Finance Management chapter 3

© All Rights Reserved

14 views

Finance Management chapter 3

© All Rights Reserved

- Business Decision Making
- School Management Systems Project
- 242107601 Introduction to Managerial Accounting
- Managing IT Projects 160 v1
- Jam Marmalade
- Chapter 7
- Net Present Value Documents
- Investment Decision and Capital Budgeting
- FCF 9th Edition Chapter 19
- Exercícios Valuation 825453
- WSU Manual
- Group 6 Rosewood CLTV (1)
- Chapter 14 Outline
- Artifact v. Mgmt 565 - Team Paris Waldo County
- Capital Budgeting
- Sample Print Materials
- OB_DowntownStrategiesATT4
- 102 Session 8
- FM
- Introduction to CF

You are on page 1of 20

Agenda / Topics

Chapter3:

Financial Decision

Making and the

Law of One Price

1.

2.

3.

4.

5.

Valuing Decisions

Interest Rates and the Time Value of Money

Present Value and the NPV Decision Rule

Arbitrage and the Law of One Price

No-Arbitrage and Security Prices

Group1

Agenda / Topics

6. Appendix

The price of risk

Risky vs Risk-Free Cash Flow

Risk Aversion and the Risk Premium

Risk Premiums Depend on Risk

Risk Is Relative to the Overall Market

Risk, Return, and Market Prices

Arbitrage with Transactions Costs

Objectives

To understand Valuation Principle to express all costs and benefits

in common terms.

To understand concept of net present value (NPV) as a way to

compare the costs and benefits of a project in terms of a common

unit, dollars today.

To understand how evaluate a decision like Does the cash value

today of its benefits exceed the cash value today of its costs?

28/08/57

Objectives (cont.)

How to make decisions that increase the value of the firm to its

investors ?

Valuing Decisions

To understand the strategies and advantage of arbitrage and noarbitrage (Law of One Price)

Valuing Decisions

Valuing Decisions

Skill

Economics

Skill

Skill

Accounting

Organizational

Behavior

Strategy

Skill

Marketing

Skill

Skill

How to make decisions that increase the value of the firm to its investors???

Operations

28/08/57

compare 400 ounces to 10 ounces and conclude that the larger quantity is better.

Instead, to compare the costs and benefits, we first need to quantify their values

in equivalent terms.

example

Gold 10 ounces

3. Evaluate them in the same terms cash today

If the current market price for gold is $900 per ounce, then the 10

ounces of gold we receive has a cash value of

Now that we have quantified the costs and benefits in terms of a common

measure of value, cash today, we can compare them. The jewelers

opportunity has a benefit of $9000 today and a cost of $6000 today, so

the net value of the decision is

$9000 -$6000 = $3000 today.

By accepting the trade, the jewelry firm will be richer by $3000.

Consider the silver. What is its cash value today? Suppose silver can be

bought and sold for a current market price of $15 per ounce. Then the 400

ounces of silver we give up has a cash value

An ounce of gold differs in value from an ounce of silver, its incorrect to compare 400 ounces to 10

ounces and conclude that the larger quantity is better. Instead, to compare the costs and benefits, we

first need to quantify their values in equivalent terms.

Consider the silver. What is its cash value today? Suppose silver can be

bought and sold for a current market price of $15 per ounce. Then the 400

ounces of silver we give up has a cash value

28/08/57

Do such consideration matter? (Gold matter example)

Consideration 1

The current price is too HIGH always sell the gold at the

current market price and receive $9000

Consideration 2

The current price is too LOW always buy the gold at the

current market price for $9000

Competitive market prices = not your own personal preference

Example

- You won 4 free concert tickets (face value is $40 each)

- Not your favorite concert and intend not to go to the concert

- Find out the ticket of your favorite concert are being sold on eBay

$50 each (face value is $45 each are sold-out and you need 2 tickets)

- Not your favorite concert tickets are also being bought and sold

on eBay $30 each

Competitive market

Bought and Sold at the same price

As long as a competitive market exists, the value

of the good will not depend on the views or

preferences of the decision maker.

