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Chapter 3

Financial Decision
Making and the Law
of One Price

Chapter Outline
3.1 Valuing Decisions
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
3.5 No-Arbitrage and Security Prices

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3.1 Valuing Decisions


Identify Costs and Benefits
May need help from other areas in identifying
the relevant costs and benefits

Marketing
Economics
Organizational Behavior
Strategy
Operations

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Using Market Prices to Determine


Cash Values
Competitive Market
A market in which goods can be bought and sold
at the same price
!

In evaluating costs and benefits, we use the


current market price to convert all options to
dollars
We do not concern ourselves with whether we
think prices are fair or whether we need the
particular products

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Example 3.2

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Example 3.2 (continued)

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3.2 Interest Rates and the Time


Value of Money
Time Value of Money

Consider an investment opportunity with the


following certain cash flows.

Cost: $100,000 today


Benefit: $105,000 in one year

The difference in value between money today and


money in the future is due to the time value of
money.

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The Interest Rate: An Exchange


Rate Across Time

The rate at which we can exchange money today for


money in the future is determined by the current
interest rate.

Suppose the current annual interest rate is 7%. By


investing or borrowing at this rate, we can exchange
$1.07 in one year for each $1 today.
RiskFree Interest Rate (Discount Rate), rf = The interest rate
at which money can be borrowed or lent without risk.
Interest Rate Factor = (1 + rf)
Discount Factor = 1 / (1 + rf)

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The Interest Rate: An Exchange


Rate Across Time (continued)
Value of Investment in One Year
If the interest rate is 7%, then we can express our
costs as:

!
Cost = ($100,000 today)(1.0 + 7%)
= $107,000 in one year

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The Interest Rate: An Exchange


Rate Across Time (continued)
Value of Investment in One Year

Both costs and benefits are now in terms of


dollars in one year, so we can compare them and
compute the investments net value:
$105,000 $107,000 = $2000 in one year

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.

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The Interest Rate: An Exchange


Rate Across Time (continued)
Value of Investment Today

Consider the benefit of $105,000 in one year.


What is the equivalent amount in terms of dollars
today?
Benefit = ($105,000 in one year) (1.0 + 7%)

= ($105,000 in one year) 1/1.07


= $98,130.84 today
This is the amount the bank would lend to us
today if we promised to repay $105,000 in one
year.
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The Interest Rate: An Exchange


Rate Across Time (continued)
Value of Investment Today
Now we are ready to compute the net value of the
investment:
$98,130.84 $100,000 = $1869.16 today
Once again, the negative result indicates
that we should reject the investment.

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The Interest Rate: An Exchange


Rate Across Time (continued)
Present Value versus Future Value
This demonstrates that our decision is the same
whether we express the value of the investment in
terms of dollars in one year or dollars today. If we
convert from dollars today to dollars in one year,
($1869.16 today) (1.07 $ in one year/$ today)
= $2000 in one year

The two results are equivalent, but expressed as values


at different points in time.

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The Interest Rate: An Exchange


Rate Across Time (continued)
Present Value versus Future Value
When we express the value in terms of dollars
today, we call it the present value (PV) of the
investment

If we express it in terms of dollars in the future,


we call it the future value of the investment
The amount

is called the one-year discount factor

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


for a risk-free investment.

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Textbook Example 3.3

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Textbook Example 3.3


(continued)

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3.3 Present Value and the NPV


Decision Rule

The net present value (NPV) of a project


or investment is the difference between the
present value of its benefits and the present
value of its costs

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The NPV Decision Rule


start here!
on Aug 9

When making an investment decision among


multiple options, take the alternative with
the highest NPV
!

Choosing this alternative is equivalent to


receiving its NPV in cash today

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The NPV Decision Rule


(continued)
When deciding whether or not to invest your
money in a project
Invest in those projects with positive NPV

because accepting them is equivalent to receiving


their NPV in cash today

Reject those projects with negative NPV because


accepting them would reduce the wealth of
investors.

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Example 3.4

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Example 3.4 (continued)

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Choosing Among Alternatives


We can also use the NPV decision rule to
choose among many different projects.
To do so, we must compute the NPV of each
alternative, and then select the one with the
highest NPV.
This alternative with the highest NPV is the one
which will lead to the largest increase in the
value of the firm.

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Textbook Example 3.5

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Table 3.1 Cash Flows and NPVs for


Web Site Business Alternatives

1
2
3
max NPV

Costs and Benefits

NPV of each Option

To make the right financial decision !


1)
2)
3)

determine all Costs & Benefits of each alternative


determine the NPV of all
choose the alternative with highest NPV

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NPV and Cash Needs

Regardless of our preferences for cash today


versus cash in the future, we should always
maximize NPV first
!

We assume we always can then borrow or


lend (at the risk free rate) to shift cash flows
through time and find our most preferred
pattern of cash flows

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3.4 Arbitrage and the Law of


One Price
Arbitrage

The practice of buying and selling


equivalent goods in different markets to
take advantage of a price difference.

An arbitrage opportunity occurs when it


is possible to make a profit without taking
any risk or making any investment.

Normal Market

A competitive market in which there are


no arbitrage opportunities.

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3.4 Arbitrage and the Law of


One Price (continued)
Law of One Price

If equivalent investment opportunities


trade simultaneously in different
competitive markets, then they must
trade for the same price in both
markets.

