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ch27.docx - Chapter 27 The Basic Tools of Finance WHAT’S...

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Chapter 27The Basic Tools of FinanceWHAT’S NEW IN THE THIRD EDITION:This is an entirely new chapter.LEARNING OBJECTIVES:By the end of this chapter, students should understand:the relationship between present value and future value.the effects of compound growth.how risk-averse people reduce the risk they face.how asset prices are determined.CONTEXT AND PURPOSE:Chapter 14 is the third chapter in a four-chapter sequence on the level and growth ofoutput in the long run.In Chapter 12, we discuss how capital and labor are among theprimary determinants of output and growth.In Chapter 13, we addressed how saving andinvestment in capital goods affect the production of output.In Chapter 15, we will showsome of the tools people and firms use when choosing capital projects in which to invest.Since both capital and labor are among the primary determinants of output, Chapter 15will address the market for labor.The purpose of Chapter 14 is to introduce the students to some tools that people usewhen they participate in financial markets.We will show how people compare differentsums of money at different points in time, how they manage risk, and how these conceptscombine to help determine the value of a financial asset, such as a share of stock.KEY POINTS:1.Because savings can earn interest, a sum of money today is more valuable than thesame sum of money in the future.A person can compare sums from different timesusing the concept of present value.The present value of any future sum is theamount that would be needed today, given prevailing interest rates, to produce thatfuture sum.2.Because of diminishing marginal utility, most people are risk averse.Risk aversepeople can reduce risk using insurance, through diversification, and by choosing aportfolio with lower risk and lower return.3.The value of an asset, such as a share of stock, equals the present value of the cashflows the owner of the share will receive, including the stream of dividends and the
final share price.According to the efficient markets hypothesis, financial marketsprocess valuable information rationally, so a stock price always equals the bestestimate of the value of the underlying business.Some economists question theefficient markets hypothesis, however, and believe that irrational psychologicalfactors also influence asset prices.CHAPTER OUTLINE:I.Definition offinance: the field that studies how people make decisionsregarding the allocation of resources over time and the handling of risk.A.Many of the basic insights of finance are central to understanding how theeconomy works.B.The tools of finance may also help students think through some of thedecisions that they will make in their own lives.II.Present Value: Measuring the Time Value of MoneyA.Money today is more valuable than the same amount of money in the future.

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Term
Winter
Professor
emine esra

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