27TheBasicToolsofFinance27TheBasicToolsofFinanceInthischapter,wearegoingtostudy…TheconceptofpresentvalueanditscalculationWaysofmanagingrisksDiversificationofidiosyncraticriskFundamentalanalysisEfficientmarketshypothesisInthischapter,wearegoingFinanceisthefieldthatstudieshowpeoplemakedecisionsregardingtheallocationofresourcesovertimeandthehandlingofrisk.FinanceisthefieldthatstudPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYPresentvaluereferstotheamountofmoneytodaythatwouldbeneededtoproduce,usingprevailinginterestrates,agivenfutureamountofmoney.PRESENTVALUE:MEASURINGTHETPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYTheconceptofpresentvaluedemonstratesthefollowing:Receivingagivensumofmoneyinthepresentispreferredtoreceivingthesamesuninthefuture.Inordertocomparevaluesatdifferentpointsintime,comparetheirpresentvalues.Firmsundertakeinvestmentprojectsifthepresentvalueoftheprojectexceedsthecost.PRESENTVALUE:MEASURINGTHETPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYIfristheinterestrate,thenanamountXtobereceivedinNyearshaspresentvalueof:X/(1+r)NPRESENTVALUE:MEASURINGTHETPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYFutureValueTheamountofmoneyinthefuturethatanamountofmoneytodaywillyield,givenprevailinginterestrates,iscalledthefuturevalue.PRESENTVALUE:MEASURINGTHETFYI:Ruleof70Accordingtotheruleof70,ifsomevariablegrowsatarateofxpercentperyear,thenthatvariabledoublesinapproximately70/xyears.FYI:Ruleof70AccordingtothMANAGINGRISKApersonissaidtoberiskaverseifsheexhibitsadislikeofuncertainty.MANAGINGRISKApersonissaidMANAGINGRISKIndividualscanreduceriskchoosinganyofthefollowing:BuyinsuranceDiversifyAcceptalowerreturnontheirinvestmentsMANAGINGRISKIndividualscanrFigure1RiskAversionWealth0UtilityCurrentwealth$1,000gain$1,000lossUtilitylossfromlosing$1,000Utilitygainfromwinning$1,000Copyright?2004South-WesternFigure1RiskAversionWealth0UTheMarketsforInsuranceOnewaytodealwithriskistobuyinsurance.Thegeneralfeatureofinsurancecontractsisthatapersonfacingariskpaysafeetoaninsurancecompany,whichinreturnagreestoacceptallorpartoftherisk.TheMarketsforInsuranceOnewDiversificationofIdiosyncraticRiskDiversificationreferstothereductionofriskachievedbyreplacingasingleriskwithalargenumberofsmallerunrelatedrisks.DiversificationofIdiosyncratDiversificationofIdiosyncraticRiskIdiosyncraticriskistheriskthataffectsonlyasingleperson.Theuncertaintyassociatedwithspecificcompanies.DiversificationofIdiosyncratDiversificationofIdiosyncraticRiskAggregateriskistheriskthataffectsalleconomicactorsatonce,theuncertaintyassociatedwiththeentireeconomy.Diversificationcannotremoveaggregaterisk.DiversificationofIdiosyncratFigure2DiversificationNumberofStocksinPortfolio49(Morerisk)(Lessrisk)2001468102040Risk(standarddeviationofportfolioreturn)AggregateriskIdiosyncraticrisk30Copyright?2004South-WesternFigure2DiversificationNumberDiversificationofIdiosyncraticRiskPeoplecanreduceriskbyacceptingalowerrateofreturn.DiversificationofIdiosyncratFigure3TheTradeoffbetweenRiskandReturnRisk(standarddeviation)051015208.33.1Return(percentperyear)50%stocks25%stocksNostocks100%stocks75%stocksCopyright?2004South-WesternFigure3TheTradeoffbetweenASSETVALUATIONFundamentalanalysisisthestudyofacompany’saccountingstatementsandfutureprospectstodetermineitsvalue.ASSETVALUATIONFundamentalanaASSETVALUATIONPeoplecanemployfundamentalanalysistotrytodetermineifastockisundervalued,overvalued,orfairlyvalued.

