N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eight Edition

CHAPTER The Basic Tools of

27 Finance
Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University
© 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
1
management system for classroom use.
 Look for the answers to these questions:
• What is “present value”? How can we use it
to compare sums of money from different
times?
• Why are people risk averse?
How can risk-averse people use insurance
and diversification to manage risk?
• What determines the value of an asset?
What is the “efficient markets hypothesis”?
Why is beating the market nearly
impossible?
© 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 2
management system for classroom use.
 Introduction
• The financial system
– Coordinates saving and investment
• Participants in the financial system
– Make decisions regarding the allocation of
resources over time and the handling of
risk
• Finance
– Studies such decision making

© 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 3
management system for classroom use.
 Present Value:
The Time Value of Money
• The present value of a future sum:
– The amount that would be needed today
to yield that future sum at prevailing
interest rates
• The future value of a sum:
– The amount the sum will be worth at a
given future date, when allowed to earn
interest at the prevailing rate

© 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 4
management system for classroom use.
 EXAMPLE 1: A Simple Deposit
Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
• Present value, PV = $100
• Interest rate, r = 0.05
• In N years, future value FV = PV(1 + r)N
• In one year, FV = $100(1 + 0.05) = $105.00
• In two years, FV=$100(1 + 0.05)2 = $110.25
• In three years, FV=$100(1 + 0.05)3=$115.76
• So, PV = FV / (1 + r)N
© 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 5
management system for classroom use.
 EXAMPLE 2: Investment Decision
PV = FV / (1 + r)N
Suppose r = 0.06. Should General Motors
spend $100 million to build a factory that will
yield $200 million in ten years?

Solution: need to find present value of $200

million in 10 years:
• PV = ($200 million)/(1.06)10 = $112 million
• Since PV > cost of factory, GM should build
it.
© 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 6
management system for classroom use.
 EXAMPLE 2: Investment Decision
Instead, suppose r = 0.09.
Should General Motors spend $100 million to
build a factory that will yield $200 million in ten
years?

Solution: need to find present value of $200

million in 10 years:
• PV = ($200 million)/(1.09)10 = $84 million
• Since PV < cost of factory, GM should not
build it.
Present value helps explain why investment
falls when the interest rate rises.
© 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 7
management system for classroom use.
 Active Learning 1 Present value
You are thinking of buying a six-acre lot for
$70,000. The lot will be worth $100,000 in five
years.
A. Should you buy the lot if r = 0.05?
B. Should you buy it if r = 0.10?

© 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 8
management system for classroom use.
 Active Learning 1 Answers
You are thinking of buying a six-acre lot for $70,000.
The lot will be worth $100,000 in five years.
A. Should you buy the lot if r = 0.05?
PV = $100,000/(1.05)5 = $78,350.
PV of lot > price of lot.
Yes, buy it.
B. Should you buy it if r = 0.10?
PV = $100,000/(1.1)5 = $62,090.
PV of lot < price of lot.
No, do not buy it.

© 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 9
management system for classroom use.
 Compounding
• Compounding:
– The accumulation of a sum of money
where the interest earned on the sum
earns additional interest
• Because of compounding
– Small differences in interest rates lead to
big differences over time.

© 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 10
management system for classroom use.
 Compounding
• Example: Buy $1000 worth of Microsoft
stock, hold for 30 years.
– If rate of return = 0.08, FV = $10,063
– If rate of return = 0.10, FV = $17,450
– Thus, a 2% increase in the rate of return
leads to over $7000 of additional interest
earned over the 30 years.

© 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 11
management system for classroom use.
 The Rule of 70
• The Rule of 70:
– If a variable grows at a rate of x percent
per year, that variable will double in about
70/x years.
• Example:
– If interest rate is 5%, a deposit will double
in about 14 years.
– If interest rate is 7%, a deposit will double
in about 10 years.
© 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 12
management system for classroom use.
 Risk Aversion
• Most people are risk averse—they dislike
uncertainty.
– Example: You are offered the following gamble. Toss
a fair coin:
• If heads, win $1000; If tails, you lose $1000
– Should you take this gamble?
• If you are risk averse, the pain of losing $1000
would exceed the pleasure of winning $1000.
• Since both outcomes are equally likely, you should
not take this gamble.
• WHY ?
© 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 13
management system for classroom use.
 The Utility Function

Utility is a subjective Utility Current

measure of well-being utility
that depends on wealth.