Not your favorite concerts tickets

at $30 each = $120 market value

Two of your favorite bands tickets

at $50 each = $100 market value

Instead of buying the tickets to your favorite band, you should accept all 4

free tickets, sell them on eBay, and use the proceeds to buy two tickets to

your favorite bands show. Youll even have $20 left over to buy a T-shirt

28/08/57

Valuation Principle

The value of an asset to the firm or its investors is determined by its

competitive market price. The benefits and costs of a decision should

be evaluated using these market prices, and when the value of the

benefits exceeds the value of the costs, the decision will increase the

market value of the firm.

Example

- You have the opportunity to buy 200 barrels of oil and 3,000

pounds of copper for a total $12,000.

- The current competitive market price of oil is $50 per

barrel and for copper is $2 per pound.

- You are concerned that the value of both commodities may

fall in the future.

Should you take this opportunity?

(200 barrels of oil) * ($50/barrel of oil today) = $10,000 today

(3000 pounds of copper) * ($2/pound of copper today) = $6000 today

The net value of the opportunity is

$10,000 + $6000 - $12,000 = $4000 today.

Because the net value is positive,

you should take it.

Thus, the opportunity is a good one for the

firm, and will increase its value by $4000.

Time Value of Money

28/08/57

Cost:

$100,000 today

Benefit:

$105,000 in one year

Example:

If you have $1 today, you can invest it by deposit it in a bank account

paying 7% interest, you will have $1.07 at the end of one year.

$105,000 - $100,000 = $5000.

But this calculation ignores the timing of the costs and benefits,

and it treats money today as equivalent to money in one year.

money in the future the time value of money

The rate at which we can exchange money today for money in the

future is determined by the current interest rate. The rate at which

we can exchange money today for money in the future is determined

by the current interest rate.

rf , for a given period as the interest

rate at which money can be borrowed

or lent without risk over that period

Interest Rate: 7%

= $107,000 in one year (in case: left money in the bank)

28/08/57

Value of Investment in One Year

Interest Rate: 7%

Value of Investment Today

From making an investment

In other words, we could earn $2000 more in one year by putting

our $100,000 in the bank rather than making this investment. We

should reject the investment: If we took it, we would be $2000

poorer in one year than if we didnt.

From making an investment

From making an investment

= -$2,000 in one year

Taking the investment would make us $1869.16 poorer today

because we have given up $100,000 for something worth only

$98,130.84.

present value (PV) of the investment. If we express it in terms of dollars

in the future, we call it the future value (FV) of the investment.

28/08/57

Problem:

Money in the future is worth less today, and so its price reflects a

discount. Because it provides the discount at which we can purchase

money in the future, the amount 1/1+r is called the one-year discount

factor. The risk-free interest rate is also referred to as the discount rate

for a risk-free investment.

Solution:

If the project were delayed,

$3 billion * (1.10) = $3.3 billion in 2005.

To compare this amount to the cost of $3 billion in 2004,

we must convert it using the interest rate of 2%:

$3.3 billion in 2005 / ($1.02 in 2005/$ in 2004) = $3.235 billion in 2004

Therefore, the cost of a delay of one year was

$3.235 billion - $3 billion = $235 million in 2004

That is, delaying the project for one year was equivalent to

giving up $235 million in cash.

make it earthquake-safe was approximately $3 billion in

2004. At the time, engineers estimated that if the

project were delayed to 2005, the cost would rise by

10%. If the interest rate were 2%, what would be the

cost of a delay in terms of dollars in 2004?

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.

28/08/57

(NPV) Decision Role

Value (NPV) Decision Role

Convert between cash today and cash in the future using the

risk-free interest rate.

Convert costs and benefits to the same point in time and

compare them to make a decision.

Example 1

In exchange for $500 today, you will receive $550 in one year with certainty.

the present value of its cost

NPV = PV(All project cash flows)

= PV(Benefits) PV(Costs)

PV (Benefit) = ($550 in one year) / (1.08 $ in one year/$ today)

= $509.26 today

This PV is the amount we would need to put in the bank today to generate $550 in

one year ($509.26 * 1.08 = $550).

The costs and benefits are in present value terms, we can compute the

investments

NPV:

NPV = $509.26 - $500 = $9.26 today

28/08/57

Example 1 (Con)

If your firm doesnt have the $500, it could borrow $509.26 from the bank

at the 8% interest rate and then take the project.

the highest NPV.

Today

today.

This transaction leaves you with exactly $9.26 extra cash today and no

future net obligation. So taking the project is like having an extra $9.26 in

cash up front.

equivalent to receiving their NPV in cash today.

