Chapter 27

The Basic Tools of Finance

Part 2

FinanceDecisions about

money, time, and risk

Present ValueThe amount of money need today, using an

interest rate, to produce a future

amount

Future ValueThe amount of money in the future, using an interest rate, that a present amount will

produce

CompoundingFormula

(1+r)N

Discounting

The process of finding the present value of a future sum of money

Risk Aversion

A dislike of uncertainty

Insurance

Sharing risk

Does not eliminate riskSpread around risk

ScenarioCost: 1000

Risk: 1 in 100Expected cost =

cost x risk = 1000 x .01

=10

ScenarioExpected cost =10Total Cost = 1000

Get 100 people to give 10 each to fund the

account10 x 100 = 1000

Insurance Problems

Asymmetric InformationAdverse Selection

Moral Hazard

Asymmetric Information

Parties to a trade do not have the same

information

Not Equal

Adverse Selection

Making a bad choice due to asymmetric

information

Moral Hazard

Changing behavior after an agreement

Temptation to abuse the other party

Diversification

Replace one large risk with lots of smaller

unrelated risks

Three Risks

Firm RiskIndustry RiskMarket Risk

Firm Risk

Risk that affects only a single company

Industry Risk

Risk that affects all the companies in an

industry

Market Risk

Risk that affects all the companies in the stock

market

Valuation

What is it worth?

Analyze financial statements and future

prospects

Speculative Bubble

Price is greater than fundamental value

Buy because everyone else is buying