The Valuation Principle

Cost-Benefit Analysis

Quantifying Costs and Benefits

Any decision in which the value of the benefits exceeds the costs will increase the value of the firm
To compare the costs and benefits, we first need to convert them to a common unit

Market Prices and the Valuation Principle

Role of Competitive Markets

A competitive market is one in which a good can be bought and sold at the same price
In a competitive market, the price determines the value of the good

Valuation Principle

The value of a commodity or 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 those market prices
When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm

Law of One Price

In competitive markets, the same goods must have the same price

Arbitrage

The practice of buying and selling equivalent goods in different markets to take advantage of a price difference

Arbitrage opportunity

Any situation in which it is possible to make a profit without taking any risk or making any investment

Principle of No Arbitrage

In normal competitive markets, supply and demand forces cause prices to adjust so that arbitrage opportunities are eliminated

Valuing Cash Flows at Different Points in Time

Rule 1: Comparing and Combining Values

It is only possible to compare or combine values at the same point in time

Rule 2: Compounding

To calculate a cash flow’s future value, you must compound it

Compound Interest

The combination of earning interest on the original principle and earning interst on accrued interest

F V_{n} = C_{0} \times (1 + r)^{n}

Rule 3: Discounting

To calculate the value of a future cash flow at an earlier point in time, we must discount it

P V_{0} = \frac{C_{n}}{(1 + r)^{n}}