PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University The Basic Tools of Finance 1 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value Finance –Studies how people make decisions: Allocation of resources over time Handling of risk Present value –Amount of money today that would be needed using prevailing interest rates to produce a given future amount of money 2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value Future value –Amount of money in the future that an amount of money today will yield given prevailing interest rates Compounding –Accumulation of a sum of money Interest earned remains in the account to earn additional interest in the future 3 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value Present value = $100 –Interest rate = r –Future value = … $100(1+r) after 1 year $100(1+r)(1+r) = $100(1+r) 2 after 2 years $100(1+r) 3 after 3 years … $100(1+r) N after N years 4 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value Future value = $200 in N years –If interest rate = r –Present value invested = $200/(1+r) N Discounting –Finding present value for a future sum of money 5 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value General formula for discounting: Given r = interest rate To find X: the amount to be received in N years (future value) –Present value = X/(1+r) N 6 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Present Value What if you invested $25,000 from age 25 for 5 straight years and left it until retirement at 65: Given r = interest rate of 8% Age (1.08) 40 = $ Age (1.08) 39 = $ Age (1.08) 38 = $93126 Age (1.08) 37 = $86228 Age (1.08) 36 = $79841 Total at age 65 = $468,394 from a $25000 investment 7 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk Rational response to risk –Not necessarily to avoid it at any cost –Take it into account in your decision making Risk aversion –Dislike of uncertainty Utility –A person’s subjective measure of well- being/ satisfaction due to wealth 8 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk Utility function –Every level of wealth provides a certain amount of utility (personal satisfaction) –Exhibits diminishing marginal utility The more wealth a person has the less utility he gets from an additional dollar 9 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 10 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Utility Function Utility Wealth 0 This utility function shows how utility, a subjective measure of satisfaction, depends on wealth. As wealth rises, the utility function becomes flatter, reflecting the property of diminishing marginal utility. Because of diminishing marginal utility, a $1,000 loss decreases utility by more than a $1,000 gain increases it. Current wealth $1,000 loss Utility loss from losing $1,000 $1,000 gain Utility gain from winning $1,000

Managing Risk The markets for insurance –Person facing a risk Pays a fee to insurance company –Insurance company Accepts all or a part of risk Insurance contract – gamble –You may not face the risk –Pay the insurance premium –Receive: peace of mind 11 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk Role of insurance Not to eliminate the risks Spread the risks around more efficiently Markets for insurance – Inherent Problems: –Adverse selection High-risk person is more likely to apply for insurance because would more likely benefit than a low-risk person –Moral hazard After people buy insurance they less incentive to be careful about risky behavior 12 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk Diversification –Reduction of risk by replacing a single risk with a large number of smaller, unrelated risks –“Don’t put all your eggs in one basket” Enron situation Risk –Measured by standard deviation - the volatility of a variable 13 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk Risk of a portfolio of stocks –Depends on number of stocks in the portfolio –The higher the standard deviation the riskier the portfolio 14 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 15 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Diversification Reduces Risk Risk (standard deviation of portfolio return) (Less risk) (More risk) This figure shows how the risk of a portfolio, measured here with a statistic called the standard deviation, depends on the number of stocks in the portfolio. The investor is assumed to put an equal percentage of his portfolio in each of the stocks. Increasing the number of stocks reduces, but does not eliminate, the amount of risk in a stock portfolio. Number of Stocks in Portfolio but market risk remains Increasing the number of stocks in a portfolio reduces firm-specific risk through diversification...

Managing Risk Diversification –Can eliminate firm-specific risk –Cannot eliminate market risk Firm-specific risk –Affects only a single company Market risk –Affects all companies in the stock market, while a high tide floats all boats, a bad storm can also sink them all 16 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Risk Risk-return trade-off –Two types of assets Diversified group –8% average return –20% standard deviation –Vary from gain of 48% to a loss of 32% Safe alternative –3% return –0% standard deviation –The more a person puts into stocks The greater the risk and the return 17 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 18 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Trade-off between Risk and Return When people increase the percentage of their savings that they have invested in stocks, they increase the average return they can expect to earn, but they also increase the risks they face. Return (percent per year) 3 8 Risk (standard deviation) % stocks 75% stocks 50% stocks 25% stocks No stocks

Asset Valuation Fundamental analysis –Study of a company’s accounting statements and future prospects to determine its value Undervalued stock: Price < value Overvalued stock: Price > value Fairly valued stock: Price = value 19 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Valuation Use fundamental analysis to pick a stock –Do all the necessary research yourself –Rely on the advice of Wall Street analysts –Buy a mutual fund A manager conducts fundamental analysis and makes the decision for you 20 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Valuation The efficient markets hypothesis –Asset prices reflect all publicly available information about the value of an asset –Each company listed on a major stock exchange is followed closely by many money managers –Equilibrium of supply and demand sets the market price 21 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Valuation Stock markets –Exhibit informational efficiency, arbitrage situations don’t exist Informational efficiency –Description of asset prices that rationally reflect all available information Implication of efficient markets hypothesis –Stock prices should follow a random walk Changes in stock prices should be impossible to predict from available information 22 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Random walks and index funds The efficient markets hypothesis –Theory about how financial markets work –Probably not completely true Evidence –Stock prices are very close to a random walk Index fund –Mutual fund that buys all stocks in a given stock index (Dow fund, S & P fund) 23 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Random walks and index funds Active funds –Actively managed mutual funds by professional portfolio manager that buy only the best stocks Historically index funds outperform actively managed funds 24 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Random walks and index funds Characteristics of active portfolio managers –Generally lower return than index funds –Tend to trade more frequently –Incur more trading costs –Charge greater fees –Only 25% of active managers beat the market and very few of these do it long term (Warren Buffet) 25 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Valuation Efficient markets hypothesis –Assumes that people buying & selling stock are rational Process information about stock’s underlying value Fluctuations in stock prices –John Maynard Keynes noted that irrational waves of optimism and pessimism moved the market 26 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Valuation When price of an asset is above its fundamental value –Market is experiencing a speculative bubble (Trouble!) Possibility of speculative bubbles –The value of the stock to a stockholder depends on stream of dividend payments and final sale price –People may be willing to pay more today if the expectation is it will be worth more tomorrow based upon future expectations. 27 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Asset Valuation Debate among economists concerning the frequency & importance of departures from rational pricing –Market irrationality economists Movement in stock market is hard to explain on the basis that the news (not necessarily company specific) might alter a rational valuation –Efficient markets hypothesis economists Impossible to know the correct/rational valuation of a company so no one should jump to the conclusion that any particular valuation is irrational. If the valuation were irrational, a rational person would take advantage. 28 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.