CH 3

Chapter 3
Arbitrage
and Financial
Decision
Making
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Chapter Outline
3.1 Valuing Decisions
3.2
Interest Rates and the Time Value of
Money
3.3
Present Value and the NPV Decision Ru
le
3.4 Arbitrage and the Law of One Price
3.5 No-Arbitrage and Security Prices
3-2
Learning Objectives
1.
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 arent, and
discuss the importance of a competitive market in
determining the value of a good.
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.
3-3
Learning Objectives (cont'd)

6. Show how value additivity can be used to help
managers maximize the value of the firm.
7. Describe the Separation Principle.
3-4
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
3-5
Analyzing Costs and Benefits

Suppose a jewelry manufacturer has the
opportunity to trade 10 ounces of platinum
and receive 20 ounces of gold today. To
compare the costs and benefits, we first
need to convert them to a common unit.
3-6

(cont'd)
Suppose gold can be bought and sold for a
current market price of $250 per ounce.
Then the 20 ounces of gold we receive has
a cash value of:
(20 ounces of gold) X ($250/ounce) = $5000
today
3-7

(cont'd)
Similarly, if the current market price for
platinum is $550 per ounce, then the 10
ounces of platinum we give up has a cash
value of:
(10 ounces of platinum) X ($550/ounce) =
$5500
3-8

(cont'd)
Therefore, the jewelers opportunity has a
benefit of $5000 today and a cost of $5500
today. In this case, the net value of the
project today is:
$5000 $5500 = $500
Because it is negative, the costs exceed

the benefits and the jeweler should reject
the trade.
3-9
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 jewelers 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.
3-10
Textbook Example 3.1
3-11
Textbook Example 3.1 (cont'd)
3-12
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?
3-13
Alternative Example 3.1 (cont'd)

Solution
Competitive markets, not your personal
preferences (or the MSRP of the motorcycle),
are relevant here: One Motorcycle with a
market value of $12,000 or $10,000 cash.
Instead of taking the cash, you should accept
the motorcycle, sell it for $12,000, use $2,000
to pay for your car repairs, and still have
$10,000 left over.
3-14
3-15
3-16

Problem
You are offered the following investment
opportunity: In exchange for $27,000 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?
3-17

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.
3-18
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
The difference in value between money today

and money in the future is due to the time
value of money.
3-19
The Interest Rate:

An Exchange Rate Across Time
The rate at which we can exchange money today
for money in the future is determined by the
current interest rate.
Suppose the current annual interest rate is 7%. By
investing or borrowing at this rate, we can exchange
$1.07 in one year for each $1 today.
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)
3-20
The Interest Rate:

An Exchange Rate Across Time (cont'd)
Value of Investment in One Year
If the interest rate is 7%, then we can express
our costs as:
Cost = ($100,000 today) (1.07 $ in one year/$
today)
= $107,000 in one year
3-21
The Interest Rate: An Exchange

Rate Across Time (cont'd)
Value of Investment in One Year
Both costs and benefits are now in terms of
dollars in one year, so we can compare them
and compute the investments net value:
$105,000 $107,000 = $2000 in one year
In other words, we could earn $2000 more in
one year by putting our $100,000 in the bank
rather than making this investment. We should
reject the investment.
3-22

Value of Investment Today
Consider the benefit of $105,000 in one year.
What is the equivalent amount in terms of dollars
today?
Benefit = ($105,000 in one year) (1.07 $ in one year/
$ today)
= ($105,000 in one year) 1/1.07 = $98,130.84

today
This is the amount the bank would lend to us
today if we promised to repay $105,000 in one
year.
3-23

Value of Investment Today
Now we are ready to compute the net value of the
investment:
$98,130.84 $100,000 = $1869.16 today
Once again, the negative result indicates that we
should reject the investment.
3-24

Present Versus Future Value
This demonstrates that our decision is the same
whether we express the value of the investment
in terms of dollars in one year or dollars today. If
we convert from dollars today to dollars in one
year,
($1869.16 today) (1.07 $ in one year/$ today) = $2000
in one year.
The two results are equivalent, but expressed as

values at different points in time.
3-25

Present Versus Future Value
When we express the value in terms of dollars
today, we call it the present value (PV) of the
investment. If we express it in terms of dollars in
the future, we call it the future value of the
investment.
3-26

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.
3-27
3-28
3-29

Problem
The cost of replacing a fleet of company trucks
with more energy efficient vehicles was $100
million in 2009.
The cost is estimated to rise by 8.5% in 2010.
If the interest rate was 4%, what was the
cost of a delay in terms of dollars in 2009?
3-30

