Chapter3b+notes

Chapter3b notes - Chapter 3(contd Valuation Principle Focusing Question Why do the arbitrage opportunities arising from the difference between

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Chapter 3 (cont’d) Valuation Principle
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2 Spring 2009 Focusing Question Why do the arbitrage opportunities arising from the difference between coffee prices in local exchanges in Brazil and Vietnam, and the global benchmarks in New York and London maximize returns to farmers and funds?
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3 Spring 2009 Outline Valuation Principle Cost- Benefit Analysis Time Value of Money NPV Decision Rule Law of One Price Competitive Market Prices
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4 Spring 2009 Learning Objectives 1. Compute the NPV of an investment opportunity. 2. Explain why maximizing NPV is always the best investment decision rule. 3. Define arbitrage and the Law of One Price. 4. Determine the no-arbitrage price of an investment.
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5 Spring 2009 Finding NPV Consider an investment opportunity with the following certain cash flows: Cost: $100,000 today Benefit: $105,000 in one year ± Net value of the investment in cash today = $98,131 – $100,000 = -$1869 today = the difference between the present value of its benefits and the present value of its costs. Æ the net present value (NPV) of a project or investment Æ (Benefits) (Costs) =− NPV PV PV
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6 Spring 2009 Why NPV? Problem: ± After saving $1,500 , you are about to buy a 42-inch plasma TV. You notice that the store is offering “one- year same as cash” deal. You can take the TV home today and pay nothing until one year from now. That is, you can pay the store the $1,500 purchase price one year later. Assume your savings account earns 5% per year. ± What is the NPV of this offer? ± Show that the NPV represents cash in your pocket. Example 3.5
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7 Spring 2009 Why NPV? Solution: Plan: ± You are getting the TV worth $1,500 today. It is a positive cash flow (benefit today). ± Find the PV of the payment, $1,500, in one year (the cost today). Today In one year Cash flows: $1,500 –$1,500 ± The discount rate is your interest rate of 5%.
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8 Spring 2009 Why NPV? Execute: Evaluate: ± By taking the delayed payment offer, you have extra net cash flows of $71.43 today. ± That is, if you put $1,428.57 in your savings account today, with interest, in one year it would grow to $1,428.57 × (1.05) = $1,500 , enough to pay the store. ± Therefore, The extra $71.43 is equivalent to money in your pocket now to spend as you like. () 1, 500 1,500 1,500 1,428.57 $71.43 1.05 NPV =+ = =
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9 Spring 2009 NPV Decision Rule ± To accept or reject a project ² Accept positive NPV projects because accepting them is equivalent to receiving cash today in an amount equivalent to their NPV.
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This note was uploaded on 04/03/2010 for the course FINA FINA111 taught by Professor Lynnpi during the Spring '09 term at HKUST.

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Chapter3b notes - Chapter 3(contd Valuation Principle Focusing Question Why do the arbitrage opportunities arising from the difference between

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