1. Chapter 3 Arbitrage and Financial Decision Making

2. 3-2 Chapter Outline 3.1 Valuing Costs and Benefits 3.2 Interest Rates and the Time Value of Money 3.3 Present Value and the NPV Decision Rule 3.4 Arbitrage and the Law of One Price

3. 3-3 3.1 Valuing Costs and Benefits Financial Decision Making and the NPV rule Using Market Prices to Determine Cash Values When Competitive Market Prices Are Not Available

4. 3-4 Example 3.1 Competitive Market Prices Determine Value

5. 3-5 Example 3.1 Competitive Market Prices Determine Value

6. 3-6 Example 3.2 Calculating Cash Values Using Market Prices

7. 3-7 Example 3.2 Calculating Cash Values Using Market Prices

8. 3-8 Example 3.3 When Value Depends on Preferences

9. 3-9 Example 3.3 When Value Depends on Preferences

10. 3-10 3.2 Interest Rates and the Time Value of Money The Time Value of Money The Interest Rate: An Exchange Rate Across Time

11. 3-11 Example 3.4 Comparing Costs at Different Points in Time

12. 3-12 Example 3.4 Comparing Costs at Different Points in Time

13. 3-13 Figure 3.1 Converting Between Dollars Today and Gold, Euros, or Dollars in the Future We can convert dollars today to different goods, currencies, or points in time by using the competitive market price, exchange rate, or interest rate.

14. 3-14 3.3 Present Value and the NPV Decision Rule Net Present Value The NPV Decision Rule –Accepting or Rejecting a Project –Choosing Among Projects NPV and Individual Preferences

15. 3-15 Equation 3.1 Net Present Value

16. 3-16 Equation 3.2

17. 3-17 Example 3.5 The NPV Is Equivalent to Cash Today

18. 3-18 Example 3.5 The NPV Is Equivalent to Cash Today

19. 3-19 Table 3.1 Cash Flows of Three Possible Projects

20. 3-20 Table 3.2 Computing the NPV of Each Project

21. 3-21 Table 3.3 Cash Flows from Combining Project B with Borrowing

22. 3-22 Table 3.4 Cash Flows from Combining Project B with Saving

23. 3-23 3.4 Arbitrage and the Law of One Price An Old Joke Arbitrage Law of One Price

24. Price of a Bond Suppose a bond promises to pay $1,000 a year from now. If the relevant interest rate is 5%, what is the price of the bond? What if the bond sells for $940? What if the bond sells for 960? 3-24

25. 3-25 Table 3.5 Net Cash Flows from Buying the Bond and Borrowing

26. 3-26 Table 3.6 Net Cash Flows from Selling the Bond and Investing

27. 3-27 Equation 3.3 No Arbitrage Price of a Security

28. 3-28 Example 3.6 Computing the No-Arbitrage Price

29. 3-29 Example 3.6 Computing the No-Arbitrage Price