1. Chapter 27
!
Basic Tools
of
Finance

2. Key Terms
finance
present value
future value
compounding
discounting
risk aversion
diversification
firm-specific risk
market risk
fundamental analysis
efficient market
hypothesis
information efficiency
random walk

3. Survey
Question 1
What would you prefer?
!
A. Win 1,000 riyals
!
B. Flip a coin:
50 percent chance you win 2,000 riyals
50 percent chance you win nothing.

4. Survey
Question 2
What would you prefer?
!
A. Lose 1,000 riyals
!
B. Flip a coin:
50 percent chance you lose 2,000 riyals
50 percent chance you lose nothing.

5. Payback?
One year?
Five years?
Ten years?

6. Promissory Note
I.O. U.
10 SAR
Dr. Gale
Trading paper for paper

7. Compounding
The process of finding
the future value of a
present sum of money
!
multiplying

8. Discounting
The process of finding
the present value of a
future sum of money
!
dividing

9. compounding is the
inverse of discounting
discounting is the
inverse of compounding

10. Finance
Time and Risk

11. Future Value
The amount of money
in the future, using an
interest rate, that a
present amount will
produce

12. Key Formula 1
Future Value or FV
N
(1+r)
r = rate
N = number of periods

13. r = 7%
FV =?
N
(1+r)
N
1
2
3
FV
1.070
1.145
1.225

14. r = 10%
FV =?
N
(1+r)
N
1
2
3
4
5
FV
1.100
1.210
1.331
1.464
1.611

15. r = 15%
FV =?
N
(1+r)
N
1
2
3
FV
1.150
1.323
1.521

16. r = 15%
N = 3
FV =?
N
(1+r)
N
1
2
3
FV
1.150
1.323
1.521

17. Present Value
The amount of money
need today, using an
interest rate, to
produce a future
amount

18. Key Formula 2
Present Value or PV
Reciprocal
1
of the
N
FV formula
(1+r)
r = rate
N = number of periods

19. r = 7%
N = 3
PV =?
1
N
(1+r)
N
1
2
3
PV
.935
.873
.816

20. r = 10%
N = 5
PV =?
1
N
(1+r)
N
1
2
3
4
5
PV
.909
.826
.751
.683
.621

21. Insurance
Sharing risk
!
Does not eliminate risk
Spread around risk

23. Risk Aversion
A dislike of uncertainty

24. Scenario
Cost: 1000
Risk: 1 in 100
Expected cost =
cost x risk =
1000 x .01
=10

25. Scenario
Expected cost =10
Total Cost = 1000
Get 100 people to give
10 each to fund the
account
10 x 100 = 1000

26. Insurance Problems
Asymmetric Information
Adverse Selection
Moral Hazard

27. Asymmetric Information
Parties to a trade do
not have the same
information
!
Not Equal

28. Adverse Selection
Making a bad choice
due to asymmetric
information

29. Moral Hazard
Changing behavior after
an agreement
!
Temptation to abuse
the other party

30. Diversification
Replace one large risk
with lots of smaller
unrelated risks

31. Three Risks
Firm Risk
Industry Risk
Market Risk

32. Firm Risk
Risk that affects only a
single company

33. Industry Risk
Risk that affects all the
companies in an
industry

34. Market Risk
Risk that affects all the
companies in the stock
market

35. Valuation
What is it worth?
!
Analyze financial
statements and future
prospects

36. Speculative Bubble
Price is greater than
fundamental value
!
Buy because everyone
else is buying