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3.5 No-Arbitrage and Security


Prices
Valuing a Security with the Law of One Price
Assume a security promises a risk-free payment
of $1000 in one year
If the risk-free interest rate is 5%, what can we
conclude about the price of this bond in a normal
market?

Price(Bond) today = $952.38 in any normal market

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Identifying Arbitrage
Opportunities with Securities

What if the price of the bond is not $952.38?

Assume the price is $960.

!
!
!
!
!

give to bond holder


receive from bank

When the bond is overpriced, the arbitrage strategy


involves selling the bond for $960 and investing at the
bank. This nets us $7.62 today and we get $1000 more
in a year, which we give to the bond holder
The opportunity for arbitrage will force the price of the
bond to fall until it is equal to $952.38.

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Determining the No-Arbitrage


Price

Unless the price of the security equals the


present value (PV) of the securitys cash flows,
an arbitrage opportunity will appear.

The No Arbitrage Price of a Security = NPV

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Example 3.6

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Example 3.6 (continued)

You should know how to calculate this


arbitrage Profit using NPV of all cash flows
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Determining the Interest Rate


From Bond Prices

If we know the price of a risk-free bond, we


can use
to determine what the risk-free interest rate
must be if there are no arbitrage
opportunities.

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Determining the Interest Rate


From Bond Prices (continued)

Suppose a risk-free bond that pays $1000 in


one year is currently trading with a market
price of $929.80 today

The bonds price must equal the present


value of the $1000 cash flow it will pay

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Determining the Interest Rate


From Bond Prices (continued)

The risk-free interest rate must be 7.55%

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The NPV of Trading Securities and


Firm Decision Making
In a normal market, the NPV of buying or selling a
security is zero
!
!
!
!
!
Thus we conclude: security transactions (buying/
selling stocks and bonds) in an efficient (normal)
market, neither creates nor destroys value on its own

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Example 3.7

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Example 3.7 (continued)


1

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Where Do We Go From Here?


Impact of Risk on Valuation
!

Question - what is the impact?

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Where Do We Go From Here?


Impact of Risk on Valuation
When cash flows are risky, we must discount them at a

rate equal to (the risk-free interest rate plus an


appropriate risk premium).

The appropriate risk premium will be higher the more


the projects returns tend to vary with overall risk in the
economy
Question: If the risk is higher, all other things being
equal, is the NPV higher, lower or the same as the NPV
for a less-risky project?
To Answer: Consider a future cash flow of $1000. Is its
NPV larger or smaller with a higher risk?
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The Risk Premium


Risk Premium

The additional return that investors expect to


earn to compensate them for a securitys risk
When a cash flow is risky, to compute its
present value we must discount the cash flow
we expect on average at a rate that equals the
risk-free interest rate plus an appropriate risk
premium

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Chapter 3
!

Appendix

Learning Objectives
1.

Assess the relative merits of two-period


projects using net present value.

2.

Define the term competitive market,


give examples of markets that are
competitive and some that arent, and
discuss the importance of a competitive
market in determining the value of a good.

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Learning Objectives (continued)


3.

Explain why maximizing NPV is


always the correct decision rule.

4.

Define arbitrage, and discuss its role in


asset pricing. How does it relate to the
Law of One Price?

5.

Calculate the no-arbitrage price of an


investment opportunity.

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Chapter Quiz
1.

If gasoline trades in a competitive market,


would a transportation company that has a use
for the gasoline value it differently than
another investor?

2.

How do you compare benefits at different


points in time?

3.

If interest rates fall, what happens to the value


today of a promise of money in one year?

4.

What is the NPV decision rule?

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Chapter Quiz (continued)


5.

Does the NPV decision rule depend on


the investors preferences?

6.

What is the Law of One Price?

7.

What is Arbitrage?

8.

If a firm makes an investment that has a


negative NPV, how does the value of the
firm change?

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Chapter Quiz (continued)


9. If a Big Mac at McDonalds costs $4.00 in
the United States but only $3.75 (U.S. dollars)
in Canada, does this violate the Law of One
Price?
Is there an arbitrage opportunity?

Why or why not?

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Another Example like 3.6


Problem

Questions

Consider a security that pays its owner


$2,000 today and $3,000 in one year,
without any risk.
Suppose the risk-free interest rate is 6%.
What is the no-arbitrage price of the
security today (before the $2,000 is
paid)?
If the security is trading for $4,750,
what arbitrage opportunity is
available?

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Alternative Example 3.6


(continued)
Solution

We need to compute the present value


of the securitys cash flows. The present
value of the first cash flow is $2,000
since it is received today.
The present value of the second cash
flow of $3,000 received in one year is:
$3,000 / (1.06) = $2,830.19

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Alternative Example 3.6


(continued)
Solution

Therefore, the total present value of the


cash flows is $2,000 + $2,830.19 =
$4,830.19 today, which is the noarbitrage price of the security.
If the security is trading for $4,950, we
can exploit its overpricing by selling it
for $4,950.

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Alternative Example 3.6


(continued)
Solution

We can then use $2,000 of the sale


proceeds to replace the $2,000 we
would have received from the security
today and invest $2,830.19 of the sale
proceeds at 6% to replace the $3,000
we would have received in one year.
The remaining $4,950 - $2,000 $2,830.19 = $119.81 is an arbitrage
profit.

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