Chapter 27Chapter 27

The Basic Tools of Finance

WHAT’S NEW IN THE THIRD EDITION:

This is an entirely new 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. Since both capital and labor are among the primary determinants of output,
Chapter 15 will address the market for labor.
The purpose of Chapter 14 is to introduce the students to some tools that people use when they
participate in financial markets. We will show how people compare different sums of money at different
points in time, how they manage risk, and how these concepts combine to help determine the value of a
financial asset, such as a share of stock.

KEY POINTS:

1. 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.

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2  Chapter 27/The Basic Tools of Finance

2. Because of diminishing marginal utility, most people are risk averse. Risk averse people can reduce
risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower
return.

3. The value of an asset, such as a share of stock, equals the present value of the cash flows the owner
of the share will receive, including the stream of dividends and the final share price. According to the
efficient markets hypothesis, financial markets process valuable 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 may also help students think through some of the decisions that
they will make in their own 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
to produce, using prevailing interest rates, 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. Definition of future value: the amount of money in the future that an

amount of money today will yield, given prevailing interest rates.

a. Definition 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 percent 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 percent and the $200 will be received 10
years from now, the present value is $200/(1.05)10 = $123.

If r is th e in te re s t ra te , th e n a n a m o u n t $ X to b e
re c e iv e d in N y e a rs h a s a p re s e n t v a lu e o f $ X / (1 + r ) N .
 Chapter 27/The Basic Tools of Finance  3

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: Jerry and Elaine both graduate from college at the age of 22 and take
jobs earning $30,000 per year.

a. Jerry lives in an economy where incomes grow at 1 percent per year.

b. Elaine lives in an economy where incomes grow at 3 percent per year.

c. Forty years later (when both are 62) Jerry will be earning $45,000 and
Elaine will be earning $98,000.

3. The Rule of 70 can help us understand the effects of compounding:

R u le o f 7 0 : If a v a ria b le g ro w s a t X % p e r y e a r, th e n
th a t v a ria b le w ill d o u b le in a p p ro x im a te ly 7 0 / X y e a rs .

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.
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 gain from winning $1,000.

Figure 1
4  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 he 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.

c. As a result, people are risk averse.

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.

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 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. This is adverse selection.

b. After people buy insurance, they have less incentive to be careful about
their risky behavior. This is moral hazard.
 Chapter 27/The Basic Tools of Finance  5

C. Diversification of Idiosyncratic 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.

a. A person who buys stock in a company is placing a bet on the future

profitability of that company.

b. Risk can be reduced by placing a large number of small bets, rather than
a small number of large ones.

Figure 2

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. Definition of idiosyncratic risk: risk that affects only a single

economic actor.

b. Definition of aggregate risk: risk that affects all economic actors

at once.

c. Diversification can eliminate idiosyncratic risk, but will not affect

aggregate risk.

D. The Tradeoff between Risk and Return

1. Principle #1: People face tradeoffs.

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.

Figure 3
6  Chapter 27/The Basic Tools of Finance

4. The choice of a particular combination of risk and return depends on a person’s

risk aversion, which reflects a person’s own preferences.

IV. Asset Valuation

A. The price of a share of stock is determined by supply and demand.

B. To understand stock prices, we need to understand what determines a person’s

willingness to pay for a share of stock.

C. Definition of fundamental analysis: the study of a company’s accounting

statements and future prospects to determine its value.

1. If the price of a share of stock is less than the value, the stock is said to be
undervalued.

2. If the price of a share of stock is greater than its value, the stock is said to be
overvalued.

3. If the price of a share of stock is equal to its value, the stock is said to be fairly
valued.

4. The value of a stock to a shareholder is what he 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.

5. 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 a mutual fund.

D. Definition of the efficient markets hypothesis: the theory according to which

asset prices reflect all publicly available information about the value of an
asset.

1. 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.

2. 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.

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.
 Chapter 27/The Basic Tools of Finance  7

b. As judged by the typical person in the market, all stocks are fairly valued
all of the time.

3. 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).

4. Definition 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. Since news is unpredictable, changes in stock prices should be

unpredictable.

5. 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.

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 final sale price expected in the future.
8  Chapter 27/The Basic Tools of Finance

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.

b. Believers in the efficient markets hypothesis point out that it is difficult to

know the correct, rational valuation of a company so it is hard to tell if
any particular valuation is irrational.

F. In the News: Some Lessons from Enron

1. After the Enron collapse, Congress debated whether or not to limit the amount of
their own company’s stock that employees can put into their own retirement
plan.

a. Those in favor believed that such a restriction would encourage

diversification and reduce risk.

b. Those opposed to the legislation felt that it violated free choice.

2. This is an article written by economist Hal Varian discussing why the restriction
of choice may be a good idea in this case.

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/(1.07)10 = $76.25.

2. There are three ways in which a risk-averse person may reduce the risk he faces: (1) purchase
insurance, (2) diversify his portfolio, or (3) choose safer alternatives by accepting a lower rate of
return.

