Finance Study Guide - Valuation principle use market prices...

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Valuation principle – use market prices to determine value of investment opportunity - Law of One Price – time value of money (NPV of project’s future cashflows) o Comparing costs and benefits difficult because they occur at different times (NPV, dollars today) o Competitive market – good bought and sold at same price Personal preferences, use for (cash needs), and opinion of fair price are irrelevant o Dollar today is worth more, money in the future is worth less today Price reflects a discount Discount factor = 1 / 1+r o DEFINITION – difference in value b/w $ today and future, observation that 2 cashflows at 2 diff. points in time have diff values r = rate at which money can be borrowed or lent over a given period, interest/discount rate r+1 = interest rate factor FV=PV(1+r) o Example: PS3 delayed til 2006. In 2005 estimated that if launched immediately would make revenues of $2 billion. If delayed, reduce sales by 20%. If interest rate is 8%, what is cost of delay in terms of $ in 2005? $1.6 billion in 2006 ÷ (1.08 in 2006/$1 in 2005) = $1.481 billion in 2005 cost = $2 b – 1.481 b = $519 million o No arbitrage opportunities exist (make profit without taking any risk, like money on the street) Law of one price DEFINITION – in competitive markets, securities or portfolios w/ same cash flows must have the same price NPV and the Time Value of Money - Timeline o Compounding – ROI over long horizon by multiplying return factors associated w/ each period FV n = C x (1+r) n o Must discount future value PV = C / (1+r) no o Present value of a cash flow stream PV = C 0 + C 1 /(1+r) + C 2 /(1+r) 2 + C n /(1+r) n o Example: If invest $1000 today, you will receive $500 at end of each of next 2 yrs and $550 at end of 3 rd yr.
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