Name: ________________________________________________________________________________
CHAPTER 27 - The Basic Tools of Finance
The Basic Tools of Finance
 Finance – field that studies ______________________________________________________________________
the allocation of resources over time and the _____________________________________________
Present Value: measuring the Time Value of Money
 Present Value – the current worth of a _____________________________________________ given a specified rate
of return
 Future Value – amount of money in the future that an _________________________________________________,
given prevailing ___________________________________
 Simple Interest - calculated only on the _____________________________________
 Formula for Simple Interest = _____ x _____ x _____
 ____________________ = P
 ____________________= R
 ____________________= T
 Compounding – ability of an asset _____________________________________________, which can then
____________________________________________________________
 Both ______________________________and ______________________________ earn interest
 “_____________________________________________________________________________________”,
Albert Einstein
 Formula
o _____ = _____ (_____ + _____)
o ___________________________________= 1
o ___________________________________= r
o ___________________________________= n
Determining Future Values Application
 Determine the future value of $1000, using simple interest and compounding interest and the following
information:
 Principal - $1000.00
 Interest – 20%
 10 years
 FV = $__________ x __________ x __________ = __________ (value of the bond__________+ $1000 = $3000)
 FV = $__________ (__________ + __________) = $__________
Present Value of a Future Payment
 Discounting – process of finding a ______________________________of a ______________________________
 Formula
o __________ = __________/(___________ +_________)
 X – amount to be received ______________________________ (future value)
 Determine the present value of $200 in 10 years at a 5 + 8% interest rates respectively
 $__________/(__________) = $__________
 $__________/(__________) = $__________
Managing Risk
 Risk aversion – is a dislike ______________________________; dislike ______________________________more
than __________________________________________________
 Utility - A person’s subjective ____________________________________________________________
 Diminishing marginal utility - a decrease in the (____________________) usefulness due to the
____________________________________________________________
 Utility function - shows __________________________________________________
 The more wealth a person has the ______________________________they get from an additional dollar
 More likely a person with more wealth will have less ______________________________, person with less
wealth will ______________________________________
The Markets for Insurance
 One way to deal with risk is to ______________________________
 Person facing a risk pays a ________________________________________to absorb
________________________________________
 Auto, ____________________, health, ____________________, annuity, ____________________, etc.
 Insurance is a gamble
 You may not ____________________ (may never be in a car accident, get sick, house flood, etc.)
 Pay the insurance premium to receive ______________________________


Role of insurance
 Not to eliminate ____________________, but to spread the ______________________________________
Two problems with the markets for insurance:
 Adverse selection – a high-risk person is _______________________________________________________
 Moral hazard – after people buy insurance ____________________________________________________
 Insurance price is reflected in risk of the ________________________________________
o Auto insurance in __________ is higher than in __________
 Utility function - shows diminishing marginal utility
o Every level of wealth provides a ______________________________
o The more wealth a person has the ____________________they get from an additional dollar
Diversification of Firm-Specific Risk
 Diversification – ______________________________by replacing a single risk with a large number of smaller,
unrelated risks
 “Don’t put all of your ______________________________.”
 Can eliminate ______________________________
 Cannot eliminate ______________________________
 Firm-specific risk – uncertainty associated with investing in ________________________________________
 Market risk – uncertainty associated with ________________________________________
The Trade-off between Risk and Return
 Risk-return trade-off – potential return __________________________________________________
 Low risk, ____________________ (bonds, ______________________________, etc.)
 High risk, ______________________________ (stocks, ____________________, collectibles etc.)
 Stocks vs. Bonds
 Over past 200 years, stocks ________________________________________
 Bonds ________________________________________
Asset Valuation
 What determines the price of a stock?
 __________________________________________________
 Fundamental analysis – detailed analysis of a company to ______________________________
1. __________________________________________________
2. __________________________________________________
3. __________________________________________________
 Undervalued stock
1. ____________________ < ____________________
 Overvalued stock
1. ____________________ < ____________________
 Fairly valued stock
1. ____________________ < ____________________
 Buy undervalued stock, “______________________________________!”