Ch 27 basic tools of finance
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Transcript of Ch 27 basic tools of finance
![Page 1: Ch 27 basic tools of finance](https://reader030.fdocuments.in/reader030/viewer/2022032616/55a57e6a1a28ab4c618b4579/html5/thumbnails/1.jpg)
Chapter 27
Basic Tools of
Finance
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SurveyQuestion 1
What would you prefer?
A. Win 1,000 riyals
B. Flip a coin: 50 percent chance you win 2,000 riyals50 percent chance you win nothing.
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SurveyQuestion 2
What would you prefer?
A. Lose 1,000 riyals
B. Flip a coin: 50 percent chance you lose 2,000 riyals50 percent chance you lose nothing.
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SurveyMost people avoid risk
on gains
but prefer to take risks to avoid loss
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Key Termsfinancepresent valuefuture valuecompoundingdiscountingrisk aversiondiversification
firm-specific riskmarket riskfundamental analysisefficient market hypothesisinformation efficiencyrandom walk
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Key Formulas
(1+r)N
r = rate N = number of periods
Compounding Future Value or FVmultiplying
Discounting Present Value or PVdividing
(1+r)N1
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Finance
Time and Risk
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Tomorrow
One Year
Ten Years
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Discount the future
Today is worth more than tomorrow
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Growin the Future
Today
One year
Ten Years
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Promissory Note
Trading paper for paper
I.O. U.
10 SARDr. Gale
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Rates and
Compounding Linear versus
Exponential
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0
8
16
24
32
40
48
56
64
1 2 3 4 5 62
48
16
32
64
24
68
1012
Linear versus ExponentialAdding versus Compounding
+
^
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N Start Add End
0 100.00 7.00 107.00
1 107.00 7.00 114.00
2 114.00 7.00 121.00
3 121.00 7.00 128.00
4 128.00 7.00 135.00
5 135.00 7.00 142.00
Fixed Amount
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Grow by a percentage each year,
not a fixed amount
Compounding
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Compounding
The process of finding the future value of a
present sum of money
multiplying
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Discounting
The process of finding the present value of a future sum of money
dividing
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compounding is the inverse of discounting
discounting is the inverse of compounding
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7%
N Start Add End
0 100.00 7.00 107.00
1 107.00 7.49 114.49
2 114.49 8.01 122.50
3 122.50 8.58 131.08
4 131.08 9.18 140.26
5 140.26 9.82 150.07
Compounding
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Fixed 7%
N Start Add End Start Add End
0 100.00 7.00 107.00 100.00 7.00 107.00
1 107.00 7.00 114.00 107.00 7.49 114.49
2 114.00 7.00 121.00 114.49 8.01 122.50
3 121.00 7.00 128.00 122.50 8.58 131.08
4 128.00 7.00 135.00 131.08 9.18 140.26
5 135.00 7.00 142.00 140.26 9.82 150.07
Fixed vs. Compounding
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Compounding8%
4%
2%
time
amount
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Rate Amount in 30 years
1% 136.13
2% 184.76
4% 337.31
8% 1,086.77
16% 9,958.59
32% 546,753.87
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Future ValueThe amount of money in the future, using an interest rate, that a present amount will
produce
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Key Formula 1
(1+r)N
r = rate N = number of periods
Future Value or FV
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(1+r)N
r = 10% FV =?
1 1.1002 1.2103 1.3314 1.4645 1.611
N FV
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Present ValueThe amount of money need today, using an
interest rate, to produce a future
amount
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Key Formula 2
(1+r)N
r = rate N = number of periods
Present Value or PV1 Reciprocal
of the FV formula
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(1+r)N
r = 10% N = 5PV =?
1 .9092 .8263 .7514 .6835 .621 3.791
N PV
1
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Worth less and less due to time and risk
1 0.935
2 0.873
3 0.816
4 0.763
5 0.713
6 0.666
7 0.623
8 0.582
9 0.54410 0.508
7% discount
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Insurance
Sharing risk
Does not eliminate riskSpread around risk
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Risk Aversion
A dislike of uncertainty
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ScenarioCost: 1000
Risk: 1 in 100Expected cost =
cost x risk = 1000 x .01
=10
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ScenarioExpected cost =10Total Cost = 1000
Get 100 people to give 10 each to fund the
account10 x 100 = 1000
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Insurance Problems
Asymmetric InformationAdverse Selection
Moral Hazard
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Asymmetric Information
Parties to a trade do not have the same
information
Not Equal
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Adverse Selection
Making a bad choice due to asymmetric
information
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Moral Hazard
Changing behavior after an agreement
Temptation to abuse the other party
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Diversification
Replace one large risk with lots of smaller
unrelated risks
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Three Risks
Firm RiskIndustry RiskMarket Risk
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Firm Risk
Risk that affects only a single company
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Industry Risk
Risk that affects all the companies in an
industry
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Market Risk
Risk that affects all the companies in the stock
market
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Valuation
What is it worth?
Analyze financial statements and future
prospects
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Speculative Bubble
Price is greater than fundamental value
Buy because everyone else is buying