Chapter 5

Chapter 5: The Basic Tools of Finance
Finance: The field that studies how people make decisions regarding the allocation of
resources over time and the handling of risk.
Present Value: The amount of money today needed to produce a future amount of money,
given prevailing interest rates
Future Value: The amount of money in the future that an amount of money today will yield,
given prevailing interest rates
Compounding: 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
Present Value: Measuring the Time Value of Money

FV = PV × (1+r)n
- FV: Future Value - PV: Present Value
- n: year - r: interest rate
1. If the interest rate is zero, then $100 to be paid in 10 years has a present value that is
- PV = 100 / (1+0)10
- PV = 100 / 1
- PV = 100
2. If the interest rate is 10 percent, then the future value in 2 years of $100 today is
- FV=100×(1+0.10)2
- FV=100×(1.10)2
- FV=100×1.21
- FV = $121
3. If the interest rate is 10 percent, then the present value of $100 to be paid in 2 years
is
- FV = 100
- PV = 100 / (1 + 0,10)2
- PV = 100 / 1,21
- PV = $82.64
Risk Aversion: A dislike of uncertainty
4. the ability of insurance to spread risk is limited by
a. risk aversion and moral hazard.
b. risk aversion and adverse selection.
c. moral hazard and adverse selection.
d. risk aversion only.
5. the benefit of diversification when constructing a portfolio is that it can eliminate
a. adverse selection.
b. risk aversion.
c. firm-specific risk.
d. market risk.
6. the extra return that stocks earn over bonds (on average) compensates stockholders
for …………..
a. the greater market risk that stockholding entails.
b. the greater firm-specific risk that stockholding entails.
c. the higher taxes levied on stockholders.
d. the higher brokerage costs incurred buying stocks.
7. the goal of fundamental analysis is to
a. determine the true value of a company.
b. put together a diversified portfolio.
c. predict changes in investor irrationality.
d. eliminate investor risk aversion.
8. according to the efficient markets hypothesis,
a. excessive diversification can reduce an investor’s expected portfolio returns.
b. changes in stock prices are impossible to predict from public information.
c. actively managed mutual funds should generate higher returns than index funds.
d. the stock market moves based on the changing animal spirits of investors.
9. Historically, index funds have had _________ than most actively managed mutual
funds.
a. higher fees
b. less diversification
c. larger tax burdens
d. better returns
1. b 2. d 3. b 4. c 5. c 6. a 7. a 8. b 9. d
Questions For review
1. The interest rate is 7 percent. Use the concept of present value to compare $200 to be
received in 10 years and $300 to be received in 20 years.
2. What benefit do people get from the market for insurance? What two problems
impede the insurance market from working perfectly?
- People pay premiums to insurance companies to protect themselves against unexpected
events. Two problems are adverse selection and moral hazard.
3. What is diversification? Does a stockholder get a greater benefit from diversification
when going from 1 stock to 10 stocks or when going from 100 stocks to 120 stocks?
- Diversification is a risk management strategy that involves spreading investments across
different assets to reduce exposure to any single asset or risk.
4. Between stocks and government bonds, which type of asset has more risk? Which
pays a higher average return?
- Stocks represent ownership in a company and are subject to market volatility and business
risks. In contrast, government bonds are debt securities issued by governments and are
generally considered safer investments because they are backed by the government's ability
to tax or print money. While stocks tend to offer higher average returns over the long term,
they also come with higher risk compared to government bonds, which typically offer lower
but more stable returns.
5. What factors should a stock analyst think about in determining the value of a share
of stock?
- Stock analysts evaluate various factors to determine the value of a stock. These factors
include the company's financial performance and growth prospects.
Problems And Applications

1. According to an old myth, Native Americans sold the island of Manhattan about 400
years ago for $24. If they had invested this amount at an interest rate of 7 per cent per
year, how much, approximately, would they have today?
2. A company has an investment project that would cost $10 million today and yield a payoff
of $15 million in 4 years.
a. Should the firm undertake the project if the interest rate is 11 percent? 10 percent? 9
percent? 8 percent?
b. Can you figure out the exact interest rate at which the firm would be indifferent between
undertaking and forgoing the project? (This interest rate is called the project’s internal rate of
return.)
a-) NPV=Present Value of Payoff−Initial Investment

