Chapter 27: The Basic Tools of Finance

Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum. Because of diminishing marginal utility, most people are risk averse. Risk-averse people can reduce risk by buying insurance, diversifying their holdings, and choosing a portfolio with lower risk and lower return. The value of an asset equals the present value of the cash flows the owner will receive. For a share of stock, these cash flows include the stream of dividends and the final sale price. According to the efficient markets hypothesis, financial markets process available information rationally, so a stock price always equals the best estimate of the value of the underlying business. Some economists question the efficient markets hypothesis, however, and believe the irrational psychological factors also influence asset prices.