Chapter 3

Financial Decision
Making and the
Law of One Price

Valuation Principle
Goal of financial decision making?
Costs vs. Benefits
Complications
Net Present Value

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3.1 Valuing Decisions

Identify Costs and Benefits
May need help from other areas in identifying the
relevant costs and benefits

Marketing
Economics
Organizational Behavior
Strategy
Operations

Why Apple, Uber are betting on Super

Bowl sponsorship?
http://
finance.yahoo.com/news/apple-uber-super-bowl-50-spon
sorship-155606373.html
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Analyzing Costs and Benefits

Suppose a jewelry manufacturer has the
opportunity to trade 10 ounces of gold and
receive 20 ounces of palladium today.
Is this a good deal?

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Analyzing Costs and Benefits

(cont'd)
Gold can be bought and sold for a current market price
of $1,500 per ounce.
(10 ounces of gold) X ($1,500/ounce) = $15,000 today

The current market price for palladium is $600 per

ounce.
(20 ounces of palladium) X ($600/ounce) = $12,000

Net value of the project today is:

$12,000 $15,000 = $3,000

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Alternative Example 3.1

Problem
Your car recently broke down and it needs
$2,000 in repairs. But today is your lucky day
because you have just won a contest where the
prize is either a new motorcycle, with a MSRP of
$15,000, or $10,000 in cash. You do not have a
motorcycle license, nor do you plan on getting
one. You estimate you could sell the motorcycle
for $12,000. Which prize should you choose?

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Alternative Example 3.2

Problem
You are offered the following investment
opportunity: In exchange for $40,000 today, you
will receive 2,500 shares of stock in the Ford
Motor Company and 10,000 euros today. The
current market price for Ford stock is $9 per
share and the current exchange rate is $1.50
per . Should you take this opportunity? Would
your decision change if you believed the value of
the euro would rise over the next month?

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Alternative Example 3.2 (cont'd)

Solution
The costs and benefits must be converted to their cash
values. Assuming competitive market prices:
2,500 shares $9/share = $22,500
10,000 $1.50/ = $15,000
The net value of the opportunity is $22,500 + $15,000 $40,000 = -$2,500, we should not take it. This value
depends only on the current market prices for Ford and
the euro. Our personal opinion about the future prospects
of the euro and Ford does not alter the value the decision
today.

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3.2 Interest Rates

and the Time Value of Money
Time Value of Money
Consider an investment opportunity with the
following certain cash flows.
Cost: $100,000 today
Benefit: $105,000 in one year
Suppose the current annual interest rate is 7%. By
investing or borrowing at this rate, we can exchange $1
today for $1.07one year.
RiskFree Interest Rate (Discount Rate), rf: The interest rate
at which money can be borrowed or lent without risk.
Interest Rate Factor = 1 + rf
Discount Factor = 1 / (1 + rf)

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The Interest Rate: An Exchange Rate

Across Time (cont'd)
Value of Investment in One Year (Future value)
Time

Investment

$100k

$105k

Bank

$100k

$107k

Value of Investment today (Present value)

Time

Investment

?k

$105k

Bank

$100k

$107k

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The Interest Rate: An Exchange

Rate Across Time (cont'd)
Discount Factors and Rate
We can interpret

1
1

0.93458
1 r 1.07
1
1 r

as the price today of $1 in one year. The amount

is
called the one- year discount factor. The risk-free rate is
also referred to as the discount rate for a risk-free
investment.

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Alternative Example 3.3

Problem
The cost of replacing a fleet of company trucks
with more energy efficient vehicles was $100
million in 2012.
The cost is estimated to rise by 8.5% in 2013.
If the interest rate was 4%, what was the
cost of a delay in terms of dollars in 2012?

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Alternative Example 3.3

Solution
If the project were delayed, its cost in 2013
would be:
$100 million (1.085) = $108.5 million

Compare this amount to the cost of $100 million

in 2012 using the interest rate of 4%:
$108.5 million 1.04 = $104.33 million in 2012
dollars.

The cost of a delay of one year would be:

$104.33 million $100 million = $4.33 million in 2012
dollars.

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Figure 3.1 Converting Between Dollars Today

and Gold, Euros, or Dollars in the Future

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3.3 Present Value

and the NPV Decision Rule
The Net Present Value (NPV) of a project
or investment is the difference between the
present value of its benefits and the present
value of its costs.
NPV PV (Benefits) PV (Costs)
NPV PV (All project cash flows)

When making an investment decision, take the

alternative with the highest NPV.
Reject those projects with negative NPV

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Textbook Example 3.5

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Table 3.1 Cash Flows and NPVs for

Web Site Business Alternatives

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Table 3.2 Cash Flows of Hiring and

Borrowing Versus Selling and Investing

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3.4 Arbitrage and the Law of One

Price
Arbitrage
The practice of buying and selling equivalent
goods in different markets to take advantage of
a price difference. An arbitrage opportunity
occurs when it is possible to make a profit
without taking any risk or making any
investment.

Normal Market
A competitive market in which there are no
arbitrage opportunities.

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3.4 Arbitrage and the Law of

One Price (cont'd)
Law of One Price
If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both markets.

Valuing a Security with the Law of One Price

Assume a security promises a risk-free payment of $1000
in one year. If the risk-free interest rate is 5%, what can
we conclude about the price of this bond in a normal
market?

