Chapter 3: (edit for 3.6)

Question 1

What is the job of a financial manager?

Answer 1

To make decisions on behalf of the firms investors

Question 2

How does a financial manager make a decision?

Answer 2

They must be able to compare the costs and benefits and determine the best decision to make so as to maximize the value of the firm

Question 3

When a good decision is made, what do we expect to see?

Answer 3

The benefits exceeding the costs.

Question 4

To make a good decision, a financial manager cannot make these decisions by himself. What are the other departments are involved in management decisions?

Answer 4

1. Marketing
2. Economics
3. Organizational behavior
4. Strategy
5. Operations

Question 5

What is the first thing a team has to do in order to start the ‘decision-making process’?

Answer 5

• A team must identify the costs and benefits of a decision

Question 6

What is the second step of the decision-making process?

Answer 6

After identifying both the cost and the benefits they must be able to quantify both the costs and the benefits.

Question 7

In order to compare both the costs and benefits what do we need to do?

Answer 7

We need to evaluate both the costs and the benefits in the same term - cash today

Question 8

Example: Suppose a jewelry manufacturer has the opportunity to trade 400 ounces of silver for 10 ounces of gold today:

What do we need to do in order to compare the costs and benefits?

Answer 8

1. It would be incorrect to compare the value an ounce of gold to silver because they are two different commodities.
2. We need to quantify their values in equivalent terms

Question 9

Suppose a jewelry manufacturer has the opportunity to trade 400 ounces of silver for 10 ounces of gold today.

Consider the silver.

What is its cash value today?

Suppose silver can be bought and sold for a current market price of $35 per ounce?

Answer 9

The cash value of silver is the

(400 ounces of silver) * ($35 per ounce of silver) = 14,000

Question 10

Suppose a jewelry manufacturer has the opportunity to trade 400 ounces of silver for 10 ounces of gold today.

Consider the gold.

What is its cash value today if the current market price for gold is $1700 per ounce?

Answer 10

The cash value would be

(10 ounces of gold) * (1700 per ounce of gold) = $17,000

Question 11

Suppose a jeweler manufacturer has the opportunity to trade 400 ounces of silver for 10 ounces of gold today.

Considering the example above where the cash value of silver is 14,000 and the cash value of gold is 17,000.

What is the benefit and cost if the trade happens?

Answer 11

The jeweler’s opportunity is that it has the benefit of receiving 17,000 today and a cost of 14,000.

By accepting the trade the jeweler will be richer by 3,000.

Question 12

From the gold and silver example, what determines the cash value of the good?

Answer 12

When a good is trades in the competitive marketing - which is the market it can be bought and sold at the same price that price determines the cash value of the good.

As long as the competitive market exists, the value of the good will not be at all dependent o the views or preferences of the decision maker.

Question 13

You have just won a radio contest and are disappointed to find out that the prize is four tickets to the Drake concert (face value $200 each). Not being a fan of Drake, you have no intention of going to the show. However, it turns out that there is a second choice: two tickets to The Weeknd’s sold-out show (face value $150 each). You notice that on StubHub, tickets to the Drake show are being bought and sold for $225 each, and tickets to The Weeknd’s show are being bought and sold at $400 each. What should you do?

Answer 13

Solution:

Market prices, not your personal preferences (or the face value of the tickets), are relevant here:
-four Drake tickets at $225 each
- two tickets to The Weeknd at $400 each.

You need to compare the market values of both options, and choose the one with the highest market value.

The Drake tickets have a total value of versus the $800 total value of The Weeknd tickets . Instead of taking the tickets to The Weeknd, you should accept the four Drake tickets, sell them on StubHub, and use the proceeds as you wish. Even though you are not a fan of Drake, you should still take the opportunity to take Drake tickets as they give you the most value in terms of dollars today. As we emphasized earlier, whether this opportunity is attractive depends on its net value using market prices. Because the value of Drake tickets is $100 more than the value of The Weeknd tickets, the opportunity is financially appealing. Your personal preferences are irrelevant because you can still realize the value of the Drake tickets by trading them in the competitive market and then acquiring (at a lower cost) tickets to The Weeknd concert.

Question 14

What do we do when we evaluate the cost ad benefit’s using competitive market prices?

Answer 14

We help determine whether a decision will make the firm and its investors wealthy

Question 15

What is the valuation principle?

Answer 15

Its the value of an asset to the firm or its investors is determined by the ‘competitive market price’.

