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**Unformatted text preview: **Course Review: The Big Ideas • Time Value of Money • Law of One Price • NPV • Diversification • Risk is Covariance, not Variance • Modigliani-Miller • Options • Real options • Investor decision biases QUIZ QUIZ QUIZ • If the Law of One Price holds then which of the following are true: • Statement 1) All bonds with the same promised payment schedule (i.e., same promised coupon payments, same face value, and same term) and same risk must trade at the same price. • Statement 2) (Similar) oranges in California, Minnesota, and Florida must sell at the same price. • A) Statement 1 is true and statement 2 is false. • B) Statement 1 is false and statement 2 is true. • C) Statement 1 is true and statement 2 is true. • D) Statement 1 is false and statement 2 is false. • E) The Law of One Price was repealed in California by voter initiative Proposition 13 in 1978. Arbitrage and Financial Decision Making • To compare costs and benefits that occur at different times, in different currencies, or with different risks, we must put all costs and benefits in common terms. Typically, we convert costs and benefits into cash today. • A competitive market is one in which a good can be bought & sold at the same price. • The time value of money is the difference in the value between money today and money in the future. The rate at which we can exchange money today for money in the future by borrowing or investing is the current market interest rate. The risk-free interest rate is the rate at which money can be borrowed or lent without risk. • The present value (PV) of a cash flow is its value in terms of cash today. • The net present value (NPV) of a project is PV(Benefits) - PV(Costs). • A good project is one with a positive net present value. The NPV decision rule states that when choosing from among a set of alternatives, choose the one with the highest NPV. The NPV of a project is equivalent to the cash value today of the project. Arbitrage and Financial Decision Making (cont) • Arbitrage is the process of trading to take advantage of equivalent goods that have different prices in different competitive markets. • A normal market is a competitive market with no arbitrage opportunities. • The Law of One Price states that if equivalent goods or securities trade simultaneously in different competitive markets, they will trade for the same price in each market. This law is equivalent to saying that no arbitrage opportunities should exist. • To maximize the value of the entire firm, managers should make decisions that maximize the NPV. The Time Value of Money • The three rules of time travel: • Only cash flows that occur at the same time can be compared or combined....

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