3. No. According to the efficient markets hypothesis, the price of a share of stock should reflect all
available information about its value. Thus, the stocks in this list should do no better on average
than any other stock listed on the stock exchange.

Questions for Review

 Chapter 27/The Basic Tools of Finance  9

1. If the interest rate is 7 percent, the present value of $200 to be received in 10 years is $200/(1.07) 10
= $101.67. If the interest rate is 7 percent, the present value of $300 to be received 20 years from
now is $300/(1.07)20 = $77.53.

2. Purchasing insurance allows an individual to reduce the level of risk he faces. Two problems that
impede the insurance industry from working correctly are adverse selection and moral hazard.
Adverse selection occurs because a high-risk person is more likely to apply for insurance than a low-
risk person is. Moral hazard occurs because people have less incentive to be careful about their risky
behavior after they purchase insurance.

3. Diversification is the reduction of risk achieved by replacing a single risk with a large number of
smaller unrelated risks. A stockholder will get more diversification going from 1 to 10 stocks than
from 100 to 120 stocks.

4. Stocks have more risk because their value depends on the future value of the firm. Because of its
higher risk, shareholders will demand a higher return. There is a positive relationship between risk
and return.

5. A stock analyst will consider the future profitability of a firm when determining the value of the stock.

6. The efficient markets hypothesis suggests that stock prices reflect all available information. This
means that we cannot use current information to predict future changes in stock prices. One piece
of evidence that supports this theory is the fact that many index funds outperform mutual funds that
are actively managed by a professional portfolio manager.

7. Economists who are skeptical of the efficient markets hypothesis believe that fluctuations in stock
prices are partly psychological. People may in fact be willing to purchase a stock that is overvalued if
they believe that someone will be willing to pay even more in the future. This means that the stock
price may not be a rational valuation of the firm.

Problems and Applications

1. The future value of $24 invested for 400 years at an interest rate of 7 percent is (1.07) 400  $24 =
$13,600,000,000,000 = $13.6 trillion.

2. a. The present value of $15 million to be received in four years at an interest rate of 11 percent is
$15 million/(1.11)4 = $9.88 million. Since the present value of the payoff is less than the cost,
the project should not be undertaken.

The present value of $15 million to be received in four years at an interest rate of 10 percent is
$15 million/(1.10)4 = $10.25 million. Since the present value of the payoff is greater than the
cost, the project should be undertaken.

The present value of $15 million to be received in four years at an interest rate of 9 percent is
$15 million/(1.09)4 = $10.63 million. Since the present value of the payoff is greater than the
cost, the project should be undertaken.

The present value of $15 million to be received in four years at an interest rate of 8 percent is
$15 million/(1.08)4 = $11.03 million. Since the present value of the payoff is greater than the
cost, the project should be undertaken.
10  Chapter 27/The Basic Tools of Finance

b. The exact cutoff for the interest rate between profitability and nonprofitability is the interest rate
that will equate the present value of receiving $15 million in four years with the current cost of
the project ($10 million):
$10 =15/(1 + x)4
10(1 + x)4 = 15
(1 + x)4 = 1.5
1 + x = (1.5)0.25
1 + x = 1.1067
x = 0.1067

Therefore, an interest rate of 10.67 percent would be the cutoff between profitability and
nonprofitability.

3. a. A sick person is more likely to apply for health insurance than is a well person. This is adverse
selection. Once a person has health insurance, he may be less likely to take good care of
himself. This is moral hazard.

b. A risky driver is more likely than a safe driver to apply for car insurance. This is adverse
selection. Once a driver has insurance, he may drive more recklessly. This is adverse selection.

4. To reduce the risk associated with the portfolio, it is better to diversify. This means that the stocks
should be of companies from different industries as well as located in different countries.

5. A stock that is very sensitive to economic conditions will have more risk associated with it. Thus, we
would expect for that stock to pay a higher return. To get stockholders to be willing to accept the
risk, the expected return must be larger than average.

6. Shareholders will likely demand a higher return due to the stock’s idiosyncratic risk. Idiosyncratic risk
is risk that affects only that particular stock. All stocks in the economy are subject to aggregate risk.

7. a. If a roommate is buying stocks in companies that everyone believes will experience big profits in
the future, the price-earnings ratio is likely to be high. The price is high because it reflects
everyone’s expectations about the firm’s future earnings. The largest disadvantage in buying
these stocks is that they are currently overvalued and may not pay off in the future.

b. Firms with low price-earnings ratios will likely have lower future earnings. The reason why these
stocks are cheap is that everyone has lower expectations about the future profitability of these
firms. The largest disadvantage to buying this stock is that the market may be correct and the
firm's stock may provide a low return.

8. a. Answers will vary, but may include things like information on new products under development or
information concerning future government regulations that will affect the profitability of the firm.

b. The fact that those who trade stocks based on inside information earn very high rates of return
does not violate the efficient markets hypothesis. The efficient market hypothesis suggests that
the price of a stock reflects all available information concerning the future profitability of the firm.
Inside information is not readily available to the public and thus is not reflected in the stock’s
price.

c. Insider trading is illegal because it gives some buyers or sellers an unfair advantage in the stock
market.