Solution
If the project were delayed, its cost in 2010
would be:
$100 million (1.085) = $108.5 million
Compare this amount to the cost of $100

million in 2009 using the interest rate of 4%:
$108.5 million 1.04 = $104.33 million in 2009
dollars.
The cost of a delay of one year would be:

$104.33 million $100 million = $4.33 million in
2009 dollars.
3-31
Figure 3.1 Converting Between Dollars Today and

Gold, Euros, or Dollars in the Future
3-32
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.
Net Present Value
(Benefits) (Costs)
(All project cash flows)
3-33
The NPV Decision Rule

When making an investment decision, take
the alternative with the highest NPV.
Choosing this alternative is equivalent to
receiving its NPV in cash today.
3-34
The NPV Decision Rule (cont'd)

Accepting or Rejecting a Project
Accept those projects with positive NPV
because accepting them is equivalent to
receiving their NPV in cash today.
Reject those projects with negative NPV
because accepting them would reduce the
wealth of investors.
3-35
3-36
3-37
Choosing Among Alternatives

We can also use the NPV decision rule to
choose among projects. To do so, we must
compute the NPV of each alternative, and
then select the one with the highest NPV.
This alternative is the one which will lead
to the largest increase in the value of the
firm.
3-38
3-39
3-40
Choosing Among Alternatives

(cont'd)
Table 3.1 Cash Flows and NPVs for Web Site Business Alternatives
3-41
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.
3-42
NPV and Cash Needs (cont'd)

Table 3.2 Cash Flows of Hiring and Borrowing Versus Selling and Investing
3-43
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.
3-44
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.
3-45
3.5 No-Arbitrage and Security Prices

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?
($1000 in one year) ($1000 in one year) (1.05 $ in one year / $ today)
$952.38 today
Price(Bond) = $952.38
3-46
Identifying Arbitrage Opportunities

with Securities
What if the price of the bond is not $952.38?
Assume the price is $940.
Table 3.3 Net Cash Flows from Buying the Bond and Borrowing
The opportunity for arbitrage will force the price of the

bond to rise until it is equal to $952.38.
3-47
Identifying Arbitrage Opportunities

with Securities
What if the price of the bond is not $952.38?
Assume the price is $960.
Table 3.4 Net Cash Flows from Selling the Bond and Investing
The opportunity for arbitrage will force the price of the

bond to fall until it is equal to $952.38.
3-48
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) (All cash flows paid by the security)
3-49
3-50
3-51
Determining the Interest Rate

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

rate must be if there are no arbitrage
opportunities.
3-52

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.
3-53

From Bond Prices (cont'd)
$929.80 today ($1000 in one year) (1 $ in one year / $ today)
1
$1000 in one year

1.0755 $ in one year / $ today
$929.80 today
The risk-free interest rate must be 7.55%.
3-54
The NPV of Trading Securities and

Firm Decision Making
In a normal market, the NPV of buying or
selling a security is zero.
(Buy security) (All cash flows paid by the security) Price(Security)
0
(Sell security) Price(Security) (All cash flows paid by the security)
0
3-55
The NPV of Trading Securities and

Firm Decision Making (contd)
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.
3-56
3-57
3-58
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)

3-59
3-60
3-61

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?
3-62

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
3-63
Chapter Quiz
1. If gasoline trades in a competitive market,
would a transportation company that has a
use for the gasoline value it differently
than another investor?
2. How do you compare benefits at different
points in time?
3. If interest rates fall, what happens to the
value today of a promise of money in one
year?
4. What is the NPV decision rule?
3-64
Chapter Quiz (cont'd)

5. Does the NPV decision rule depend on the
investors preferences?
6. What is the Law of One Price?
7. What is Arbitrage?
8. If a firm makes an investment that has a
negative NPV, how does the value of the
firm change?
9. What is the Separation Principle?
3-65
Chapter 3
Appendix
Learning Objectives
1. Calculate the value of a risky asset, using the
Law of One Price.
2. Describe the relationship between a securitys
risk premium and its correlation with returns of
other securities.
3. Describe the effect of transactions costs on
arbitrage and the Law of One Price.
3-67
Appendix: The Price of Risk

Risky Versus Risk-free Cash Flows
Table 3A.1 Cash Flows and Market Prices (in $) of a Risk-Free
Bond and an Investment in the Market Portfolio
Assume there is an equal probability of either a

weak economy or strong economy.
3-68
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
Although both investments have the same expected
value, the market index has a lower value since it has
a greater amount of risk.
3-69
Risk Aversion and the Risk Premium

