Chapter 6: The Basic Tools of
Finance
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Finance is the field of economics that studies how
people make decisions regarding the allocation of
resources over time and the handling of risk.
Money today is more valuable than the same amount
in the future.
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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.
Future value is the amount of money in the future
that an amount of money today will yield, given
prevailing interest rates.
Compounding is the accumulation of a sum of
money in, say, a bank account where the interest
earned remains in the account to earn additional
interest in the future.
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Present Value: Measuring The Time
Value Of Money
The concept of present value is useful when we
make investment decisions.
◦ In order to compare values at different points in time,
compare their present values.
◦ A firm will undertake an investment project if the present
value of the stream of income the project is expected to
generate exceeds the present value of the costs.
If r is the interest rate, then an amount X to be
received in N years has present value of:
X/(1 + r)N
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Present Value: Measuring The Time
Value Of Money
What is the present value of Rs1,000 received in two years if the interest rate is
12% per year discounted annually? 1,000 / (1 + 0.12) 2 = Rs.797.19
You have just won a Rs 10 lakh lottery. This new lottery, however, will pay out
the award 60 years from today. What is the present value of your award based
on a 16% p.a. interest rate? 1,000,000 / (1 + 0.16) 60 = Rs 135.68
If you invested Rs.50,000 at one point in time and received back Rs.80,000 ten
years later, what annual interest (or growth) rate (compounded annually)
would you have obtained?
(80,000/50,000) (1/10) – 1= 4.81%
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Managing Risk
A person is said to be risk averse if that person exhibits
a dislike of uncertainty.
Individuals can reduce risk by choosing any of the
following:
① Buy insurance.
② Diversify.
③ Accept a lower return on their investments.
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Figure 1 Risk Aversion
Utility
Utility gain
from winning
€1,000
Utility loss
from losing
€1,000
0 Wealth
Current
€1,000 wealth €1,000
loss gain
① The Markets for Insurance
One way to deal with risk is to buy insurance.
A person facing a risk pays a fee to an insurance
company, which in return agrees to accept all or
part of the risk.
Insurance markets suffer two key problems:
◦ A high-risk person is more likely to apply for insurance
than a low-risk person. This is adverse selection.
◦ After people buy insurance, they have less incentive
to be careful about their risky behaviour. This is moral
hazard.
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② 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, or a single firm, or a single project.
◦ It’s the risk associated with a specific company.
Aggregate risk is the risk that affects all economic
actors at once, the uncertainty associated with the
entire economy.
Diversification cannot remove aggregate risk.
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Figure 2 Diversification
Risk (standard
deviation of
portfolio return)
(More risk)
49
Idiosyncratic
risk
20
Aggregate
(Less risk) risk
0 1 4 6 8 10 20 30 40 Number of
Stocks in
Portfolio
③ The Trade-Off Between Risk and
Return
People face trade-offs.
◦ People can reduce risk by accepting a lower rate of
return.
◦ The choice of a particular combination of risk and
return depends on a person’s risk aversion, which
reflects a person’s own preferences.
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Figure 3 The Trade-Off Between Risk and Return
Return
(percent 100%
per year) stocks
75%
stocks
50%
8.3 stocks
25%
stocks
No
stocks
3.1
0 5 10 15 20 Risk
(standard
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Asset Valuation
The price of a share of stock is determined by supply
and demand.
To understand stock prices, we need to understand what
determines a person’s willingness to pay for a share of stock.
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Fundamental Analysis
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.
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