Both the benefits and the costs of a decision should be evaluated using these market prices and when the value benefits exceeds the value of the costs, the decision will increase the market value of the firm.

Question 16

What does the valuation principle provide basis for?

Answer 16

The decision making process

Question 17

You are the operations manager at your firm. Due to a pre-existing contract, you have the opportunity to acquire 200 barrels of oil and 3000 kilograms of copper for a total of $35,000. The current competitive market price of oil is $100 per barrel and of copper is $7 per kilogram. You are not sure you need all of the oil and copper, and are concerned that the values of both commodities may fall in the future. Should you take this opportunity?

Answer 17

To answer this question, you need to convert the costs and benefits to their cash values using market prices:

The net value of the opportunity today is 20k+ 21K - 35K = 6K . Because the net value is positive, you should take it.
This value depends only on the current market prices for oil and copper. Even if you do not need all the oil or copper, or expect their values to fall, you can sell them at current market prices and obtain their value of $41,000. Thus, the opportunity is a good one for the firm, and will increase its value by $6000.

Question 18

What does competitive market prices allow us to calculate?

Answer 18

The value of a decision without worrying about the tastes or opinion of the decision maker and if they are not available we can no longer do this.

Question 19

The local Lexus dealer hires you as an extra in a commercial. As part of your compensation, the dealer offers to sell you today a new Lexus for $53,000. The best available retail price for the Lexus is $60,000, and the price you could sell it for in the used car market is $55,000. How would you value this compensation?

(List all possible options)

Answer 19

If you plan to buy a Lexus anyway, then the value to you of the Lexus is $60,000, the price you would otherwise pay for it. In this case, the value of the dealer’s offer is 60k - 53k = 7k . But suppose you do not want or need a Lexus. If you were to buy it from the dealer and then sell it, the value of taking the deal would be 55k - 53k = 2k . Thus, depending on your desire to own a new Lexus, the dealer’s offer is worth somewhere between $2000 (you don’t want a Lexus) and $7000 (you definitely want one). Because the price of the Lexus is not competitive (you cannot buy and sell at the same price.), the value of the offer is ambiguous and depends on your preferences.

Question 20

What do we see (specifically in the time periods for) costs and benefits?

Answer 20

The costs and benefits occur at different points in time.

Question 21

Example:
Consider an investment opportunity with the following certain cash flows:

Cost: 100,000 today
Benefit: 105,000 in one year

Do you think just because its expressed in dollar terms, it can be directly comparable?

How can we make them be in the same time period (specifically how can we make the cost in the same period as the benefit)?

Or

How can we make them be in the same time period (specifically how can we make the benefit in the same period as the cost)?

Answer 21

No, due to the fact that would be ignoring the timing of the costs and benefits and it treats money today as equivalent to money in one year.

C = 100,000 today * (1.07 $ in on year $ today) = 107,000 in one year

We think of this amount as the opportunity cost of not spending 100k today to get 107k we would have in one year if we leave it in the bank.

Now that its expressed in the same terms (dollars in one year), the net value of this would be = 105k (benefit) - 107k (cost) = -2k

In other words, we could earn $2000 more in one year by putting our $100,000 in the bank rather than making this investment. We should reject the investment: if we took it, we would be $2000 poorer in one year than if we didn’t.

Or

benefit = 105 (in one year) / 1.07 in one year / today) = 98,130.84 today

Benefit - cost = -1869.16

Question 22

What do we have to think about the relationship between a dollar today and one more in the future?

Answer 22

In general, a dollar today is worth more than a dollar in one year. If we have a $1 today you can invest it

Question 23

What does time value of money discuss?

Answer 23

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

Question 24

What happens when we deposit money in a savings account and also what happens when we borrow money from the bank?

Answer 24

We can convert money today (with interest) into money in the future with no added risk.

When we borrow money from the bank we can exchange money today for money in the future determine by the current interest rate

Question 25

What does an interest rate allow us to do?

Answer 25

The interest rate allows us to convert a currency at one point of time to the same currency at another point in time.

In essence, an interest rate is like an exchange rate across time.

It tells us the market price today of money in the future.

Question 26

What is the risk-free interest rate?

Answer 26

Its the interest rate for a given period at which money can be borrowed or lent without risk over that period:

We can exchange (1+ rF) dollars in the future per dollar today and vice versa

Question 27

What does (1+rF) refer to?

Answer 27

It refers to the interest rate factor for a risk free cash flow;

It defines the exchange rate (or how we calculate money) across time and has units of $in one year per $ today.

