CHAPTER

27

The Basic Tools of Finance

Economics
PRINCIPLES OF

N. Gregory Mankiw

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by Ron Cronovich
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In this chapter,
look for the answers to these questions:
 What is “present value”? How can we use it to
compare sums of money from different times?
 Why are people risk averse?
How can risk-averse people use insurance
and diversification to manage risk?
 What determines the value of an asset?
What is the “efficient markets hypothesis”?
Why is beating the market nearly impossible?

2
 Introduction

 The financial system

coordinates saving
and investment.
 Participants in the financial system make decisions
regarding the allocation of resources over time
and the handling of risk.
 Finance is the field that studies such
decision making.

THE BASIC TOOLS OF FINANCE 3

Present Value: The Time Value of Money
 To compare a sums from different times, we use
the concept of present value.
 The present value of a future sum: the amount
that would be needed today to yield that future sum
at prevailing interest rates
 Related concept:
The future value of a sum: the amount the sum
will be worth at a given future date, when allowed
to earn interest at the prevailing rate

THE BASIC TOOLS OF FINANCE 4

 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In three years, FV = $100(1 + 0.05)3 = $115.76
 In two years, FV = $100(1 + 0.05)2 = $110.25
 In one year, FV = $100(1 + 0.05) = $105.00

THE BASIC TOOLS OF FINANCE 5

 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In this example, $100 is the present value (PV).
 In general, FV = PV(1 + r )N
where r denotes the interest rate (in decimal form).
 Solve for PV to get: PV = FV/(1 + r )N

THE BASIC TOOLS OF FINANCE 6

 EXAMPLE 2: Investment Decision
Present value formula: PV = FV/(1 + r )N
 Suppose r = 0.06.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.06)10 = $112 million
Since PV > cost of factory, GM should build it.

THE BASIC TOOLS OF FINANCE 7

 EXAMPLE 2: Investment Decision
 Instead, suppose r = 0.09.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.09)10 = $84 million
Since PV < cost of factory, GM should not build it.

Present value helps explain why

investment falls when the interest rate rises.

THE BASIC TOOLS OF FINANCE 8

ACTIVE LEARNING 1
Present value
You are thinking of buying a six-acre lot for $70,000.
The lot will be worth $100,000 in five years.
A. Should you buy the lot if r = 0.05?
B. Should you buy it if r = 0.10?

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ACTIVE LEARNING 1
Answers
You are thinking of buying a six-acre lot for $70,000.
The lot will be worth $100,000 in five years.
A. Should you buy the lot if r = 0.05?
PV = $100,000/(1.05)5 = $78,350.
PV of lot > price of lot.
Yes, buy it.
B. Should you buy it if r = 0.10?
PV = $100,000/(1.1)5 = $62,090.
PV of lot < price of lot.
No, do not buy it.
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 Compounding
 Compounding: the accumulation of a sum of
money where the interest earned on the sum
earns additional interest
 Because of compounding, small differences in
interest rates lead to big differences over time.
 Example: Buy $1000 worth of Microsoft stock,
hold for 30 years.
If rate of return = 0.08, FV = $10,063
If rate of return = 0.10, FV = $17,450

THE BASIC TOOLS OF FINANCE 11

 The Rule of 70
 The Rule of 70:
If a variable grows at a rate of x percent per year,
that variable will double in about 70/x years.
 Example:
 If interest rate is 5%, a deposit will double in
about 14 years.
 If interest rate is 7%, a deposit will double in
about 10 years.

THE BASIC TOOLS OF FINANCE 12

 Risk Aversion
 Most people are risk averse – they dislike
uncertainty.
 Example: You are offered the following gamble.
Toss a fair coin.
 If heads, you win $1000.
 If tails, you lose $1000.
Should you take this gamble?
 If you are risk averse, the pain of losing $1000
would exceed the pleasure of winning $1000,
and both outcomes are equally likely,
so you should not take this gamble.
THE BASIC TOOLS OF FINANCE 13
 The Utility Function
Utility is a Utility
subjective
measure of Current
well-being utility
that depends
Asonwealth
wealth. rises, the
curve becomes flatter
due to diminishing
marginal utility:
the more wealth a Wealth
person has, the less
Current
extra utility he would get wealth
from an extra dollar.
THE BASIC TOOLS OF FINANCE 14
 The Utility Function and Risk Aversion
Utility
Utility gain from
winning $1000
Utility loss
from losing
$1000

Because of diminishing
marginal utility,
a $1000 loss reduces Wealth
utility more than a $1000 –1000 +1000
gain increases it.

