14 The Basic Tools of Finance

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, 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?

CHAPTER 27 THE BASIC TOOLS OF FINANCE 2

 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 is the field that studies such
decision making.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 3

Present Value: The Time Value of Money
 To compare a sums from different times, we use
the concept of present value.
 The present value of a future sum: the amount
that would be needed today to yield that future
sum at prevailing interest rates.
 Related concept:
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.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 4

 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In three years, FV = $100(1 + 0.05)3 = $115.76
 In two years, FV = $100(1 + 0.05)2 = $110.25
 In one year, FV = $100(1 + 0.05) = $105.00

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 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In this example, $100 is the present value (PV).
 In general, FV = PV(1 + r )N
where r denotes the interest rate (in decimal form).

 Solve for PV to get: PV

PV == FV/(1
FV/(1 ++ rr ))NN

CHAPTER 27 THE BASIC TOOLS OF FINANCE 6

 EXAMPLE 2: Investment Decision
Present
Present value
value formula:
formula: PV
PV == FV/(1
FV/(1 ++ rr ))NN
 Suppose r = 0.06.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
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.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 7

 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:
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
present value
value helps
helps explain
explain why
why
investment
investment falls
falls when
when the
the interest
interest rate
rate rises
rises

CHAPTER 27 THE BASIC TOOLS OF FINANCE 8

A C T I V E L E A R N I N G 1:
Present value
You are thinking of buying a six-acre lot for $70,000.
The lot will be worth $100,000 in 5 years.
A. Should you buy the lot if r = 0.05?
B. Should you buy it if r = 0.10?

9
A C T I V E L E A R N I N G 1:
Answers
You are thinking of buying a six-acre lot for $70,000.
The lot will be worth $100,000 in 5 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.
10
 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.
 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

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 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.

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 Risk Aversion
 Most people are risk averse – they dislike
uncertainty.
 Example: You are offered the following gamble.
Toss a fair coin.
• If heads, you 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,
so you should not take this gamble.
CHAPTER 27 THE BASIC TOOLS OF FINANCE 13
 The Utility Function
Utility
Utility is
is aa Utility
subjective
subjective
measure
measure of of Current
well-being
well-being utility
that
that depends
depends
As
Ason wealth
wealth
wealth. rises,
rises, the
the
on wealth.
curve
curve becomes
becomes flatter
flatter
due
due toto diminishing
diminishing
marginal
marginal utility:
utility:
the
the more
more wealth
wealth aa Wealth
person
person has,
has, thethe less
less Current
extra
extra utility
utility he
he would
would getget wealth
from
from anan extra
extra dollar.
dollar.
CHAPTER 27 THE BASIC TOOLS OF FINANCE 14
 The Utility Function and Risk Aversion
Utility
Utility gain from
winning $1000
Utility loss
from losing
$1000

Because
Because of of diminishing
diminishing
marginal
marginal utility,
utility,
aa $1000
$1000 loss
loss reduces
reduces Wealth
utility –1000 +1000
utility more
more than
than aa
$1000
$1000 gain
gain increases
increases it.
it.
CHAPTER 27 THE BASIC TOOLS OF FINANCE 15
 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 the entire risk alone.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 16

 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.
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.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 17

A C T I V E L E A R N I N G 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.

18
A C T I V E L E A R N I N G 2:
Answers
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.
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
19
 Measuring Risk
 We can measure risk of an asset with the
standard deviation, a statistic that measures a
variable’s volatility – how likely it is to fluctuate.
 The higher the standard deviation of the asset’s
return, the greater the risk.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 20

 Reducing Risk Through Diversification
 Diversification reduces risk by replacing a
single risk with a large number of smaller,
unrelated risks.
 A diversified portfolio contains 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.
CHAPTER 27 THE BASIC TOOLS OF FINANCE 21
 Reducing Risk Through Diversification
 Diversification can reduce firm-specific risk,
which only a single company.
 Diversification cannot reduce market risk,
which affects all companies in the stock market.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 22

 Reducing Risk Through Diversification

50 Increasing
Increasing the
the number
number
of
of stocks
stocks reduces
reduces firm-
firm-
Standard dev of
portfolio return

40
specific
specific risk.
risk.
30

20 But
But
market
market
10
risk
risk
remains.
remains.
0
0 10 20 30 40
# of stocks in portfolio
CHAPTER 27 THE BASIC TOOLS OF FINANCE 23
The Tradeoff Between Risk and Return
 One of the Ten Principles from Chapter 1:
People face tradeoffs.
 A tradeoff between risk and return:
Riskier assets pay a higher return, on average,
to compensate for the extra risk of holding them.
 E.g., over past 200 years, average real return on
stocks, 8%. On short-term govt bonds, 3%.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 24

The Tradeoff Between Risk and Return
 Example:
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…

CHAPTER 27 THE BASIC TOOLS OF FINANCE 25

The Tradeoff Between Risk and Return
Increasing
Increasing
the
the share
share of of
stocks
stocks in
in the
the
portfolio
portfolio
increases
increases
the
the average
average
return
return but
but
also
also the
the risk.
risk.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 26

 Asset Valuation
 When deciding whether to buy a company’s stock,
you compare the price of the shares to
the value of the company.
• If share price > value, the stock is overvalued.
• If price < value, the stock is undervalued.
• If price = value, the stock is fairly valued.
 It’s easy to look up the price.
But how does one determine the stock’s value?

