Chapter 3

Financial Decision
Making and the Law
of One Price
 3.1 Valuing Decisions

• Identify Costs and Benefits

– May need help from other areas in identifying the
relevant costs and benefits
• Marketing
• Economics
• Organizational Behavior
• Strategy
• Operations

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 Using Market Prices to
Determine Cash Values
• Competitive Market
– A market in which goods can be bought and sold
at the same price.

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 Alternative Example 3.1

• Problem
– Your car recently broke down and it needs
$2,000 in repairs. But today is your lucky day
because you have just won a contest where the
prize is either a new motorcycle, with a
manufacturer's suggested retail price (MSRP) of
$15,000, or $10,000 in cash. You do not have a
motorcycle license, nor do you plan on getting
one. You estimate you could sell the motorcycle
for $12,000. Which prize should you choose?

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 Alternative Example 3.2

• Problem
– You are offered the following investment
opportunity: In exchange for $40,000 today, you
will receive 2,500 shares of stock in the Ford
Motor Company and 10,000 euros today. The
current market price for Ford stock is $9 per
share and the current exchange rate is $1.50 per
€. Should you take this opportunity? Would your
decision change if you believed the value of the
euro would rise over the next month?

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 3.2 Interest Rates
and the Time Value of Money
• Time Value of Money
– Consider an investment opportunity with the
following certain cash flows.
• Cost: $100,000 today
• Benefit: $105,000 in one year
– The difference in value between money today
and money in the future is due to the time value
of money.

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 The Interest Rate:
An Exchange Rate Across Time
• The rate at which we can exchange money today
for money in the future is determined by the
current interest rate.
– Suppose the current annual interest rate is 7%. By
investing or borrowing at this rate, we can exchange $1.07
in one year for each $1 today.
• Risk–Free Interest Rate (Discount Rate), rf: The interest rate at
which money can be borrowed or lent without risk.
– Interest Rate Factor = 1 + rf
– Discount Factor = 1 / (1 + rf)

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 The Interest Rate: An Exchange Rate
Across Time (cont'd)

• Value of Investment in One Year

– If the interest rate is 7%, then we can express
our costs as:
Cost = ($100,000 today) × (1.07 $ in one year/$
today)
= $107,000 in one year

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 The Interest Rate: An Exchange
Rate Across Time (cont'd)
• Value of Investment in One Year
– Both costs and benefits are now in terms of
“dollars in one year,” so we can compare them
and compute the investment’s net value:
$105,000 − $107,000 = −$2000 in one year
– In other words, we could earn $2000 more in one
year by putting our $100,000 in the bank rather
than making this investment. We should reject
the investment.

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 The Interest Rate: An Exchange
Rate Across Time (cont'd)
• Value of Investment Today
– Consider the benefit of $105,000 in one year.
What is the equivalent amount in terms of
dollars today?
Benefit = ($105,000 in one year) ÷ (1.07 $ in one
year/$ today)
= ($105,000 in one year) × 1/1.07 = $98,130.84
today
– This is the amount the bank would lend to us
today if we promised to repay $105,000 in one
year.

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 The Interest Rate: An Exchange
Rate Across Time (cont'd)
• Value of Investment Today
– Now we are ready to compute the net value of
the investment:
$98,130.84 − $100,000 = −$1869.16 today
– Once again, the negative result indicates that we
should reject the investment.

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 The Interest Rate: An Exchange
Rate Across Time (cont'd)
• Present Versus Future Value
– This demonstrates that our decision is the same
whether we express the value of the investment
in terms of dollars in one year or dollars today. If
we convert from dollars today to dollars in one
year,
(−$1869.16 today) × (1.07 $ in one year/$ today) = −$2000
in one year.
– The two results are equivalent, but expressed as
values at different points in time.

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 The Interest Rate: An Exchange
Rate Across Time (cont'd)
• Present Versus Future Value
– When we express the value in terms of dollars
today, we call it the present value (PV) of the
investment. If we express it in terms of dollars in
the future, we call it the future value of the
investment.

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 The Interest Rate: An Exchange
Rate Across Time (cont'd)
• Discount Factors and Rate
– We can interpret

1 1
 0.93458
1  r 1.07

1
as the price today of $1 in one year. The amount 1  ris
called the one- year discount factor. The risk-free rate is
also referred to as the discount rate for a risk-free
investment.

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 Alternative Example 3.3

• Problem
– The cost of replacing a fleet of company trucks
with more energy efficient vehicles was $100
million in 2012.
– The cost is estimated to rise by 8.5% in 2013.
– If the interest rate was 4%, what was the
cost of a delay in terms of dollars in 2012?

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 Figure 3.1 Converting Between Dollars Today
and Gold, Euros, or Dollars in the Future

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 3.3 Present Value
and the NPV Decision Rule
• The net present value (NPV) of a project
or investment is the difference between the
present value of its benefits and the present
value of its costs.
– Net Present Value

NPV  PV (Benefits)  PV (Costs)

NPV  PV (All project cash flows)

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 The NPV Decision Rule

• When making an investment decision, take

the alternative with the highest NPV.
Choosing this alternative is equivalent to
receiving its NPV in cash today.

