The Basic Tools of
Finance
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• Finance is the field that studies
how people make decisions
regarding the allocation of
resources over time and the
handling of risk.
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PRESENT VALUE: MEASURING
THE TIME VALUE OF MONEY
• The concept of present value demonstrates the
following:
• Receiving a given sum of money in the present
is preferred to receiving the same sum in the
future.
• In order to compare values at different points in
time, compare their present values.
• Firms undertake investment projects if the
present value of the project exceeds the cost.
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PRESENT VALUE: MEASURING
THE TIME VALUE OF MONEY
• If i is the interest rate, then an amount R to be
received in t years has present value of:
PDV = R/(1 + i)t
R
_______________ = PDV
t
)i +1 (
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Net present value:
t
PDV = R / (1+i)
R = return
t =year
i = rate of interest or discount rate
(expressed as decimal)
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Row 2 of the following table shows the net
revenues of a project with an initial capital
cost of $ 16 m in years 1-4, and row 3
shows these figures discounted to their
present value using a discount rate of 10 per
cent.
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Year 1 2 3 4
Net revenue in million 2.0 5.0 6.0 6.0
Present discounted value of 1.82 4.13 4.5 4.1
net revenues (PDV)
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-Costs at present value $ 16.00 m
-Revenue at present value $ 14.55 m
-Net present value of revenues-$ 1.45 m
**This negative figure indicates an
unprofitable investment.
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Calculate the PDV of 6m $ that will be earned •
after 3 years ( Rate of interest is 14%)
m6
$ PDV = _______________ = 4.05m
3
)14% +1 (
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MANAGING RISK
• A person is said to be risk
averse if he exhibits a dislike of
uncertainty.
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MANAGING RISK
• Individuals can reduce risk choosing
any of the following:
• Buy insurance
• Diversify
• Accept a lower return on their
investments
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The Markets for Insurance
• One way to deal with risk is to buy
insurance.
insurance
• The general feature of insurance contracts
is that a person facing a risk pays a fee to
an insurance company, which in return
agrees to accept all or part of the risk.
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Diversification of Idiosyncratic Risk
• Diversification refers to the reduction
of risk achieved by replacing a single
risk with many smaller unrelated
risks.
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Diversification of Idiosyncratic Risk
• Idiosyncratic risk is the risk that
affects only a single person.
• The uncertainty associated with
specific companies.
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• For example, the risk that airline industry employees will go on strike,
is unsystematic risk. This risk primarily affects the airline company and
the companies with whom the airline does business.
• It does not affect the entire market system, so it is an idiosyncratic risk.
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• An investor who owned nothing, but an airline
company would face a high level of
idiosyncratic risk.
• By diversifying his or her portfolio with
unrelated businesses, such as health-care
business and retail business, the investor would
face less risk.
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In July of 2002, the company became a Holding Company with
eight subsidiaries:
EGYPTAIR AIRLINES
EGYPTAIR DUTY FREE
EGYPTAIR MAINTENANCE & ENGINEERING
EGYPTAIR GROUND SERVICES
EGYPTAIR IN-FLIGHT SERVICES
EGYPTAIR MEDICAL SERVICES
EGYPTAIR SUPPLEMENTARY INDUSTRIES
EGYPTAIR CARGO
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في ش هر يولي و ، 2002تغ ير الهيك ل الق انوني لمص ر
للطيران وتحولت إلى شركة قابضة مع 8شركات فرعية
:
مصر للطيران للخطوط الجوية.
مصر للطيران لألسواق الحرة.
مصر للطيران للصيانة واألعمال الفنية.
مصر للطيران الخدمات األرضية.
مصر للطيران للخدمات الجوية.
مصر للطيران الخدمات الطبية.
مصر للطيران للصناعات المكملة.
مصر للطيران للشحن
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Diversification of Idiosyncratic Risk
• Aggregate risk is the risk that affects all
economic actors at once, the uncertainty
associated with the entire economy.
• Diversification cannot remove aggregate risk.
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Managing risk
• People can reduce risk by
accepting a
lower rate of return.
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Summary
• 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.
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Summary
• Risk-averse people can reduce risk using
insurance, through diversification, and by
choosing a portfolio with lower risk and lower
returns.
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