Reject those projects with negative NPV; accepting them would

reduce the wealth of investors, whereas not doing them has no cost

(NPV = 0).

Example 2

Example 2 (Con)

Suppose you started a Web site hosting business and then decided to return to school. Now that

you are back in school, you are considering selling the business within the next year. An investor

has offered to buy the business for $200,000 whenever you are ready. If the interest rate is 10%,

which of the following three alternatives is the best choice?

1. Sell the business now.

2. Scale back the business and continue running it while you are in school for one more year,

and then sell the business (requiring you to spend $30,000 on expenses now, but generating

$50,000 in profit at the end of the year).

3. Hire someone to manage the business while you are in school for one more year, and

then sell the business (requiring you to spend $50,000 on expenses now, but generating

$100,000 in profit at the end of the year).

28/08/57

Example 2 (Con)

Need $60,000 to pay for school

Arbitrage

One Price

markets to take advantage of a price difference.

the same.

any risk or making any investment. (has a positive NPV)

different competitive markets, then they must trade for the same

price in both markets.

28/08/57

No-Arbitrage

and Security Prices

financial market is known as a financial security

(or, more simply, a security).

How does a security imply with Arbitrage

and the Law of One Price Concept ?

Individual securities

Package of securities (Portfolio)

Bond is a security sold by

investment opportunities should be the same.

One example of a simple security that

promises a onetime payment to its owner in one

years time with no risk that the payment will not

be made is Bond.

Governments

Corporate

the promised future payment.

28/08/57

Example

If the risk-free interest rate is 5%, what can we conclude

about the price of this bond in a normal market ? Assume

that we need to invest today to receive $1000 in one year.

PV = $ 1000 /1.05

= $ 952.38 today

Identifying Arbitrage Opportunities with Securities

If the bond had a different price, there would be an

arbitrage opportunity.

Ex.1 The Bond Price is $940.

Ex.2 The Bond Price is $960.

Ex.1 The Bond Price is $940.

Ex.2 The Bond Price is $960.

Buy the bond for $940

Borrow $952.38 from the bank with 5% interest rate

If others who see the

opportunitystart buying

the bond, its price will

quickly rise until it reaches

$952.38 and the arbitrage

opportunity disappears.

Sell the bond and

Invest $952.38 at the bank

If others who see the

opportunitystart selling

the bond, the price will fall

until it reaches $952.38 and

the arbitrage opportunity

disappears.

28/08/57

Short sale

SET 100 Index (

2540) (

2553)

Q: Does only the current owners of the bond can exploit it ?

A: No, in financial markets it is possible to sell a security you

do not own by doing a short sale.

security first borrows it from someone

who already owns it.

Later, that person must either return

the security by buying it back or pay

the owner the cash flows he or she

would have received.

Ref:http://www.setmai.com/%E0%B8%81%E0%B8%B2%E0%B8%A3%E0%B8%82%E0%B8%B2%E0%B8%

A2%E0%B8%8A%E0%B8%AD%E0%B8%A3%E0%B9%8C%E0%B8%95-short-selling/

Short sale

Short sale

Short Selling

(Buy To Cover)

Short Selling 2

1.

2.

Ref:http://www.setmai.com/%E0%B8%81%E0%B8%B2%E0%B8%A3%E0%B8%82%E0%B8%B2%E

0%B8%A2%E0%B8%8A%E0%B8%AD%E0%B8%A3%E0%B9%8C%E0%B8%95-short-selling/

Ref:

http://www.settrade.com/C13_MarketSummary.jsp?detail=SET100

http://www.set.or.th/dat/content/rule/th/cir53_2540_ShortSale.pdf

http://www.set.or.th/dat/content/rule/th/BorSorKhor0101SecuritiesEligibleforShortSelling_TH.pdf

http://www.set.or.th/set/shortsales.do?language=th&country=TH

28/08/57

Determining the No-Arbitrage Price

No-Arbitrage Price of a Security

Determining the Interest Rate from Bond Prices

$ today = $ in one year/(1 + rf )

No-arbitrage prices

NPV (Buy or Sell security) = 0

Block inmarkets,

study

Arbitrage opportunities do not exist in normal

of corporate

the NPV of all security trades must befinance

zero.