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 The NPV Decision Rule (cont'd)

• Accepting or Rejecting a Project

– Accept those projects with positive NPV because
accepting them is equivalent to receiving their
NPV in cash today.
– Reject those projects with negative NPV because
accepting them would reduce the wealth of
investors.

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 Choosing Among Alternatives

• We can also use the NPV decision rule to

choose among projects. To do so, we must
compute the NPV of each alternative, and
then select the one with the highest NPV.
This alternative is the one which will lead to
the largest increase in the value of the firm.

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 Textbook Example 3.5

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 NPV and Cash Needs

• Regardless of our preferences for cash today

versus cash in the future, we should always
maximize NPV first. We can then borrow or
lend to shift cash flows through time and
find our most preferred pattern of cash
flows.

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 3.4 Arbitrage and the Law of One
Price
• Arbitrage
– The practice of buying and selling equivalent
goods in different markets to take advantage of
a price difference. An arbitrage opportunity
occurs when it is possible to make a profit
without taking any risk or making any
investment.
• Normal Market
– A competitive market in which there are no
arbitrage opportunities.

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 3.4 Arbitrage and the Law of
One Price (cont'd)
• Law of One Price
– If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both
markets.

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 3.5 No-Arbitrage and Security
Prices
• Valuing a Security with the Law of One Price
– Assume a security promises a risk-free payment
of $1000 in one year. If the risk-free interest rate
is 5%, what can we conclude about the price of
this bond in a normal market?

PV ($1000 in one year) ($1000 in one year) (1.05 $ in one year / $ today)
• Price(Bond) = $952.38
$952.38 today

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 Identifying Arbitrage
Opportunities with Securities
• What if the price of the bond is not $952.38?
– Assume the price is $940.

– The opportunity for arbitrage will force the price of the

bond to rise until it is equal to $952.38.

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 Identifying Arbitrage
Opportunities with Securities
• What if the price of the bond is not $952.38?
– Assume the price is $960.

– The opportunity for arbitrage will force the price of the

bond to fall until it is equal to $952.38. (If you don’t own
the bond, you can always “short sell” it)

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 Determining the No-Arbitrage
Price
• Unless the price of the security equals the
present value of the security’s cash flows,
an arbitrage opportunity will appear.
• No Arbitrage Price of a Security

Price(Security)  PV (All cash flows paid by the security)

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 Alternative Example 3.6

• Problem
– Consider a security that pays its owner $2,000
today and $3,000 in one year, without any risk.
– Suppose the risk-free interest rate is 6%.
– What is the no-arbitrage price of the
security today (before the $2,000 is paid)?
If the security is trading for $4,950, what
arbitrage opportunity is available? And if it
is trading for $4,800?

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 Determining the Interest Rate
From Bond Prices

• If we know the price of a risk-free bond, we

can use
Price(Security)  PV (All cash flows paid by the security)
to determine what the risk-free interest
rate must be if there are no arbitrage
opportunities.

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 Determining the Interest Rate
From Bond Prices (cont'd)

• Suppose a risk-free bond that pays $1000

in one year is currently trading with a
competitive market price of $936.75 today.
The bond’s price must equal the present
value of the $1000 cash flow it will pay.
• What the imply risk-free interest rate is?

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 The NPV of Trading Securities
and Firm Decision Making
• In a normal market, the NPV of buying or
selling a security is zero.

NPV (Buy security)  PV (All cash flows paid by the security)  Price(Security)
0

NPV (Sell security)  Price(Security)  PV (All cash flows paid by the security)
0

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 The NPV of Trading Securities and
Firm Decision Making (cont’d)

• Separation Principle
– We can evaluate the NPV of an investment
decision separately from the decision the firm
makes regarding how to finance the investment
or any other security transactions the firm is
considering.

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 Valuing a Portfolio

• The Law of One Price also has implications

for packages of securities.
– Consider two securities, A and B. Suppose a third
security, C, has the same cash flows as A and B
combined. In this case, security C is equivalent
to a portfolio, or combination, of the securities A
and B.
• Value Additivity

Price(C)  Price(A  B)  Price(A)  Price(B)

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 Alternative Example 3.8

• Problem
– Moon Holdings is a publicly traded company with
only three assets:
• It owns 50% of Due Beverage Co., 70% of Mountain
Industries, and 100% of the Oxford Bears, a football
team.
• The total market value of Moon Holdings is $200
million, the total market value of Due Beverage Co. is
$75 million and the total market value of Mountain
Industries is $100 million.
– What is the market value of the Oxford
Bears?

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 Valuing a Portfolio

• Value Additivity and Firm Value

– To maximize the value of the entire firm,
managers should make decisions that maximize
NPV.
– The NPV of the decision represents its
contribution to the overall value of the firm.

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 Where Do We Go From Here?

• Impact of Risk on Valuation

– When cash flows are risky, we must discount
them at a rate equal to the risk-free interest rate
plus an appropriate risk premium.
– The appropriate risk premium will be higher the
more the project’s returns tend to vary with
overall risk in the economy.

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 Check the following problems
• 1
• 3
• 4
• 6
• 7
• 8
• 9
• 11
• 12
• 14
• 16
• 19

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