Question 28

What does the risk-free interest rate depend on?

Answer 28

Its dependent on the supply and demand.
We can use this to rate evaluate other decisions in which costs and benefits are separated in time without knowing the investors preferences

Question 29

Example:

What if we asked the bank for 105k in the future with 7% risk free interest rate how much would we ask for today?

Answer 29

= 105k / 1.07 = 98,130.84

Question 30

When we make a decision on an investment does it matter if the investments value is expressed in terms of dollars in one year or dollars today?

Answer 30

No we should reject if the costs exceed the benefits and vice versa

Question 31

What is the present value?

Answer 31

when we express the value in terms of dollars today

Question 32

What is the future value?

Answer 32

If we express it in terms of dollars in the future

Question 33

what happens when the price is presented in terms of today?

Answer 33

Money is worth less today than in the future, so the price reflects a discount as there’s a reduction in value

Because it provides the discount at which we can purchase money in the future (future money), the amount 1/ (1+r) is called the one-year discount factor.

Question 34

What do we call the risk-free interest rate in terms of today?

Answer 34

Discount rate for a risk -free investment in the PV

Question 35

The cost of building the Canada Line that extends Vancouver’s rapid transit from downtown to Richmond and the airport was projected to be about $2.05 billion in 2005. The Canada Line opened in 2009 in advance of the 2010 Vancouver Winter Olympics. In 2005, projections for Vancouver-area construction costs indicated that costs were rising by about 10% per year. If the interest rate was 3.25%, what would have been the cost of a one-year delay in terms of dollars in 2005?

Answer 35

Look at example 3.4 in chapter 3 (3.2)

Question 36

Example: Suppose you are offered the following investment opportunity: in exchange for $500 today, you will receive $550 in one year with certainty. If the risk-free interest rate is 8% per year then

Answer 36

PV(Benefit) = 550 in one year / (1.08) = 509.26

This PV is the amount we would need to put in the bank today to generate $550 in one year . -
it is the amount you need to invest at the current interest rate to recreate the cash flow (FV cash flow)

Once the costs and benefits are in present value terms, we can compute the investment’s NPV: we can subtract the PV(benefit) - PV(Cost)

Question 37

What is the net present value?

Answer 37

Its when we compute the value of both costs and benefits to the present (today) and after we take the difference between the present value of its benefits and the present value of its costs:

NPV = PV(benefits) - PV(Costs)

Or

If we use positive cash flows as benfits
Negative cash flows (costs)
We can define this as the sum of present value for individual cash flows

NPV = PV(All project cash flows)

Question 38

In the example above what if we don’t have $500 to cover the initial cost of the project?

Does the project still have the same value?

If you don’t have the $500, suppose you borrow $509.26 from the bank at the 8% interest rate and then take the project.

What are your cash flows in this case?

Answer 38

Because we computed the value using competitive market prices, it should not depend on your tastes or the amount of cash you have in the bank.

Today’s Cash Flow:

You borrow $509.26 from the bank and immediately invest $500 into the project.
The difference between the borrowed amount ($509.26) and the invested amount ($500) leaves you with $9.26 in your pocket.
Today’s cash flow: 509.26(loan) −500 (investment) = 9.26

In One Year:

You receive $550 from the project.
You need to pay back the loan, which has grown to 509.26×1.08 =550 due to the 8% interest. Your total cash flow in one year is $550 from the project, minus the $550 you owe for the loan, leaving you with $0.
So, the cash flow after one year:
550−550 = 0

This transaction leaves you with exactly $9.26 extra cash in your pocket today and no future net obligations. So taking the project is like having an extra $9.26 in cash up front. Thus, the NPV expresses the value of an investment decision as an amount of cash received today. As long as the NPV is positive, the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money.

Question 39

What does the NPV represent?

Answer 39

The value of the project in terms of cash today

Question 40

What would be the NPV of a good project?

Answer 40

If the NPV is positive and makes both the firm + investor wealthy

Question 41

What happens if the project has a negative NPV?

Answer 41

The costs exceed benefits meaning accepting this project is equivalent to losing money today.

Question 42

What is the NPV decision rule?

Answer 42

If the NPV is expressed in cash today (PV) and if captured all the correct costs and benefits, it will increase the wealth of firm + investors:

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 43

what is a common financial decision a business has to make?