As wealth rises, the

curve becomes flatter
due to diminishing
marginal utility: the
more wealth a person
has, the less extra utility Wealth
he would get from an Current
extra dollar. wealth
© 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 14
management system for classroom use.
 The Utility Function and Risk Aversion

Utility
Utility gain from
winning $1000
Utility loss
from losing
$1000

Because of diminishing
marginal utility,
a $1000 loss reduces utility Wealth
more than a $1000 gain –1000 +1000
increases it.

© 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 15
management system for classroom use.
 Managing Risk With Insurance
• How insurance works:
– A person facing a risk pays a fee to the
insurance company, which in return accepts
part or all of the risk.
• Insurance
– Allows risks to be pooled, and can make risk
averse people better off:
• E.g., it is easier for 10,000 people to each bear
1/10,000 of the risk of a house burning down
than for one person to bear entire risk alone.
© 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 16
management system for classroom use.
 Two Problems in Insurance Markets
1. Adverse selection:
– A high-risk person benefits more from
insurance, so is more likely to purchase it.
2. Moral hazard:
– People with insurance have less incentive
to avoid risky behavior.

© 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 17
management system for classroom use.
 Two Problems in Insurance Markets
• Insurance companies
– Cannot fully guard against these problems,
so they must charge higher prices.
– As a result, low-risk people sometimes
forego insurance and lose the benefits of
risk-pooling.

© 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 18
management system for classroom use.
 Active Learning 2 Adverse selection or moral hazard?
Identify whether each of the following is an
example of adverse selection or moral hazard.
A. Joe begins smoking in bed after buying fire
insurance.
B. Both of Susan’s parents lost their teeth to gum
disease, so Susan buys dental insurance.
C. When Gertrude parks her Corvette convertible,
she doesn’t bother putting the top up, because
her insurance covers theft of any items left in
the car.

© 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 19
management system for classroom use.
 Active Learning 2 Answers
A. Joe begins smoking in bed after buying fire
insurance.
Moral hazard
B. Both of Susan’s parents lost their teeth to gum
disease, so Susan buys dental insurance.
Adverse selection
C. When Gertrude parks her Corvette convertible,
she doesn’t bother putting the top up, because
her insurance covers theft of any items left in
the car.
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 20
management system for classroom use.
 Measuring Risk
• Standard deviation
– A statistic that measures a variable’s
volatility—how likely it is to fluctuate.
– Used to measure the risk of an asset
– The higher the standard deviation of the
asset’s return, the greater the risk

© 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 21
management system for classroom use.
 Reducing Risk
Through Diversification
• Diversification
– Reduces risk by replacing a single risk with a
large number of smaller, unrelated risks.
• A diversified portfolio
– Assets whose returns are not strongly related
– Some assets will realize high returns, others low
returns.
– The high and low returns average out, so the
portfolio is likely to earn an intermediate return
more consistently than any of the assets it
contains.
© 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 22
management system for classroom use.
 Reducing Risk
Through Diversification
• Firm-specific risk
– Affects only a single company
• Market risk
– Affects all companies in the stock market
• Diversification
– Can eliminate firm-specific risk
– Cannot eliminate market risk

© 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 23
management system for classroom use.
 Reducing Risk Through Diversification

Increasing the number

50 of stocks reduces
firm-specific risk.
Standard dev of
portfolio return

40

30

20 But
market
10 risk
remains.
0
0 10 20 30 40
# of stocks in portfolio
© 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 24
management system for classroom use.
 Tradeoff Between Risk and Return
• Tradeoff:
– Riskier assets pay a higher return, on
average, to compensate for the extra risk
of holding them.
– E.g., over the past 200 years, average
real return:
• On stocks, 8% (riskier asserts)
• On short-term government bonds, 3%.

© 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 25
management system for classroom use.
 Tradeoff Between Risk and Return
Suppose you are dividing your portfolio
between two asset classes.
– A diversified group of risky stocks:
• average return = 8%, standard dev. = 20%
– A safe asset:
• return = 3%, standard dev. = 0%
• The risk and return on the portfolio
depends on the percentage of each asset
class in the portfolio…
© 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 26
management system for classroom use.
 The Tradeoff Between Risk and Return

Increasing
the share of
stocks in the
portfolio
increases
the average
return but
also the risk.