Instead, value is created by the real investment projects in which the firm

engages, such as developing new products, opening new stores, or creating

more efficient production methods.

Summary

No arbitrage : the risk-free interest rate is equal to the return from

investing in a risk-free bond

Return of bond > the risk-free interest rate Investors would earn a

profit by borrowing at the risk-free interest rate and investing in the

bond

Return of bond < the risk-free interest rate Investors would sell the

bond and invest the proceeds at the risk-free interest rate

Separation Principle

Security transactions in a normal market neither create nor

destroy value on their own.Therefore, we can evaluate the NPV of an

investment decision separately from the decision the firm makes

regarding how to finance the investment or any other security

transactions the firm is considering.

28/08/57

Valuing a Portfolio

The Law of One Price also has implications for packages of

securities.

Example

Consider two securities, A and B.

Suppose a third security, C, has the same cash flows as A and B

combined.

Valuing a Portfolio

Example

Holbrook Holdings owns 60% of Hacakerrys Hots Restaurant Chain and Ice

hockey team

Market value of Holbrook Holdings is $160 million.

Market value of Hacakerry $120 million.

What is the market value of the hockey team?

ANSWER

Value Additivity Price(Holbrook) = Price(Hacakerry) + Price(Hockey team)

$160 million = ($120 million * 60% ) + Price(Hockey team)

Price(Hockey team) = $ 88 million

Valuing a Portfolio

Value Additivity and Firm Value

To maximize the value of the entire firm, managers should make

decisions that maximize NPV. The NPV of the decision represents its contribution

to the overall value of the firm.

28/08/57

The risk-free bond has no risk and will pay $1100 whatever the state of the economy. Risk Free Interest Rate = 4%

Assume that the market index will be worth $1400 if the economy is strong but only $800 if the economy is weak.

Risk Premium = Average Return Risk Free Interest

Rate

= 10% - 4%

= 6%

Security A will pay investors $600 if the economy is strong and nothing if it is weak.

Risk-free bond that pays $800 in one year

Market value of the bond and security A must equal $1000

Risk Free Interest Rate = 4%

Security A =

28/08/57

Security A Return

Strong = (600 - 231)/231 = 160% Weak = -100%

Suppose security B pays $600 if the economy is weak and $0 if the economy is strong.

What are its no-arbitrage price, expected return, and risk premium?

Risk Free Interest Rate = 4%

Risk-free bond Today Price =

Risk Premium=

security B Price =

Security B Return

Strong = -100%

Average Expect Return =

Risk Premium=

The risk of a security must be evaluated in relation to the fluctuations of other

investments in the economy. A securitys risk premium will be higher the more its

returns tend to vary with the overall economy and the market index. If the securitys

returns vary in the opposite direction of the market index, it offers insurance and will

have a negative risk premium.

28/08/57

Consider a risky bond with a cash flow of $1100 when the economy is strong and

$1000 when the economy is weak.

Suppose a 1% risk premium is appropriate for this bond.

Risk-free interest rate is 4%, what is the price of the bond today?

DELL is $12.60, but there is a transaction cost of $0.10 per share

when buying or selling.

diverge by more than $5, the amount of the transactions costs.