Answer 43

Whether to accept or reject a project

Question 44

How do we accept or reject a project

Answer 44

1. Accept those projects with positive NPV because accepting them is equivalent to receiving their NPV in cash today and
2. Reject those projects with negative NPV; accepting them would reduce the wealth of investors, whereas not doing them has no cost (NPV = 0)

Question 45

Should we accept or reject a firm when the NPV = 0

Answer 45

• If the NPV is exactly zero, you will neither gain nor lose by accepting the project rather than rejecting it.
• It is not a bad project because it does not reduce firm value, but it does not add value either. (so reject it)

Question 46

Example:Your firm needs to buy a new $9500 copier that can copy, scan, and print documents or files. As part of a promotion, the manufacturer has offered to let you pay $10,000 in one year, rather than pay cash today. Suppose the risk-free interest rate is 7% per year. Is this offer a good deal? Show that its NPV represents cash in your pocket.

Answer 46

If you take the offer, the benefit is that you won’t have to pay $9500 today, which is already in PV terms. The cost, however, is $10,000 in one year. We therefore convert the cost to a present value at the risk-free interest rate:

PV = 10k / 1.07

The NPV of the promotional offer is the difference between the benefits and the costs:
9500 - 9345.79 = 154.21

The NPV is positive, so the investment is a good deal. It is equivalent to getting a cash discount today of $154.21, and only paying $9345.79 today for the copier.

Question 47

Example: Example:Your firm needs to buy a new $9500 copier that can copy, scan, and print documents or files. As part of a promotion, the manufacturer has offered to let you pay $10,000 in one year, rather than pay cash today. Suppose the risk-free interest rate is 7% per year. Is this offer a good deal? Show that its NPV represents cash in your pocket.

(Already did)
how can we confirm our answer is correct?

Answer 47

To confirm our calculation, suppose you take the offer and invest $9345.79 in a bank paying 7% interest. With interest, this amount will grow to 9345.79 *1.07 = 10k in one year, which you can use to pay for the copier.

Question 48

How can the NPC decision rule help us between projects?

Answer 48

For it to help us decide between multiple projects we must compute the NPV of each alternative, and then select the one with the highest NPV.

This alternative is the one which will lead to the largest increase in the value of the firm.

Question 49

What do we consider when we comapre projects with different patters of present and future cash flows?

Answer 49

1. We have to consider preferences regarding when we want to consume and thus when we want to receive the cash.
2. Some may prefer consuming now and need cash today; others may prefer to defer consumption so they can save for the future

Question 50

What is the separation of the individuals consumption preferences from the optimal investment decision?

Answer 50

Regardless of our consumption preferences that dictate whether we prefer cash today versus cash in the future, we should always maximize NPV first. We can then borrow or lend to shift cash flows through time so as to match our most preferred consumption spending pattern through time. In effect, our preferences regarding consumption spending through time are separate from our optimal investment decision.

Question 51

Is there a possibility where the same good trades for different prices in different markets?

Answer 51

Yes

Question 52

Example:
Lets say , we sell gold in may different markets specifically in London and New York. suppose gold is trading for $1700 per ounce in New York and $1800 per ounce in London. Which price should we use?

Answer 52

• These type of sitution do not arise easily.
• Recall the concept that the comeptivie prices are what we can both buy and sell at.
• Simply you can make money in this situation by buying gold at $1700 per ounce in new york and immediaely selling it for $1800 in London.
• You will make a $100 for each you sell
• Essentially we buy low and sell high

Question 53

What would happen to the market if we bought gold in New york for $1700 and sold it in UK for $1800?

Answer 53

• Within seconds the market in NY would be flooded with buy orders and the market in London would be flooded with sell orders.
• Although a few ouces might be exchanged the price of gold would rise in response to the orders and the price in london would fall until at some point it was equalized

Question 54

What is an arbitrage opporutnity?

Answer 54

Its any situation where it is possible to make a profit without taking

• any risk or making an investment

Question 55

What does the concept of arbitrage mean?

Answer 55

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

Question 56

What is the NPV of an arbitrage opporuntiy?

Answer 56

The NPV is positive

Question 57

What happens when the NPV is positive for an arbitrage opportunity in the financial market?

Answer 57

Investors will try to race to take advantage of the opportunity and will try to take advantage of the opportunity first and trade quickly to exploit the possibility.

Once they place their trades the price will respond and the arbitrage opportunity will evaportate.

Question 58

How do we define a normal market?

Answer 58

Its a competitive market in which there are no arbitrage opportunities.

