Chapter 3 Notes 3.

1 Valuing Decisions Analyzing Costs & Benefits Using Market Prices to Determine Cash Values Valuation Principle - states that the value of an asset to the or its investors is determined by its competitive mkt price. The benefits and costs of a decision should be evaluated using these mkt. prices, and when the value of the benefits exceeds the value of the costs, the decision will increase the mkt value of the firm.

3.2 Interest Rates and the Time Value of Money The Time Value of Money The Interest Rate: An Exchange Rate Across Time Value of Investment in One Year Value of Investment Today Present Versus Future Value Discount Factors and Rates 1/(1+r) = 1/1.07 = 0.93458 Ex. 3.3 Comparing Costs at Different Points in Time Problem The cost of rebuilding is $3bill by 2004. At the time, if the project is delayed to 2005, cost would rise by 10%. If the interest rate was 2%, whats the cost of a delay in terms of dollars in 2004. AnswerIf the project is delayed, it would cost $3bill X (1.10) = $3.3 billion in 2005. 3.3bill/($1.02 in 05/$ in 04) 3.3 Present Value and the NPV Decision Rule Net Present Value NPV = PV(Benefits) PV (Costs) NPV = PV(All project cash flows) The NPV Decision Rule When making an investment decision, take the alternative w/ the highest NPV. Choosing the alternative is = to receiving NPV in cash now. Accepting or Rejecting a Project - Accept those projects w/ a positive NPV - Reject those projects w/ a negative NPV - If the NPV is exactly zero, you will neither gain nor lose by accepting the project. Choosing Among Alternatives - Select the project with the highest NPV. NPV and Cash Needs

Regardless of our preferences for 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 and find our most preferred pattern of cash flows. 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. Arbitrage opportunity Any situation in which it is possible to make a profit without taking any risk or making any investment. (has a + NPV) Normal Market a competitive market in which there are no opportunities. Law of One Price = If the equivalent investment opportunities trade simultaneously in different Competitive markets, then they must trade for the same price in both markets. 3.5 No-Arbitrage and Security Prices Valuing a Security with the Law of One Price - 2 ways to receive the same cash flow: (1) buy the bond or (2) invest $952.38 at 5% risk-free interest rate Identifying Arbitrage Opportunities w/ Securities Ex. Computing the No-Arbitrage Price p.67 Determining the No-Arbitrage Price Price(Security) = PV (All cash flows paid by the security) Determining the Interest Rate from Bond Prices The NPV of Trading Securities and Firm Decision Making NPV (Buy security) = PV ( All cash flows paid by the security) Price (Security) NPV (Sell Security) = Price (Security) -- PV ( All cash flows paid by the security) Separation Principle Security transaction in a normal mkt 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 transaction.