9 The Basic Tools of Finance

Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk.

PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY

Present value refers to the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money.

The concept of present value demonstrates the following:

Receiving a given sum of money in the present is preferred to receiving the same sun in the future.

In order to compare values at different points in time, compare their present values.

Firms undertake investment projects if the present value of the project exceeds the cost.

If r is the interest rate, then an amount X to be received in N years has present value of:

X/(1 + r)^N

Future Value

The amount of money in the future that an amount of money today will yield, given prevailing interest rates, is called the future value.

FYI: Rule of 70

According to the rule of 70, if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years.

MANAGING RISK

A person is said to be risk averse if she exhibits a dislike of uncertainty.

Individuals can reduce risk choosing any of the following:

Buy insurance

Diversify

Accept a lower return on their investments

Figure 1 Risk Aversion

The Markets for Insurance

One way to deal with risk is to buy insurance.

The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk.

Diversification of Idiosyncratic Risk

Diversification refers to the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks.

Idiosyncratic risk is the risk that affects only a single person. The uncertainty associated with specific companies.

Aggregate risk is the risk that affects all economic actors at once, the uncertainty associated with the entire economy.

Diversification cannot remove aggregate risk.

Figure 2 Diversification

People can reduce risk by accepting a lower rate of return.

Figure 3 The Tradeoff between Risk and Return

ASSET VALUATION

Fundamental analysis is the study of a company’s accounting statements and future prospects to determine its value.

People can employ fundamental analysis to try to determine if a stock is undervalued, overvalued, or fairly valued.

The goal is to buy undervalued stock.

Efficient Markets Hypothesis

The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset.

A market is informationally efficient when it reflects all available information in a rational way.

If markets are efficient, the only thing an investor can do is buy a diversified portfolio

CASE STUDY: Random Walks and Index Funds

Random walk refers to the path of a variable whose changes are impossible to predict.

If markets are efficient, all stocks are fairly valued and no stock is more likely to appreciate than another. Thus stock prices follow a random walk.

Summary

Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future.

A person can compare sums from different times using the concept of present value.

The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce the future sum.

Because of diminishing marginal utility, most people are risk averse.

Risk-averse people can reduce risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower returns.

The value of an asset, such as a share of stock, equals the present value of the cash flows the owner of the share will receive, including the stream of dividends and the final sale price.

According to the efficient markets hypothesis, financial markets process available information rationally, so a stock price always equals the best estimate of the value of the underlying business.

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