Question 59

What is the price of gold in London and New york in a normal market?

Answer 59

The price of gold will be the same at any point of time in the normal market.

Question 60

What is the concept of the law of one price?

Answer 60

If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the SAME price in all market after an arbitrage opportunity occurs.

Question 61

What is the concept here in the example below:

Consider a company’s stock that is listed on two different exchanges—say, the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). Let’s assume the stock is trading for $100 per share on the NYSE, but for the equivalent of $105 per share on the LSE.

Answer 61

An arbitrage opportunity which results into the prices equalizing out and the law of one price holds.

Question 62

How can we define a financial security (security)?

Answer 62

Its an investment opportunity that trades in the financial market.

Question 63

What are two concepts that affect the prices of securities?

Answer 63

• Law of one price
• Arbitrage

Question 64

What does the law of one price help us to do finding the value of security?

Answer 64

The Law of One Price tells us that the prices of equivalent investment opportunities should be the same.

We can use this idea to find the value a security if we can find another equivalent investment whose price is already known.

Question 65

How can we use the law of one price in this example:

Consider a simple security that promises a one-time payment to its owner of $1000 in one year’s time. Suppose there is no risk that the payment will not be made.

If the risk-free interest rate is 5%, what can we conclude about the price of this bond in a normal market?

What if there was an alternative investment that would generate the same flow as this bond . Suppose we invest money at the bank at the risk-free interest rate. How much do we need to invest today to receive $1000 in one year?

Answer 65

To answer this question we have to calculate the cost today of recreating the future cash flow: (PV) for the second investment

PV = 1000/1.05 = 952.38

There are two ways to find the cash flow:

1) Buy the bond that is an equivalent investor
2) Invest 952.38 at a 5% risk-free interest rate.

Because these transactions produce equivalent cash flows, the Law of One Price implies that in a normal market, they must have the same price (or cost). Therefore,

Price(Bond) = 952.38

Question 66

What is a bond?

Answer 66

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

Question 67

What is the law of one price based off of?

Answer 67

It is based off of an arbitrage opportuntiy as if the price is different an arbitrage opportunity occurs

Question 68

What is the opportunity here?

Example:

For example, suppose the bond traded for a price of $940 in the competitive market. How could we profit in this situation if we have the opprituntiy to borrow 952.38 from the bank

Answer 68

In this case we can borrow from the bank 952.38 with the given interets rate of 5% and buy the bond for 940.

In the future we will owe the bank 952.39*1.05 = 1000

Using this strategy, we can earn $12.38 in cash today for each bond that we buy, without taking any risk or paying any of our own money in the future. Of course, as we—and others who see the opportunity—start buying the bond, its price will quickly rise until it reaches $952.38 and the arbitrage opportunity disappears.

Question 69

Example:

What happens after we buy the bond for $940 the bond is trading at a higher price of $960?

Answer 69

In that case we should sell the bond and have a gain of 7.62 today and if we are feeling special invest our money in the bank

Question 70

When a bond is overprice what is the arbitrage stragety?

Answer 70

Selling the bond and investing some of the proceeds.

Question 71

When the bond is overpriced, the arbitrage strategy involves selling the bond and investing some of the proceeds. But if the strategy involves selling the bond, does this mean that only the current owners of the bond can exploit it?

Answer 71

The answer is no

It is possible to sell a security you do not own by doing a short sale.

Question 72

What is a short sale?

Answer 72

Its when the person who intends to sell the 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 73

Wat is the no arbitrage price?

Answer 73

Its when in a normal market the price of the security equals the present value of the future cash flows paid by the security.

• Its when there are no arbitrage opportunities.

Question 74

How can we determine the no-arbitrage price of a bond (or any other security)?

Answer 74

1. Identify the cash flows that will be paid by the security
2. Find the present value of the security’s cash flows

No arbitrage price of a security =
Price(security) = PV(Its all or total of the cash flows paid by the security).

Question 75

How do we know if there is an arbitrage opportunity after we calculate the no-arbitrage price of a security?

Answer 75

if we calculate the PV(price of the security) and we look in the market and see the price of the security is higher or lower there is an arbitrage opportunity.

Question 76

What if we know the no-arbitrage price of a risk free bond what can we calculate?

Answer 76

We can use this to calculate the risk-free interest rate if there are no arbitrage opportunities

Question 77

Example: suppose a risk-free bond that pays $1000 in one year is trading with a competitive market price of $929.80 today.