28/08/57

Summary

Foundation for financial decision making

The Valuation Principle

Net Present Value

The Law of One Price

Risk of investment

www.aommoney.com/taxbugnoms// -

Member of Group 1

1. 5681504226

2. 5681532826

3. 5681568426

4. 5681538626

5. 5681552326

Kamolthip

Natthawadee

Pichaya

Thanapol

Bunanan

Yimsomboon

Potewiratananond

Reaksatjanon

Mathupayas

Suwanjak

- Thank you -

- Business Decision MakingUploaded byhalimatabera
- School Management Systems ProjectUploaded byWesley Chuck Anaglate
- 242107601 Introduction to Managerial AccountingUploaded bydubbs21
- Managing IT Projects 160 v1Uploaded byImran Memon
- Jam MarmaladeUploaded byShishir Kumar Singh
- Chapter 7Uploaded byIbra Akb
- Net Present Value DocumentsUploaded byJozsef Czirjek
- Investment Decision and Capital BudgetingUploaded byInformation should be FREE
- FCF 9th Edition Chapter 19Uploaded byAlmayaya
- Exercícios Valuation 825453Uploaded byCristiano Nunes
- WSU ManualUploaded bydsouzad12
- Group 6 Rosewood CLTV (1)Uploaded byNohar Mehra
- Chapter 14 OutlineUploaded bysalehinfmsalehi9571
- Artifact v. Mgmt 565 - Team Paris Waldo CountyUploaded byRizkyHaryogi
- Capital BudgetingUploaded byBima Aji Pamungkas
- Sample Print MaterialsUploaded byJim Wolfe
- OB_DowntownStrategiesATT4Uploaded byemmettoconnell
- 102 Session 8Uploaded byapi-3719521
- FMUploaded byRashmi Singh
- Introduction to CFUploaded byAndrea Griffone
- 03071281419047 Eghar Prima Wellyan Economic AnalysisUploaded byEghar Prima
- MoF Issue 7Uploaded byqween
- car care project feasibility study-130916161800-phpapp02Uploaded byAasami Wasaami
- 7463-18294-1-PB-1Uploaded byAgus Hilapok
- CH6.docUploaded byAnonymous zenctQ
- 1Uploaded byLucks Jana
- final productUploaded byapi-288374214
- Copy of Xl0000044Uploaded bySiddharth Sehgal
- finance managementUploaded byKaran Sharma
- Project Selection Process RevisedUploaded bysujith

- 43513-00_RevB_M_SAS_9261-8i_QIGUploaded byBunanan Suwanjak
- MR-CC20-PB100Uploaded byBunanan Suwanjak
- Mb Manual Gc-thunderbolt2Uploaded byBunanan Suwanjak
- HP Service Guard SolutionUploaded byBunanan Suwanjak
- calendar_2015-08-01_2016-02-01Uploaded byBunanan Suwanjak
- Windows PowerShell Desired State Configuration Quick Reference for Windows Management Framework 4.0Uploaded byxav197+service
- Vray manualUploaded byBunanan Suwanjak
- d.rose Jump StoreUploaded byBunanan Suwanjak
- Firebird MacOSXUploaded byBunanan Suwanjak

- Financial Statements_ Working Capital _ InvestopediaUploaded bypersephonise
- RA 9500Uploaded byArianne Cerezo
- Financial and Cost AccountingUploaded byRajendran Kajananthan
- SM Hoyle AdvAcc11e Ch02Uploaded byAnton Vitali
- Government Gazette Mining Charter Implementation GuidelinesUploaded byTiso Blackstar Group
- FI-MM Integration ConfigurationUploaded byKashif Ihsan
- The United Kingdom’s quantitative easing policy: design, operation and impactUploaded byDavid S Chen
- eev_disclosures.pdfUploaded byaplu
- Agency Costs, Mispricing, And Ownership StructureUploaded byHiển Hồ
- The Value of DELL and a Free EBIT Multiples CalculatorUploaded byOld School Value
- Cost Management WhitepaperUploaded bymufti_sb
- Presentation on SAP Reporting Workshop - FinalUploaded bylekzite
- Dcf ValuationUploaded byumasahithi91
- FSA_8e_Ch05_SM.docUploaded bynadiagus
- HOLD_DPZ_FordEquity.pdfUploaded byAmazingTrans
- Payload IeeeUploaded byLalo Angel
- Practical Guide for Pricing Amortizing and Accreting SwapUploaded byAlan White
- Solvency IIUploaded bycfalevel123
- Bershire Hathaway Owner's ManualUploaded byLao Quoc Buu
- UT Dallas Syllabus for aim6344.001 06f taught by Rafal Szwejkowski (rafalsz)Uploaded byUT Dallas Provost's Technology Group
- Product Costing ConfigurationUploaded byankish77
- Jurnal Utama Accounting HeritageUploaded bysukeksi
- Ciobanu_StockMarketAnalysisUploaded byaciobanu
- Appendix IV - RoMM Control Objectives and Control ActivitiesUploaded bydroidant
- Chapter 9Uploaded byAnnalyn Molina
- Basics of InvestmentUploaded byJohn Dawson
- dlUploaded bymercagentes
- Van Der Hoek - 2005 - From Cash to Accrual Budgeting and Accounting in the Public Sector the Dutch ExperienceUploaded bysuwarjono
- Advantages Of Audit.docUploaded byziabutt
- Rev- SylUploaded byMani Kandan