CHAPTER 27 THE BASIC TOOLS OF FINANCE 27

A C T I V E L E A R N I N G 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?

28
A C T I V E L E A R N I N G 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

29
 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.
 One way to value a stock: fundamental
analysis, the study of a company’s accounting
statements and future prospects to determine its
value

CHAPTER 27 THE BASIC TOOLS OF FINANCE 30

 The Efficient Markets Hypothesis
 Efficient Markets Hypothesis: the theory that
each asset price reflects all publicly available
information about the value of the asset
 Mutual fund managers
• use fundamental analysis to assess value of all
publicly traded companies
• buy shares when price < value,
sell shares when price > value
• continuously monitor and act on any news
that affects the valuation of any stock

CHAPTER 27 THE BASIC TOOLS OF FINANCE 31

 The Efficient Markets Hypothesis
 Stock prices determined by supply & demand.
In equilibrium,
• the number of people who believe a stock is
overvalued exactly balances the number who
believe it to be undervalued
• the typical person perceives all stocks fairly
valued

CHAPTER 27 THE BASIC TOOLS OF FINANCE 32

 Informational Efficiency
 According to the Efficient Markets Hypothesis,
the stock market is informationally efficient:
each stock price reflects all available information
about the value of the company.
• When good news about a company’s prospects
becomes public, the value of the company rises,
so money managers buy lots of shares until the
price rises to the new, higher value.
• When bad news becomes public, the value of
the company falls, so money managers sell the
shares until their price falls by the same amount.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 33

 Informational Efficiency
 At any moment, a stock price is the market’s
best guess of the company’s value
based on all available information.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 34

 Random Walk
 Random walk: the path of a variable whose
changes are impossible to predict
 The efficient markets hypothesis implies that
stock prices should follow a random walk.
 According to this theory, the only thing that can
move stock prices is news that changes the
market’s perception of the company’s value.
 Such news is impossible to predict.
(Otherwise it wouldn’t really be news, and
would already be reflected in the stock price.)
CHAPTER 27 THE BASIC TOOLS OF FINANCE 35
 Index Funds vs. Managed Funds
 An index fund is 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.
 The efficient markets hypothesis implies that it is
impossible to consistently “beat the market.”
 If true, the returns on actively managed funds
should not consistently exceed the returns on
index funds.
 In fact, most actively managed funds perform
worse than index funds (and have higher fees).
CHAPTER 27 THE BASIC TOOLS OF FINANCE 36
 Market Irrationality
 Economists have argued that stock price
movements are partly psychological:
• 1930s: John Maynard Keynes said stock prices
are driven by investors’ “animal spirits” –
irrational waves of pessimism and optimism
• 1990s: Fed Chair Alan Greenspan said the
stock boom reflected “irrational exuberance”
 Speculative “bubbles” may occur:
Someone may be willing to pay more than she
thinks a stock is worth if she believes she will be
able to sell it for even more in the future
CHAPTER 27 THE BASIC TOOLS OF FINANCE 37
 Market Irrationality
 Economists and market watchers debate the
importance of departures from rationality.
• It’s true that stock prices often move in ways
that are hard to explain rationally.
• Yet, it’s impossible to know what price
movements are “rational.”
• And if many investors behaved irrationally, there
would be profit opportunities for rational
investors. Yet, beating the market is nearly
impossible.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 38

 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 in this course.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 39

CHAPTER SUMMARY
 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 of wealth,
most people are risk-averse. Risk-averse people
can manage risk with insurance, through
diversification, and by choosing a portfolio with a
lower risk and lower return.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 40

CHAPTER SUMMARY
 The value of an asset equals the present value of
all payments its owner will receive. For a share of
stock, these payments include dividends plus the
final sale price.
 According to the efficient markets hypothesis,
financial markets are informationally efficient,
a stock price always equals the market’s best
guess of the firm’s value, and stock prices follow a
random walk as new information becomes
available.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 41

CHAPTER SUMMARY
 Some economists question the efficient markets
hypothesis, and believe that irrational
psychological factors also influence asset prices.

CHAPTER 27 THE BASIC TOOLS OF FINANCE 42