THE BASIC TOOLS OF FINANCE 15

 Managing Risk With Insurance
 How insurance works:
A person facing a risk pays a fee to the insurance
company, which in return accepts
part or all of the risk.
 Insurance allows risks to be pooled,
and can make risk averse people better off:
E.g., it is easier for 10,000 people to each bear
1/10,000 of the risk of a house burning down
than for one person to bear the entire risk alone.

THE BASIC TOOLS OF FINANCE 16

 Two Problems in Insurance Markets
1. Adverse selection:
A high-risk person benefits more from insurance,
so is more likely to purchase it.
2. Moral hazard:
People with insurance have less incentive to
avoid risky behavior.
Insurance companies cannot fully guard against
these problems, so they must charge higher prices.
As a result, low-risk people sometimes forego
insurance and lose the benefits of risk-pooling.

THE BASIC TOOLS OF FINANCE 17

ACTIVE LEARNING 2
Adverse selection or moral hazard?
Identify whether each of the following is an example of
adverse selection or moral hazard.
A. Joe begins smoking in bed after buying fire
insurance.

B. Both of Susan’s parents lost their teeth to gum

disease, so Susan buys dental insurance.

C. When Gertrude parks her Corvette convertible,

she doesn’t bother putting the top up, because her
insurance covers theft of any items left in the car.

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ACTIVE LEARNING 2
Answers
Identify whether each of the following is an example of
adverse selection or moral hazard.
A. Joe begins smoking in bed after buying fire
insurance.
moral hazard
B. Both of Susan’s parents lost their teeth to gum
disease, so Susan buys dental insurance.
adverse selection
C. When Gertrude parks her Corvette convertible,
she doesn’t bother putting the top up, because her
insurance covers theft of any items left in the car.
moral hazard
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 Measuring Risk
 We can measure risk of an asset with the
standard deviation, a statistic that measures a
variable’s volatility – how likely it is to fluctuate.
 The higher the standard deviation of the asset’s
return, the greater the risk.

THE BASIC TOOLS OF FINANCE 20

 Reducing Risk Through Diversification
 Diversification reduces risk by replacing a
single risk with a large number of smaller,
unrelated risks.
 A diversified portfolio contains assets whose
returns are not strongly related:
 Some assets will realize high returns,
others low returns.
 The high and low returns average out,
so the portfolio is likely to earn
an intermediate return more consistently
than any of the assets it contains.

THE BASIC TOOLS OF FINANCE 21

 Reducing Risk Through Diversification
 Diversification can reduce firm-specific risk,
which affects only a single company.
 Diversification cannot reduce market risk,
which affects all companies in the stock market.

THE BASIC TOOLS OF FINANCE 22

 Reducing Risk Through Diversification

50 Increasing the number

of stocks reduces firm-
Standard dev of
portfolio return

40
specific risk.
30

20 But
market
10 risk
remains.
0
0 10 20 30 40
# of stocks in portfolio
THE BASIC TOOLS OF FINANCE 23
 The Tradeoff Between Risk and Return
 Tradeoff:
Riskier assets pay a higher return, on average,
to compensate for the extra risk of holding them.
 E.g., over past 200 years, average real return on
stocks, 8%. On short-term govt bonds, 3%.

THE BASIC TOOLS OF FINANCE 24

 The Tradeoff Between Risk and Return
 Example:
Suppose you are dividing your portfolio between
two asset classes.
 A diversified group of risky stocks:
average return = 8%, standard dev. = 20%
 A safe asset:
return = 3%, standard dev. = 0%
 The risk and return on the portfolio depends on
the percentage of each asset class in the
portfolio…

THE BASIC TOOLS OF FINANCE 25

 The Tradeoff Between Risk and Return
Increasing
the share of
stocks in the
portfolio
increases
the average
return but
also the risk.

THE BASIC TOOLS OF FINANCE 26

 Asset Valuation
 When deciding whether to buy a company’s stock,
you compare the price of the shares to
the value of the company.
 If share price > value, the stock is overvalued.
 If price < value, the stock is undervalued.
 If price = value, the stock is fairly valued.

