Slide 1Chapter OutlineLearning ObjectivesLearning Objectives (continued)3.1 Valuing DecisionsAnalyzing Costs and BenefitsAnalyzing Costs and Benefits (cont'd)Analyzing Costs and Benefits (cont'd)Analyzing Costs and Benefits (cont'd)Using Market Prices to Determine Cash ValuesExample 3.1Example 3.1 (continued)Textbook Example 3.2Textbook Example 3.2 (continued)3.2 Interest Rates and the Time Value of MoneyThe Interest Rate: An Exchange Rate Across TimeThe Interest Rate: An Exchange Rate Across Time (continued)The Interest Rate: An Exchange Rate Across Time (continued)The Interest Rate: An Exchange Rate Across Time (continued)The Interest Rate: An Exchange Rate Across Time (cont'd)The Interest Rate: An Exchange Rate Across Time (cont'd)The Interest Rate: An Exchange Rate Across Time (cont'd)The Interest Rate: An Exchange Rate Across Time (cont'd)Textbook Example 3.3Textbook Example 3.3 (cont'd)Alternative Example 3.3Alternative Example 3.3Slide 283.3 Present Value and the NPV Decision RuleThe NPV Decision RuleThe NPV Decision Rule (cont'd)Textbook Example 3.4Textbook Example 3.4 (cont'd)Choosing Among AlternativesTextbook Example 3.5Textbook Example 3.5 (cont'd)Slide 37NPV and Cash NeedsSlide 393.4 Arbitrage and the Law of One Price3.4 Arbitrage and the Law of One Price (cont'd)3.5 No-Arbitrage and Security PricesIdentifying Arbitrage Opportunities with SecuritiesIdentifying Arbitrage Opportunities with SecuritiesDetermining the No-Arbitrage PriceTextbook Example 3.6Textbook Example 3.6 (cont'd)Alternative Example 3.6Alternative Example 3.6 (cont’d)Alternative Example 3.6 (cont’d)Alternative Example 3.6 (cont’d)Determining the Interest Rate From Bond PricesDetermining the Interest Rate From Bond Prices (cont'd)Determining the Interest Rate From Bond Prices (cont'd)The NPV of Trading Securities and Firm Decision MakingThe NPV of Trading Securities and Firm Decision Making (cont’d)Textbook Example 3.7Textbook Example 3.7 (cont'd)Valuing a PortfolioTextbook Example 3.8Textbook Example 3.8 (cont'd)Alternative Example 3.8Alternative Example 3.8 (cont'd)Valuing a PortfolioWhere Do We Go From Here?Discussion of Key TopicChapter QuizChapter Quiz (cont'd)Slide 69Learning ObjectivesAppendix: The Price of RiskAppendix: The Price of Risk (cont'd)Risk Aversion and the Risk PremiumRisk Aversion and the Risk Premium (cont’d)The No-Arbitrage Price of a Risky SecurityThe No-Arbitrage Price of a Risky Security (cont'd)Risk Premiums Depend on RiskRisk Is Relative to the Overall MarketTable 3A.3 Risk and Risk Premiums for Different SecuritiesTextbook Example 3A.1Textbook Example 3A.1 (cont'd)Risk, Return, and Market PricesSlide 83Textbook Example 3A.2Textbook Example 3A.2 (cont'd)Alternative Example 3A.2Alternative Example 3A.2 (cont’d)Arbitrage with Transactions CostsTextbook Example 3A.3Textbook Example 3A.3 (cont'd)Chapter Appendix QuizChapter 3Financial Decision Making and the Law of One PriceCopyright ©2014 Pearson Education, Inc. All rights reserved.Chapter Outline3.1 Valuing Decisions3.2 Interest Rates and the Time Value of Money3.3 Present Value and the NPV Decision Rule3.4 Arbitrage and the Law of One Price3.5 No-Arbitrage and Security PricesCopyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives1. Assess the relative merits of two-period projects using net present value.2. Define the term “competitive market,” give examples of markets that are competitive and some that aren’t, and discuss the importance of a competitive market in determining the value of a good.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives (continued)3. Explain why maximizing NPV is always the correct decision rule.4. Define arbitrage, and discuss its role in asset pricing. How does it relate to the Law of One Price?5. Calculate the no-arbitrage price of an investment opportunity.Copyright ©2014 Pearson Education, Inc. All rights reserved.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•OperationsCopyright ©2014 Pearson Education, Inc. All rights reserved.Analyzing Costs and Benefits•Suppose a jewelry manufacturer has the opportunity to trade 10 ounces of gold and receive 20 ounces of palladium today. To compare the costs and benefits, we first need to convert them to a common unit.Copyright ©2014 Pearson Education, Inc. All rights reserved.Analyzing Costs and Benefits (cont'd)•Similarly, if the current market price for palladium is $600 per ounce, then the 20 ounces of palladium we receive has a cash value of:–(20 ounces of palladium) X ($600/ounce) = $12,000Copyright ©2014 Pearson Education, Inc. All rights reserved.Analyzing Costs and Benefits (cont'd)•Suppose gold can be bought and sold for a current market price of $1,500 per ounce. Then the 10 ounces of gold we give up has a cash value of:–(10 ounces of gold) X ($1,500/ounce) = $15,000 todayCopyright ©2014 Pearson Education, Inc. All rights reserved.Analyzing Costs and Benefits (cont'd)•Therefore, the jeweler’s opportunity has a benefit of $12,000 today and a cost of $15,000 today. In this case, the net value of the project today is:–$12,000 – $15,000 = –$3,000•Because it is negative, the costs exceed the benefits and the jeweler should reject the trade.Copyright ©2014 Pearson Education, Inc. All rights reserved.Using Market Prices to Determine Cash Values•Competitive Market–A market in which goods can be bought and sold at the same price.•In evaluating the jeweler’s decision, we used the current market price to convert from ounces of platinum or gold to dollars. –We did not concern ourselves with whether the jeweler thought that the price was fair or whether the jeweler would use the silver or gold.Copyright ©2014 Pearson Education, Inc. All rights reserved.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?Copyright ©2014 Pearson Education, Inc. All rights reserved.Example 3.1 (continued)•Solution–Competitive markets, not your personal preferences (or the