Thegoalistobuyundervaluedstock.ASSETVALUATIONPeoplecanemplEfficientMarketsHypothesisTheefficientmarketshypothesisisthetheorythatassetpricesreflectallpubliclyavailableinformationaboutthevalueofanasset.EfficientMarketsHypothesisThEfficientMarketsHypothesisAmarketisinformationallyefficientwhenitreflectsallavailableinformationinarationalway.Ifmarketsareefficient,theonlythinganinvestorcandoisbuyadiversifiedportfolioEfficientMarketsHypothesisACASESTUDY:RandomWalksandIndexFundsRandomwalkreferstothepathofavariablewhosechangesareimpossibletopredict.Ifmarketsareefficient,allstocksarefairlyvaluedandnostockismorelikelytoappreciatethananother.Thusstockpricesfollowarandomwalk.CASESTUDY:RandomWalksandISummaryBecausesavingscanearninterest,asumofmoneytodayismorevaluablethanthesamesumofmoneyinthefuture.Apersoncancomparesumsfromdifferenttimesusingtheconceptofpresentvalue.Thepresentvalueofanyfuturesumistheamountthatwouldbeneededtoday,givenprevailinginterestrates,toproducethefuturesum.SummaryBecausesavingscanearSummaryBecauseofdiminishingmarginalutility,mostpeopleareriskaverse.Risk-aversepeoplecanreduceriskusinginsurance,throughdiversification,andbychoosingaportfoliowithlowerriskandlowerreturns.Thevalueofanasset,suchasashareofstock,equalsthepresentvalueofthecashflowstheownerofthesharewillreceive,includingthestreamofdividendsandthefinalsaleprice.SummaryBecauseofdiminishingSummaryAccordingtotheefficientmarketshypothesis,financialmarketsprocessavailableinformationrationally,soastockpricealwaysequalsthebestestimateofthevalueoftheunderlyingbusiness.Someeconomistsquestiontheefficientmarketshypothesis,however,andbelievethatirrationalpsychologicalfactorsalsoinfluenceassetprices.SummaryAccordingtotheeffici27TheBasicToolsofFinance27TheBasicToolsofFinanceInthischapter,wearegoingtostudy…TheconceptofpresentvalueanditscalculationWaysofmanagingrisksDiversificationofidiosyncraticriskFundamentalanalysisEfficientmarketshypothesisInthischapter,wearegoingFinanceisthefieldthatstudieshowpeoplemakedecisionsregardingtheallocationofresourcesovertimeandthehandlingofrisk.FinanceisthefieldthatstudPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYPresentvaluereferstotheamountofmoneytodaythatwouldbeneededtoproduce,usingprevailinginterestrates,agivenfutureamountofmoney.PRESENTVALUE:MEASURINGTHETPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYTheconceptofpresentvaluedemonstratesthefollowing:Receivingagivensumofmoneyinthepresentispreferredtoreceivingthesamesuninthefuture.Inordertocomparevaluesatdifferentpointsintime,comparetheirpresentvalues.Firmsundertakeinvestmentprojectsifthepresentvalueoftheprojectexceedsthecost.PRESENTVALUE:MEASURINGTHETPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYIfristheinterestrate,thenanamountXtobereceivedinNyearshaspresentvalueof:X/(1+r)NPRESENTVALUE:MEASURINGTHETPRESENTVALUE:MEASURINGTHETIMEVALUEOFMONEYFutureValueTheamountofmoneyinthefuturethatanamountofmoneytodaywillyield,givenprevailinginterestrates,iscalledthefuturevalue.PRESENTVALUE:MEASURINGTHETFYI:Ruleof70Accordingtotheruleof70,ifsomevariablegrowsatarateofxpercentperyear,thenthatvariabledoublesinapproximately70/xyears.FYI:Ruleof70AccordingtothMANAGINGRISKApersonissaidtoberiskaverseifsheexhibitsadislikeofuncertainty.MANAGINGRISKApersonissaidMANAGINGRISKIndividualscanreduceriskchoosinganyofthefollowing:BuyinsuranceDiversifyAcceptalowerreturnontheirinvestmentsMANAGINGRISKIndividualscanrFigure1RiskAversionWealth0UtilityCurrentwealth$1,000gain$1,000lossUtilitylossfromlosing$1,000Utilitygainfromwinning$1,000Copyright?2004South-WesternFigure1RiskAversionWealth0UTheMarketsforInsuranceOnewaytodealwithriskistobuyinsurance.Thegeneralfeatureofinsurancecontractsisthatapersonfacingariskpaysafeetoaninsurancecompany,whichinreturnagreestoacceptallorpartoftherisk.TheMarketsforInsuranceOnewDiversificationofIdiosyncraticRiskDiversificationreferstothereductionofriskachievedbyreplacingasingleriskwithalargenumberofsmallerunrelatedrisks.DiversificationofIdiosyncratDiversificationofIdiosyncraticRiskIdiosyncraticriskistheriskthataffectsonlyasingleperson.Theuncertaintyassociatedwithspecificcompanies.DiversificationofIdiosyncratDiversificationofIdiosyncraticRiskAggregateriskistheriskthataffectsalleconomicactorsatonce,theuncertaintyassociatedwiththeentireeconomy.Diversificationcannotremoveaggregaterisk.DiversificationofIdiosyncratFigure2DiversificationNumberofStocksinPortfolio49(Morerisk)(Lessrisk)2001468102040Risk(standarddeviationofportfolioreturn)AggregateriskIdiosyncraticrisk30Copyright?2004South-WesternFigure2DiversificationNumberDiversificationofIdiosyncraticRiskPeoplecanreduceriskbyacceptingalowerrateofreturn.DiversificationofIdiosyncratFigure3TheTradeoffbetweenRiskandReturnRisk(standarddeviation)051015208.33.1Return(percentperyear)50%stocks25%stocksNostocks100%stocks75%stocksCopyright?2004South-WesternFigure3TheTradeoffbetweenASSETVALUATIONFundamentalanalysisisthestudyofacompany’saccountingstatementsandfutureprospectstodetermineitsvalue.ASSETVALUATIONFundamentalanaASSETVALUATIONPeoplecanemployfundamentalanalysistotrytodetermineifastockisundervalued,overvalued,orfairlyvalued.

Thegoalistobuyundervaluedstock.ASSETVALUATIONPeoplecanemplEfficientMarketsHypothesisTheefficientmarketshypothesisisthetheorythatassetpricesreflectallpubliclyavailableinformationaboutthevalueofanasset.EfficientMarketsHypothesisThEfficientMarketsHypothesisAmarketisinformationallyefficientwhenitreflectsallavailableinformationinarationalway.Ifmarketsareefficient,theonlythinganinvestorcandoisbuyadiversifiedportfolioEfficientMarketsHypothesisACASESTUDY:RandomWalksandIndexFundsRandomwalkreferstothepathofavariablewhosechangesareimpossibletopredict.Ifmarketsareefficient,allstocksarefairlyvaluedandnostockismorelikelytoappreciatethananother.Thusstockpricesfollowarandomwalk.CASESTUDY:Ra