Chapter_27 - Chapter 27Chapter 27 The Basic Tools of...

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Unformatted text preview: Chapter 27Chapter 27 The Basic Tools of Finance WHATS 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 of output in the long run. In Chapter 12, we discuss how capital and labor are among the primary determinants of output and growth. In Chapter 13, we addressed how saving and investment in capital goods affect the production of output. In Chapter 15, we will show some 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 15 will address the market for labor. The purpose of Chapter 14 is to introduce the students to some tools that people use when they participate in financial markets. We will show how people compare different sums of money at different points in time, how they manage risk, and how these concepts combine to help determine the value of a financial asset, such as a share of stock. 1 2 Chapter 27/The Basic Tools of Finance KEY POINTS: 1. Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum. 2. Because of diminishing marginal utility, most people are risk averse. Risk averse people can reduce risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower return. 3. The value of an asset, such as a share of stock, equals the present value of the cash flows the owner of the share will receive, including the stream of dividends and the final share price. According to the efficient markets hypothesis, financial markets process valuable information rationally, so a stock price always equals the best estimate of the value of the underlying business. Some economists question the efficient markets hypothesis, however, and believe that irrational psychological factors also influence asset prices....
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This note was uploaded on 02/11/2011 for the course ECON 200 taught by Professor Thomasmiller during the Spring '11 term at Uni. Helsinki.

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Chapter_27 - Chapter 27Chapter 27 The Basic Tools of...

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