Risk Aversion
Investors prefer to have a safe income rather
than a risky one of the same average amount.
Risk Premium
The additional return that investors expect to
earn to compensate them for a securitys risk.
When a cash flow is risky, to compute its
present value we must discount the cash flow
we expect on average at a rate that equals the
risk-free interest rate plus an appropriate risk
premium.
3-70
Risk Aversion
and the Risk Premium (contd)
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%
3-71
The No-Arbitrage Price of a Risky

Security
Table 3A.2 Determining the Market Price of Security A (cash flows in $)
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.
3-72
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.
3-73
Risk Premiums Depend on Risk

If an investment has much more variable
returns, it must pay investors a higher risk
premium.
3-74
Risk Is Relative to the Overall

Market
The risk of a security must be evaluated in
relation to the fluctuations of other investments
in the economy.
A securitys risk premium will be higher the more
its returns tend to vary with the overall economy
and the market index.
If the securitys returns vary in the opposite
direction of the market index, it offers insurance
and will have a negative risk premium.
3-75
Risk Is Relative
to the Overall Market (cont'd)
Table 3A.3 Risk and Risk Premiums for Different Securities
3-76
Textbook Example 3.A.1
3-77
Textbook Example 3A.1 (cont'd)
3-78
Risk, Return, and Market Prices

When cash flows are risky, we can use the
Law of One Price to compute present
values by constructing a portfolio that
produces cash flows with identical risk.
3-79
Figure 3.3 Converting Between Dollars

Today and Dollars in One Year with Risk
Computing prices in this way is equivalent to
converting between cash flows today and the
expected cash flows received in the future using a
discount rate rs that includes a risk premium
appropriate for the investments risk:
( risk premium for investment )
3-80
Textbook Example 3A.2
3-81
3-82
Alternative Example 3A.2

Problem
Consider a risky stock with a cash flow of
$1500 when the economy is strong and $800
when the economy is weak. Each state of the
economy has an equal probability of occurring.
Suppose an 8% risk premium is appropriate for
this particular stock. If the risk-free interest
rate is 2%, what is the price of the stock
today?
3-83
Alternative Example 3A.2 (contd)

Solution
From Eq. 3A.2, the appropriate discount rate
for the stock is:
rs = rf + (Risk Premium for the Stock) = 2% +
8% = 10%
The expected cash flow of the bond is
($1,500) + ($800) = $1,150 in one year.
Thus, the price of the stock today is
$1,150/1.10 = $1,045.45.
3-84
Arbitrage with Transactions Costs

What consequence do transaction costs
have for no-arbitrage prices and the Law of
One Price?
When there are transactions costs, arbitrage
keeps prices of equivalent goods and securities
close to each other. Prices can deviate, but not
by more than the transactions cost of the
arbitrage.
3-85
Textbook Example 3A.3
3-86
3-87
Chapter Appendix Quiz

1. Why does the expected return of a risky
security generally differ from the risk-free
interest rate?
2. Should the risk of a security be evaluated
in isolation?
3. In the presence of transactions costs, why
might different investors disagree about
the value of an investment opportunity?
3-88

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Chapter 3

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Assess the relative merits of two-period projects using net

Define the term competitive market, give examples of

Explain why maximizing NPV is always the correct decision

Define arbitrage, and discuss its role in asset pricing. How

Calculate the no-arbitrage price of an investment

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives (cont'd)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

3.1 Valuing Decisions

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Analyzing Costs and Benefits

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Analyzing Costs and Benefits

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Analyzing Costs and Benefits

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Analyzing Costs and Benefits

Because it is negative, the costs exceed

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Using Market Prices to Determine

In evaluating the jewelers decision, we

Textbook Example 3.1

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Textbook Example 3.1 (cont'd)

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Alternative Example 3.1

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Alternative Example 3.1 (cont'd)

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Textbook Example 3.2

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Textbook Example 3.2 (cont'd)

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Alternative Example 3.2

Alternative Example 3.2 (cont'd)

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3.2 Interest Rates

The difference in value between money today

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The Interest Rate:

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The Interest Rate:

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The Interest Rate: An Exchange

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The Interest Rate: An Exchange

= ($105,000 in one year) 1/1.07 = $98,130.84

The Interest Rate: An Exchange

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Interest Rate: An Exchange

The two results are equivalent, but expressed as

The Interest Rate: An Exchange

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The Interest Rate: An Exchange

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

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Textbook Example 3.3

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Textbook Example 3.3 (cont'd)

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Alternative Example 3.3