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)
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)
3.3 Present Value and the NPV Decision Rule (Slide 34)
• Net Present Value (Slide 34)
• The NPV Decision Rule (Slide 35)
3.4 Arbitrage and the Law of One Price (Slide 51–52)
3.5 No-Arbitrage and Security Prices (Slide 53)
• Valuing a Security with the Law of One Price (Slide 53)
– Identifying Arbitrage Opportunities with Securities (Slides 54–55)
• Table 3.3 Net Cash Flows from Buying the Bond and Borrowing
• Table 3.4 Net Cash Flows from Selling the Bond and Investing
– Value Additivity
• Example 3.8 Valuing an Asset in a Portfolio (Slides 72–73)
• PowerPoint Alternative Example 3.8 (Slides 74–75)
– Value Additivity and Firm Value (Slide 76)
• Global Financial Crisis Liquidity and the Informational Role of Prices
• Where Do We Go From Here? (Slide 77)
Chapter 3 Appendix The Price of Risk (Slides 80)
• Risky Versus Risk-Free Cash Flows (Slides 82)
• Table 3A.1 Cash Flows and Market Prices (in $) of a Risk-Free Bond and an Investment in
the Market Portfolio (Slide 82)
• Risk Aversion and the Risk Premium (Slides 84–85)
• Figure 3A.1 Converting between Dollars Today and Dollars in One Year with Risk (Slide
94)
• Example 3A.2 Using the Risk Premium to Compute a Price (Slides 95–96)
• PowerPoint Alternative Example 3A.2 (Slides 97–98)
10 Berk/DeMarzo • Corporate Finance, Fourth Edition
II. Learning Objectives
3-2 Define the term “competitive market,” give examples of markets that are competitive and some
3-3 Explain why maximizing NPV is always the correct decision rule.
3-4 Define arbitrage, and discuss its role in asset pricing. How does it relate to the Law of One
Price?
3-6 Show how value additivity can be used to help managers maximize the value of the firm.
3-8 Calculate the value of a risky asset using the Law of One Price.
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
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
3.3 Present Value and the NPV Decision Rule
Net present value = PV(benefits) – PV(costs) (Equation 3.1)
Net present value (NPV) is introduced here as the most recommended decision criterion by the
3.4 Arbitrage and the Law of One Price
The practice of buying and selling equivalent goods in different markets to take advantage of a price
difference is known as arbitrage. “If equivalent investment opportunities trade simultaneously in
3.5 No-Arbitrage and Security Prices
Note, also, that the NPV of buying a security equals the present value of the cash flows paid by the
security minus the cost of the security. In normal (competitive, no-arbitrage) markets, this NPV will
Chapter 3 Appendix The Price of Risk
Until now, the authors have only considered risk-free cash flows. Risk aversion results from the fact
that the personal cost of losing a dollar in bad times is greater than the benefit of an extra dollar in
good times.
By definition, a risky asset has more than one possible outcome. The price must be determined
based on the expected return; its actual return could be higher or lower. The risk premium is
introduced here as the difference between the return investors expect on a risky asset and the return
12 Berk/DeMarzo • Corporate Finance, Fourth 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.