Price(Bond) = $952.38

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Identifying Arbitrage
Opportunities with Securities
What if the price of the bond is not $952.38?
Assume the price is $940.

The opportunity for arbitrage will force the price of the

bond to rise until it is equal to $952.38.

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Identifying Arbitrage
Opportunities with Securities
What if the price of the bond is not $952.38?
Assume the price is $960.

The opportunity for arbitrage will force the price of the

bond to fall until it is equal to $952.38.

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Determining the No-Arbitrage

Price
Unless the price of the security equals the
present value of the securitys cash flows,
an arbitrage opportunity will appear.
No Arbitrage Price of a Security
Price(Security) PV (All cash flows paid by the security)

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Alternative Example 3.6

Problem
Consider a security that pays its owner $2,000
today and $3,000 in one year, without any risk.
Suppose the risk-free interest rate is 6%.
What is the no-arbitrage price of the
security today (before the $2,000 is paid)?
If the security is trading for $4,950, what
arbitrage opportunity is available?

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Alternative Example 3.6 (contd)

Solution
Present value of the first cash flow = $2,000
Present value of the second cash flow =
$3,000 / (1.06) = $2,830.19
Total present value of the cash flows =
$2,000 + $2,830.19 = $4,830.19 =
no-arbitrage price of the security.

The security is trading for $4,950,

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Alternative Example 3.6 (contd)

Solution
Exploit its overpricing by selling it for $4,950.
Use $2,000 of the sale proceeds to replace the
$2,000 we would have received from the security
today
Invest $2,830.19 of the sale proceeds at 6% to
replace the $3,000 we would have received in
one year.
The remaining $119.81 is an arbitrage profit.
$4,950 - $2,000 - $2,830.19 = $119.81

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Determining the Interest Rate

From Bond Prices
If we know the price of a risk-free bond, we
can use
Price(Security) PV (All cash flows paid by the security)

to determine what the risk-free interest

rate must be if there are no arbitrage
opportunities.

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Determining the Interest Rate

From Bond Prices (cont'd)
Suppose a risk-free bond that pays $1000
in one year is currently trading with a
competitive market price of $929.80 today.
The bonds price must equal the present
value of the $1000 cash flow it will pay.

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The NPV of Trading Securities

and Firm Decision Making
In a normal market, the NPV of buying or selling a
security is zero.
NPV (Buy security) PV (All cash flows paid by the security) Price(Security)
0
NPV (Sell security) Price(Security) PV (All cash flows paid by the security)
0

Separation Principle
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.

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Valuing a Portfolio
The Law of One Price also has implications
for packages of securities.
Consider two securities, A and B. Suppose a
third security, C, has the same cash flows as A
and B combined. In this case, security C is
equivalent to a portfolio, or combination, of the
securities A and B.

Value Additivity
Price(C) Price(A B) Price(A) Price(B)
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Alternative Example 3.8

Problem
Moon Holdings is a publicly traded company with
only three assets:
It owns 50% of Due Beverage Co., 70% of Mountain
Industries, and 100% of the Oxford Bears, a football
team.
The total market value of Moon Holdings is $200
million, the total market value of Due Beverage Co. is
$75 million and the total market value of Mountain
Industries is $100 million.

What is the market value of the Oxford

Bears?

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Alternative Example 3.8 (cont'd)

Solution
Think of Moon as a portfolio consisting of a:
50% stake in Due Beverage
50% $75 million = $37.5 million

70% stake in Mountain Industries

70% $100 million = $70 million

100% stake in Oxford Bears

Under the Value Added Method, the sum of the value of

the stakes in all three investments must equal the $200
million market value of Moon.
The Oxford Bears must be worth:
$200 million $37.5 million $70 million = $92.5 million

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Valuing a Portfolio
Value Additivity and Firm Value
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.

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Where Do We Go From Here?

Impact of Risk on Valuation
When cash flows are risky, we must discount
them at a rate equal to the risk-free interest rate
plus an appropriate risk premium.
The appropriate risk premium will be higher the
more the projects returns tend to vary with
overall risk in the economy.

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Appendix: The Price of Risk

Risky Versus Risk-free Cash Flows

Assume there is an equal probability of either a

weak economy or strong economy.

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Appendix: The Price of Risk

(cont'd)
Risky Versus Risk-free Cash Flows (contd)
Price(Risk-free Bond) PV(Cash Flows)
($1100 in one year) (1.04 $ in one year / $ today)
$1058 today

Expected Cash Flow (Market Index)

($800) + ($1400) = $1100

Implies investors are risk averse and

require a risk premium.

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Risk Aversion
and the Risk Premium
Expected return of a risky investment

Expected Gain at end of year

Initial Cost

Market return if the economy is strong

(1400 1000) / 1000 = 40%

Market return if the economy is weak

(800 1000) / 1000 = 20%

Expected market return

(40%) + (20%) = 10%

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The No-Arbitrage Price of a Risky

Security

If we combine security A with a risk-free bond that pays

$800 in one year, the cash flows of the portfolio in one
year are identical to the cash flows of the market index.
By the Law of One Price, the total market value of the
bond and security A must equal $1000, the value of the
market index.
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The No-Arbitrage Price

of a Risky Security (cont'd)
Given a risk-free interest rate of 4%, the market
price of the bond is:
($800 in one year) / (1.04 $ in one year/$ today) = $769
today
Therefore, the initial market price of security A is
$1000 $769 = $231.

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