L11 Econ 1011 Study Guide - Quiz Guide: Efficient-Market Hypothesis
16 May 2018
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• Present value of a perpetual payment – for an annual interest rate r, the present value
(PV) of a perpetual annual payment (M) is the amount that would have to be deposited at
that interest rate to generate annual interest earnings of M: PV = M / r
• A share of a stock in a company is a claim to a share of the current and future accounting
profits of that company
o Ex: a company’s accounting profit will be $1 million this year and every year. If a
company has issued a total of 1,000 shares of stock and the annual interest rate is
5%, at which price will each share sell?
▪ Because there are 1,000 stocks, then each share entitles its owner $1,000
per year
▪ To calculate the economic value of the stock, we need to ask how much an
investor would need to deposit in the bank at 5% interest to generate an
annual interest payment of $1,000
▪ PV = M / r → PV = 1,000 / 0.05 = $20,000 is the price each stock will
command in the stock market
• Time value of money – that fact that a given dollar amount today is equivalent to a
larger dollar amount in the future because the money can be invested in an interest-
bearing account in the meantime
PV = M
1+r � T = time
o Ex: to get $14, 400 in 2 years
▪ If the interest rate is 20%, then PV = $14,400/ (1.2)2 = $10,000
▪ If deposit $10,000 (1 + 0.2) = $12,000 by the end of 1 year, and that
amount left on deposit for a 2nd year would grow to
$12,000 (1 + 0.2) = $14,400
• Efficient market hypothesis – the theory that the current price of a stock in a
corporation reflects all relevant information about its current and future earnings
prospects
o the incentive principle tells us that we may safely assume that there is no shortage
of investors who would be delighted to double their wealth without having to
work hard or take risks
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