THE BASIC TOOLS OF FINANCE 27

ACTIVE LEARNING 3
Valuing a share of stock
If you buy a share of AT&T stock today,
 you will be able to sell it in 3 years for $30.
 you will receive a $1 dividend at the end of
each of those 3 years.
If the prevailing interest rate is 10%,
what is the value of a share of AT&T stock today?

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ACTIVE LEARNING 3
Answers
amount
when you present value of
you will
will receive it the amount
receive
$1 in 1 year $1/(1.1) = $ .91
$1 in 2 years $1/(1.1)2 = $ .83
$1 in 3 years $1/(1.1)3 = $ .75
$30 in 3 years $30/(1.1)3 = $22.54

The value of a share of AT&T stock equals

the sum of the numbers in the last column: $25.03
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 Asset Valuation
 Value of a share
= PV of any dividends the stock will pay
+ PV of the price you get when you sell the share
 Problem: When you buy the share, you don’t
know what future dividends or prices will be.
 One way to value a stock: fundamental
analysis, the study of a company’s accounting
statements and future prospects to determine its
value

THE BASIC TOOLS OF FINANCE 30

ACTIVE LEARNING 4
Show-of-hands survey
You have a brokerage account with Merrill Lynch.
Your broker calls you with a hot tip about a stock:
new information suggests that the company will be
highly profitable.
Should you buy stock in the company?
A. Yes
B. No
C. Not until you read the prospectus.
D. What’s a prospectus?

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 The Efficient Markets Hypothesis
 Efficient Markets Hypothesis (EMH):
the theory that each asset price reflects all
publicly available information about the value of
the asset

THE BASIC TOOLS OF FINANCE 32

 Implications of EMH
1. Stock market is informationally efficient:
Each stock price reflects all available information
about the value of the company.
2. Stock prices follow a random walk:
A stock price only changes in response to new
information (“news”) about the company’s value.
News cannot be predicted, so stock price
movements should be impossible to predict.
3. It is impossible to systematically beat the market.
By the time the news reaches you, mutual fund
managers will have already acted on it.
THE BASIC TOOLS OF FINANCE 33
 Index Funds vs. Managed Funds
 An index fund is a mutual fund that buys all the
stocks in a given stock index.
 An actively managed mutual fund aims to buy
only the best stocks.
 Actively managed funds have higher expenses
than index funds.
 EMH implies that returns on actively managed
funds should not consistently exceed the returns
on index funds.

THE BASIC TOOLS OF FINANCE 34

 Index Funds vs. Managed Funds
2001-2006 2006
annualized expense
return ratio

S&P 500 (index fund) 6.2% .351

Managed large cap funds 5.9 1.020

S&P MidCap 400 (index fund) 10.9 .535

Managed mid cap funds 8.1 1.458

S&P SmallCap 600 (index fund) 12.5 .550

Managed mid cap funds 10.3 1.272

THE BASIC TOOLS OF FINANCE 35

 Market Irrationality
 Many believe that stock price movements are
partly psychological:
 J.M. Keynes: stock prices driven by “animal
spirits,” “waves of pessimism and optimism”
 Alan Greenspan: 1990s stock market boom due
to “irrational exuberance”
 Bubbles occur when speculators buy overvalued
assets expecting prices to rise further.
 The importance of departures from rational
pricing is not known.

THE BASIC TOOLS OF FINANCE 36

 CONCLUSION
 This chapter has introduced some of the basic
tools people use when they make financial
decisions.
 The efficient markets hypothesis teaches that a
stock price should reflect the company’s
expected future profitability.
 Fluctuations in the stock market have important
macroeconomic implications, which we will study
later in this course.

THE BASIC TOOLS OF FINANCE 37

CHAPTER SUMMARY

 The present value of any future sum is the amount

that would be needed today, given prevailing
interest rates, to produce that future sum.
 Because of diminishing marginal utility of wealth,
most people are risk-averse. Risk-averse people
can manage risk with insurance, through
diversification, and by choosing a portfolio with a
lower risk and lower return.

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CHAPTER SUMMARY

 The value of an asset equals the present value of

all payments its owner will receive. For a share of
stock, these payments include dividends plus the
final sale price.
 According to the efficient markets hypothesis,
financial markets are informationally efficient,
a stock price always equals the market’s best
guess of the firm’s value, and stock prices follow a
random walk as new information becomes
available.
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CHAPTER SUMMARY

 Some economists question the efficient markets

hypothesis, and believe that irrational
psychological factors also influence asset prices.

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