© 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 27
management system for classroom use.
 Asset Valuation
• When deciding whether to buy a
company’s stock
– You compare the price of the shares to
the value of the company.
• Stocks are:
– Undervalued if Price < Value
– Overvalued if Price > Value
– Fairly valued if Price = Value

© 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 28
management system for classroom use.
 Active Learning 3 Valuing a share of stock
If you buy a share of AT&T stock today,
• you will be able to sell it in 3 years for $30.
• you will receive a $1 dividend at the end of
each of those 3 years.
If the prevailing interest rate is 10%, what is the
value of a share of AT&T stock today?

© 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 29
management system for classroom use.
 Active Learning 3 Answers
amount
when you present value of
you will
will receive it the amount
receive
$1 in 1 year $1/(1.1) = $ .91
$1 in 2 years $1/(1.1)2 = $ .83
$1 in 3 years $1/(1.1)3 = $ .75
$30 in 3 years $30/(1.1)3 = $22.54

The value of a share of AT&T stock equals the

sum of the numbers in the last column: $25.03

© 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 30
management system for classroom use.
 Asset Valuation
• Value of a share
= PV of any dividends the stock will pay
+ PV of the price you get when you sell the share
• Problem:
– When you buy the share, you don’t know what
future dividends or prices will be.
• Fundamental analysis (one way to value a stock)
– The study of a company’s accounting
statements and future prospects to determine
its value
© 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 31
management system for classroom use.
 Active Learning 4 Show of hands survey
You have a brokerage account with Merrill
Lynch. Your broker calls you with a hot tip
about a stock: new information suggests that
the company will be highly profitable.
• Should you buy stock in the company?
A. Yes
B. No
C. Not until you read the prospectus.
D. What’s a prospectus?

© 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 32
management system for classroom use.
 Efficient Markets Hypothesis
• Efficient Markets Hypothesis (EMH):
– The theory that each asset price reflects
all publicly available information about the
value of the asset
Three implications of EMH:
1. Stock market is informationally efficient:
– Each stock price reflects all available
information about the value of the
company.
© 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 33
management system for classroom use.
 Efficient Markets Hypothesis
2. Stock prices follow a random walk:
– A stock price only changes in response to
new information (“news”) about the
company’s value. News cannot be
predicted, so stock price movements should
be impossible to predict.
3. It is impossible to systematically beat the
market.
– By the time the news reaches you, mutual
fund managers will have already acted on it.
© 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 34
management system for classroom use.
 Index Funds vs. Managed Funds
• An index fund
– A mutual fund that buys all the stocks in a
given stock index.
• An actively managed mutual fund
– Aims to buy only the best stocks.
– Have higher expenses than index funds
EMH implies that returns on actively
managed funds should not consistently
exceed the returns on index funds.
© 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 36
management system for classroom use.
 Index Funds vs. Managed Funds

2001–2006 2006
expense
annualized
ratio
return (in percentage)

S&P 500 (index fund) 6.2% .351

Managed large cap funds 5.9 1.020
S&P MidCap 400 (index fund) 10.9 .535
Managed mid cap funds 8.1 1.458

S&P SmallCap 600 (index fund) 12.5 .550

Managed mid cap funds 10.3 1.272

© 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 37
management system for classroom use.
 Market Irrationality
• Many believe that stock price movements
are partly psychological:
– J.M. Keynes: stock prices driven by
“animal spirits,” “waves of pessimism and
optimism”
– Alan Greenspan: 1990s stock market
boom due to “irrational exuberance”

© 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 38
management system for classroom use.
 Market Irrationality
• Possibility of speculative bubbles
– Value of the stock to a stockholder
depends on:
• Stream of dividend payments
• Final sale price
• Bubbles
– Occur when speculators buy overvalued
assets expecting prices to rise further

© 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 39
management system for classroom use.
 Conclusion
• This chapter has introduced some of the
basic tools people use when they make
financial decisions.
– The efficient markets hypothesis teaches
that a stock price should reflect the
company’s expected future profitability.
– Fluctuations in the stock market have
important macroeconomic implications,
which we will study later.

© 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 41
management system for classroom use.
 Summary
• Because savings can earn interest, a sum of
money today is more valuable than the same sum
of money in the future.
• 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.
© 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 42
management system for classroom use.
 Summary
• 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 sale 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.
© 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 43
management system for classroom use.