- Initial investment (I) = $10 million and Payoff after 4 years (FV) = $15 million
Now, let's analyze the results:
- At 11% interest rate, NPV is approximately $0.13 million, meaning the project is
marginally profitable.
- At 10% interest rate, NPV is approximately $0.24 million, indicating a slightly higher
profitability.
- At 9% interest rate, NPV is approximately $0.63 million, showing improved profitability.
- At 8% interest rate, NPV is approximately $1.03 million, indicating even higher
profitability.
Therefore, based on the NPV calculations:
- The firm should undertake the project at 8%, 9%, 10%, and 11% interest rates.
- The project becomes increasingly more profitable as the interest rate decreases.
b-) To find the exact interest rate (internal rate of return) at which the firm would be
indifferent between undertaking and forgoing the project, we need to set the NPV equal
to zero and solve for the interest rate:
3. Bond A pays $8,000 in 20 years. Bond B pays $8,000 in 40 years. (To keep things
simple, assume that these are zero-coupon bonds, meaning the $8,000 is the only
payment the bondholder receives.)
a. If the interest rate is 3.5 percent, what is the value of each bond today? Which bond
is worth more? Why? (Hint: You can use a calculator, but the rule of 70 should make
the calculation easy.)
b. If the interest rate increases to 7 percent, what is the value of each bond? Which
bond has a larger percentage change in value?
4. Your bank account pays an interest rate of 8 percent. You are considering buying a
share of stock in XYZ Corporation for $110. After 1, 2, and 3 years, it will pay a
dividend of $5. You expect to sell the stock after 3 years for $120. Is XYZ a good
investment? Support your answer with calculations.
5. For each of the following kinds of insurance, give an example of behavior that
reflects moral hazard and another example of behavior that reflects adverse selection.
a. health insurance
- Moral Hazard: People may take more health risks, like starting extreme sports, assuming
insurance will cover medical costs.
- Adverse Selection: Those with existing health issues are more likely to get insurance,
increasing risk for insurers.
b. car insurance
- Moral Hazard: Insured drivers might drive more recklessly, thinking damages are covered.
- Adverse Selection: High-risk drivers, such as those with speeding tickets, are more likely to
seek comprehensive coverage.
c. life insurance
- Moral Hazard: Insured individuals might neglect health care, knowing their family will
receive a payout.
- Adverse Selection: People with known health risks or dangerous jobs are more likely to
apply for life insurance, posing a higher risk to insurers.
6. Which kind of stock would you expect to pay the higher average return: stock in an
industry that is very sensitive to economic conditions (such as an automaker) or stock
in an industry that is relatively insensitive to economic conditions (such as a water
company)? Why?
Automaker Stocks:
- Higher average return.
- Very sensitive to economic conditions.
- Higher risk due to volatility.
- Investors demand compensation for additional risk.
Water Company Stocks:
- Lower average return.
- Relatively insensitive to economic conditions.
- Lower risk due to stable demand.
- Provides essential services, making it less volatile.
7. A company faces two kinds of risk. A firm-specific risk is that a competitor might
enter its market and take some of its customers. A market risk is that the economy
might enter a recession, reducing sales. Which of these two risks would more likely
cause the company’s shareholders to demand a higher return? Why?
Market Risk:
- More likely to cause shareholders to demand a higher return.
- Affects the entire market, not just the individual company.
- Cannot be easily diversified away by holding a variety of stocks.
- Impacts sales and profits across various sectors during a recession.
Firm Specific Risk:
- Less impact on shareholders' demand for higher return.
- Can be mitigated through diversification (owning stocks in multiple companies).
- Affects only the individual company, not the entire market.
- Shareholders can reduce exposure to this risk without demanding higher returns by
diversifying their investment portfolio.
1. b 2. d 3. b 4. c 5. c 6. a 7. a 8. b 9. d

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Chapter 5

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Chapter 5: The Basic Tools of Finance

Present Value: Measuring the Time Value of Money

Problems And Applications

a-) NPV=Present Value of Payoff−Initial Investment

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