chapter 3

Question 1

competitive market

Answer 1

a market in which a good can be bought and sold at the same price. that price determines the cash value of the good.

Question 2

Valuation Principle

Answer 2

states that the value of an asset to the firm or its investors is determined by its competitive market price. the benefits and costs of a decision should be evaluated using market prices and when the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.

Question 3

time value of money

Answer 3

the difference in value between money today and money in the future.

Question 4

risk-free interest rate (rf)

Answer 4

the interest rate at which money can be borrowed or lent without risk over that period.

Question 5

interest rate factor

Answer 5

(1 + rf) is the interest rate factor for risk-free cash flows. it defines the exchange rate across time and has units of ‘$ in one year/$today’.

Question 6

present value (PV)

Answer 6

when we express the value in terms of dollars today.

Question 7

future value (FV)

Answer 7

when we express the value in terms of dollars in the future.

Question 8

discount factor/rate

Answer 8

the discount at which we can purchase money in the future. it represent the price today of $1 in one year.

Question 9

net present value (NPV)

Answer 9

the difference between the present value of the benefits and the present value of the costs. it expresses the value of an investment decision as an amount of cash received today.

Question 10

NPV Decision Rule

Answer 10

when making an investment decision, take the alternative with the highest NPV. choosing this alternative is equivalent to receiving its NPV in cash today.

Question 11

arbitrage

Answer 11

the practice of buying and selling equivalent goods in different markets to take advantage of a price difference.

Question 12

arbitrage opportunity

Answer 12

any situation in which it is possible to make a profit without taking any risk or making any investment. once spotted, they will quickly disappear. thus, normally no arbitrage opportunities exist.

Question 13

normal market

Answer 13

a competitive market in which there are no arbitrage opportunities.

Question 14

Law of One Price

Answer 14

if equivalent investment opportunities trade simultaneousely in different competitive markets, they must trade for the same price in all markets.

Question 15

financial security

Answer 15

an investment opportunity that trades in a financial market.

Question 16

bond

Answer 16

a security sold by governments and corporations to raise money from investors today in exchange for the promised future payment.

Question 17

short sale

Answer 17

the person who intends to sell a security first borrows it from someone who already owns it. later, that person must either return the security by buying it back or pay the owner the cash flows he or she would have received.

Question 18

no-arbitrage price

Answer 18

the price where no arbitrage opportunity exists.

Question 19

the bond’s return

Answer 19

the percentage gain that you earn from investing in the bond, which is equal to the risk-free interest rate.

Question 20

separation principle

Answer 20

security transactions in a normal market neither create nor destroy value on their own. therefore, we can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering.

Question 21

portfolio

Answer 21

a collection of securities.

Question 22

value additivity

Answer 22

the price of an asset must equal the sum of prices of its component assets. so, Price (A+B) = Price A + Price B. this is true if the law of one price holds.

Question 23

risk aversion

Answer 23

the notion that investors prefer to have a safe income rather than a risky one of the same average amount.

Question 24

risk premium

Answer 24

the risk premium of a security represents the additional return that investors expect to earn to compensate them for the security’s risk.

Question 25

decision payoff

Answer 25

the decision payoff from an action that consumer feels responsible for is a weighted average of his private payoff and a fraction of the social surplus corresponding to the action, and the fractional weight on the social surplus term equals consumer’s shareholding.

Question 26

final payoffs

Answer 26

once the consumer has made his decision - taking externalities into account - he is no longer plagued by this decision. he neither suffers from externalities resulting from it nor receives a warm glow from avoiding them.

Question 27

amoral drift

Answer 27

the market for corporate control will push a board who wants to choose clean into a choice of dirty. if a shareholder thinks the bid will fail, it is better for them to tender since he will receive p and can always buy back the shares. so, tendering is a dominant strategy even for a prosocial shareholder and the bid succeeds.

Question 28

“Friedman” charter

Answer 28

specifies profit maximisation as the goal.

Question 29

separation principle

Answer 29

in a normal market we can separate the firm’s investment decision from its financing decision because security transactions neither create nor destroy value on their own in a normal market (NPV of buying or selling securities is 0).

Question 30

compounding

Answer 30

calculating the future value of a cash flow. the idea is that we earn interest on the principal and on previous interest payments.

Question 31

discounting

Answer 31

moving a cash flow backward in time.