suffer 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 benefit more from insurance protection. This is
adverse selection
.
Figure 1
240 ❖ Chapter 14/The Basic Tools of Finance
C. Diversification of Firm-Specific Risk
1. Practical advice that finance offers to risk–averse people: “Don’t put all your eggs in one
basket.”
2. Definition of diversification: the reduction of risk achieved by replacing a single risk
with a large number of smaller unrelated risks.
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.
D. The Trade-off between Risk and Return
1. Principle #1: People face trade-offs.
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.
IV. Asset Valuation
A. The price of a share of stock is determined by supply and demand.
Figure 2
Figure 3
Chapter 14/The Basic Tools of Finance ❖ 241
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
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 final sale price.
a. Both of these are highly related to the firm’s ability to earn profits.
b. The firm’s profitability depends on a large number of factors that affect 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.
D. The Efficient Markets Hypothesis
1. Definition of the efficient markets hypothesis: the theory according to which asset
prices reflect 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 offered for
sale is exactly equal to the number of shares that people want to buy.
4. Definition of informationally efficient: reflecting all available information in a
rational way.
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).
242 ❖ Chapter 14/The Basic Tools of Finance
5. Definition of random walk: the path of a variable whose changes are hard to
predict.
6.
Case Study: Random Walks and Index Funds
a. Some of the best evidence in favor of the efficient 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.
E. Market Irrationality
1. The efficient 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 fluctuations in stock prices are partly psychological.
3. The value of a stock depends on the final 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.
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.
F.
In the News: Is the Efficient Markets Hypothesis Kaput?
Chapter 14/The Basic Tools of Finance ❖ 243
1. Some individuals suggest that the financial crisis of 2008 and 2009 indicates that the efficient
markets hypothesis is wrong.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The present value of $150 to be received in 10 years if the interest rate is 7 percent is $150 /
Questions for Review
3. Diversification is the reduction of risk achieved by replacing a single risk with a large number
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Quick Check Multiple Choice
1. b
Problems and Applications
2. a. The present value of $15 million to be received in four years at an interest rate of 11% is
b. The exact cutoff for the interest rate between profitability and nonprofitability is the
Chapter 14/The Basic Tools of Finance ❖ 245
b. Using the rule of 70, when the interest rate is 7 percent the value of the bond will double
4. The value of the stock is equal to the present value of its dividends and its final sale price.
5. a. A sick person is more likely to apply for health insurance than a well person is. This is
6. A stock that is very sensitive to economic conditions will have more risk associated with it.
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9. a. Yes, Jamal is risk averse. The marginal utility of an additional dollar of wealth is