Chapter3b notes

Chapter3b notes - Chapter 3 (contd) Valuation Principle...

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Chapter 3 (cont’d) Valuation Principle
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2 Spring 2010 Focusing Question Why would 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 2010 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 2010 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 2010 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 2010 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 2010 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 2010 Why NPV?
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Chapter3b notes - Chapter 3 (contd) Valuation Principle...

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