AFM273 Study Guide - Fall 2018, Comprehensive Midterm Notes - Net Present Value, Interest Rate, Exchange Rate
12 Oct 2018
School
Department
Course
Professor
AFM273
MIDTERM EXAM
STUDY GUIDE
Fall 2018
Benefits and Costs
• Corporate financial decisions assessed in terms of costs and benefits
• Complications due to costs and benefits occurring at different times, currencies, risks
• Involve expertise from other management disciplines (strategy, operations, marketing, etc.)
o Assume the contributions from other disciplines have already been completed to
determine potential costs and benefits
o Fiaial aager’s task is maximizing the value if the firm by making the best decision
given these possible costs and benefits
Valuation Principle
• Competitive market for a good is a market in which that can be bought and sold for the same
price
o A good’s prie deteries its orth
• Valuation principle: the value of an asset to the firm or its investors is determined by its
competitive market price. The costs and benefits 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.
Non-Competitive Market Prices
• Can not value decisions without accounting for preferences or views of the decision-maker
• E.g. price of a good at a retail store is one-sided: you can buy the good for its stated price, but
ou a’t sell it to the store for that prie
o Stated price deteries the good’s aiu alue, sie ou a u it for that prie
o However, you might value it for less depending on your preferences
Interest Rates
• Almost all decisions involve costs and benefits that occur at different points in time
• Interest rate acts as an exchange rate across time
• The risk-free interest rate for a given period, rf, is the interest rate at which money can be
borrowed or lent over that period without risk
o We can exchange $1 today for $(1+ rf) after one period, or we can convert one period
from now into $1/(1+ rf). What is the value of the investment today? One year from
now?
find more resources at oneclass.com
find more resources at oneclass.com
Net Present Value
• Present value (PV) of a cost or benefit is its value in terms of money today
• Net present value (NPV) of a project of investment is
o NPV = PV(Benefits) – PV(Costs)
• NPV represents the value in terms of money today
o NPV>0, makes the firm richer today
o NPV<0, makes the firm poorer today
• NPV Decision Rule: Choose the decision with the highest NPV. Choosing this alternative is
equivalent to receiving its NPV in cash today
First Separation Principle
• Separatio of the idividual’s cosuptio prefereces fro optial ivestet decisio
o Regardless of our consumption preferences that dictate whether we prefer cash today
vs cash in the future, we should always maximize NPV first. We can then borrow or lend
to shift cash flows through time to match out most preferred consumption spending
pattern through time. In effect, our preferences regarding consumption spending
through time are separate from out optimal investment decision
Arbitrage and the Law of One Price
• Arbitrage – buying and selling equivalent goods to take advantage of a price difference
o Arbitrage opportunity is a situation where it is possible to make a risk-free profit
without making any iestet free luh
• As investors try to profit from an arbitrage opportunity, prices will respond quickly, eliminating
the opportunity
• A normal market is a competitive market in which there are no arbitrage opportunities
o Or they are so fast it is impossible to exploit them
• 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
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Benefits and costs: corporate financial decisions assessed in terms of costs and benefits, complications due to costs and benefits occurring at different times, currencies, risks. The costs and benefits 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. Interest rates: almost all decisions involve costs and benefits that occur at different points in time, the risk-free interest rate for a given period, rf, is the interest rate at which money can be. Choosing this alternative is equivalent to receiving its npv in cash today. First separation principle: separatio(cid:374) of the i(cid:374)dividual"s co(cid:374)su(cid:373)ptio(cid:374) prefere(cid:374)ces fro(cid:373) opti(cid:373)al i(cid:374)vest(cid:373)e(cid:374)t decisio(cid:374, regardless of our consumption preferences that dictate whether we prefer cash today vs cash in the future, we should always maximize npv first.