From Eq. 3.3, we know that the bond’s price equals the present value of the $1000 cash flow it will pay:

Answer 77

PV = CF (FV) / (1+R)

PV/ FV -1 = R

Question 78

How do we calculate interest rates?

Answer 78

FV/PV -1 = R

Question 79

What does the interest rate tell us?

Answer 79

Its the % gain that you earn from investing in the bond

Question 80

What do we know so far about NPV and when it comes to buying a security.

Answer 80

A positive NPV decision increases the wealth of the firm and its investors.

When buying a security:

The cost of the decision is the price we pay for the security,

The benefit is the cash flows that we will receive from owning the security.

Question 81

When securities trade at no-arbitrage prices, what can we conclude about the value of trading them and the NPV?

Answer 81

The cost and benefit are equal in a normal market and so the NPV of buying a security is zero:

PV(All cash flows paid by the security) - price(security) = 0

Answer 82

We need to compute the present value of the security’s cash flows. In this case, there are two cash flows: $100 today, which is already in present value terms, and $100 in one year. The present value of the second cash flow is given below:

100/1.10 = 90.91

Therefore, the total present value of the cash flows is 100 + 90.91 = 190.91 today, which is the no-arbitrage price of the security.

If the security is trading for $195, we can exploit its overpricing by selling it for $195. We can then use $100 of the sale proceeds to replace the $100 we would have received from the security today and invest $90.91 of the sale proceeds at 10% to replace the $100 we would have received in one year.

he remaining is an arbitrage profit.

At a price of $195, we are effectively paying $95 to receive $100 in one year. So, an arbitrage opportunity exists unless the interest rate equals

Question 83

What is the separation of the investment and financing decision?

Answer 83

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 84

What does the law of one price also have implciation on?

Answer 84

Packages for securities

Question 85

Example:

Consider two securities, A and B. Suppose a third security, C, has the same cash flows as A and B combined.

Answer 85

In this case, security C is equivalent to a combination of securities A and B

Due to the fact and the idea of the law of one price: Because security C is equivalent to the portfolio of A and B, by the Law of One Price, they must have the same price

Question 86

What is a portfolio?

Answer 86

Its a term used to describe a collection of securities

Question 87

What is the idea of value additivity?

Answer 87

Due to the law of one price a combination of one portfolio with two securities must be equal in terms of value and price to one with equivalent an cash flow.

Price(C) = Price(A+B) = Price(A) + Price(B)

Value additivity implies that the value (price) of a portfolio is equal to the sum of the value of its parts

Question 88

What would happen if there was the portfolio where the total price of A and B were lower than the price of C>

Answer 88

Then we could make a profit buying A and B and selling C and this arbitrage activity would quickly push prices until the price of security C equalled the total price of A and B.

Question 89

How can a firm maximize the value of the entire firm?

Answer 89

To maximize the value of the entire firm, managers should make decisions that maximize NPV.

The NPV of the decision represents its contribution to the overall value of the firm.

Question 90

Are cash flows always not risky?

Answer 90

In many settings cash flows are risk

Question 91

What happens when something is considered risky specifically for cash flow?

Answer 91

the actual outcome may be different from the expected outcome.

the cash may turn out to be better or worse.

Question 92

example:

Question 93

What is risk aversion?

Answer 93

Its the idea that investors prefer to have a safe income rather than a risky one of the same expected amount.

It is an aspect of an investors preferences and different investors may have different degrees of risk aversion.

Question 94

What happens if the investor is more risk averse?

Answer 94

The more risk averse investors are the less they are willing to pay for risk assets like the market index and becuase of this it lowers the current price of the market index

Question 95

What can we not do if there is risk?

Answer 95

We cannot use the risk free interest rate to compute the PV of risky cash flow.

When investing in a risky project, investors will expect a return that appropriately compensates them for the risk

Question 96

How do we compute the return of a security based on the payoff we expect to recieve?

Answer 96

Expected return of a risky investment = Expected gain at the end of the year/ initial cost

Question 97

How can we calculate the expected return using the actual returns?

Answer 97

Multiply the actual returns by their probabilities and sum them up

Question 98

What is risk premium?

Answer 98

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

Because investors are risk averse, the price of a risky security cannot be calculated by simply discounting its expected cash flow at the risk-free interest rate.

Question 99

How is risk premium of the market index determined?

Answer 99

it is determined by the investors preferences towards risk.

Question 100

What do we use the risk premium for?

Answer 100

To value other risky securities