Solution to Problems Chapter 3 Corporate Finance
CHAPTER 3
Arbitrage and Financial
Decision Making
Chapter Synopsis
3.1 Valuing Decisions
When considering an investment opportunity, a financial manager must systematically compare the costs and benefits associated with the project in order to determine whether it is worthwhile. Determining the cash value today of the costs and benefits is one way to make such a comparison.
In a competitive market, a good can be bought and sold at the same price, so the market price can be used to determine the cash value today of the good. Because competitive markets exist for many assets, such as commodities and financial securities, they can be used to determine cash values and evaluate decisions in many situations. For example, if gold trades at $250/ounce in a competitive market, then 20 ounces of gold have a cash value today of $5000. A buyer wouldn’t need to pay more, and a seller wouldn’t need to accept less, so individual preferences are not relevant.
If a manager can observe competitive market prices, he may be able to use them to determine the current cash value of different costs and benefits so they can be compared.
For example, if someone offers to trade the manager 20 ounces of gold for 10 ounces of platinum, which trades at $550 per ounce in a competitive market, he should reject the trade. The benefit (the cash value today of the gold, $5000) is smaller than the cost (the cash value today of the platinum, $5500).
By evaluating cost and benefits using competitive market prices, we can determine whether a decision will make the firm and its investors wealthier. This point is one of the central and most powerful ideas in finance, which we call the Valuation Principle:
The value of an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using these
©2011 Pearson Education
20
Berk/DeMarzo • Corporate Finance, Second Edition market prices, and when
Arbitrage and Financial
Decision Making
Chapter Synopsis
3.1 Valuing Decisions
When considering an investment opportunity, a financial manager must systematically compare the costs and benefits associated with the project in order to determine whether it is worthwhile. Determining the cash value today of the costs and benefits is one way to make such a comparison.
In a competitive market, a good can be bought and sold at the same price, so the market price can be used to determine the cash value today of the good. Because competitive markets exist for many assets, such as commodities and financial securities, they can be used to determine cash values and evaluate decisions in many situations. For example, if gold trades at $250/ounce in a competitive market, then 20 ounces of gold have a cash value today of $5000. A buyer wouldn’t need to pay more, and a seller wouldn’t need to accept less, so individual preferences are not relevant.
If a manager can observe competitive market prices, he may be able to use them to determine the current cash value of different costs and benefits so they can be compared.
For example, if someone offers to trade the manager 20 ounces of gold for 10 ounces of platinum, which trades at $550 per ounce in a competitive market, he should reject the trade. The benefit (the cash value today of the gold, $5000) is smaller than the cost (the cash value today of the platinum, $5500).
By evaluating cost and benefits using competitive market prices, we can determine whether a decision will make the firm and its investors wealthier. This point is one of the central and most powerful ideas in finance, which we call the Valuation Principle:
The value of an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using these
©2011 Pearson Education
20
Berk/DeMarzo • Corporate Finance, Second Edition market prices, and when