After reading this chapter, you should be able to: Describe the idea of present value and explain why it is critical in making financial decisions; identify and distinguish between the most common financial investments: stocks, bonds, and mutual funds; discuss how investment returns compensate for being patient and for bearing risk; explain portfolio diversification and why it implies that investors can focus on nondiversifiable risk when evaluating an investment opportunity.
17 FinancialEconomics McGrawưHill/Irwin Copyrightâ2012byTheMcGrawưHillCompanies,Inc.Allrightsreserved FinancialInvestment Economic investment New additions or replacements to • LO1 the capital stock Financial investment • Broader than economic investment • Buying or building an asset for financial gain • New or old asset • Financial or real asset 17-2 • Present Value Present day value of future returns or costs Compound interest • X dollars today=(1+i)tX dollars in t years $100 today at 8% is worth: • LO1 • Earn interest on the interest • $108 in one year • $116.64 in two years • $125.97 in three years 17-3 Present Value Model • Calculate what you should pay for an • • • asset today Asset yields future payments Asset’s price should equal total present value of future payments The formula: X ( + i) LO1 t dollars today = X dollars in t years 17-4 Applications • Take the money and run • Lottery jackpot paid over a number • LO1 of years • Calculating the lump sum value Salary caps and deferred compensation • Calculating the value of deferred salary payments 17-5 Popular Investments • Wide variety available to investors • Three features • Must pay to acquire • Chance to receive future payment • Some risk in future payments LO2 17-6 Popular Investments Stocks • Represents ownership in a company • Bankruptcy possible • Limited liability rule • Capital gains • Dividends LO2 Bonds • Debt contracts issued by government and corporations • Possibility of default • Investor receives interest 17-7 Mutual Funds • Company that maintains a portfolio of • • • • LO2 either stocks or bonds Currently more than 8,000 mutual funds Index funds Actively managed funds Passively managed funds 17-8 Calculating Investment Returns • Gain or loss stated as percentage • • • LO2 rate of return Difference between selling price and purchase price divided by purchase price Future series of payments also considered into return Rate of return inversely related to price 17-9 Arbitrage • Buying and selling process to • • LO3 equalize average expected returns Sell asset with low return and buy asset with higher return at same time Both assets will eventually have same rate of return 17-10 Risk • Future payments are uncertain • Diversification • Diversifiable risk • Specific to a given investment • Nondiversifiable risk • Business cycle effects • Comparing risky investments • Average expected rate of return • Beta LO3 17-11 Risk • Risk and average expected rates of • LO3 return • Positively related The risk-free rate of return • Short-term U.S government bonds • Greater than zero • Time preference • Risk-free interest rate 17-12 The Security Market Line Compensate investors for: • Time preference • Nondiversifiable risk LO4 Average expected rate of return = Average expected rate of return = Rate that compensates for time preference if + + Rate that compensates for risk risk premium 17-13 Average expected rate of return The Security Market Line Market Portfolio A Risk-Free Asset (i.e., a short-term U.S Government bond) Risk Premium for the Market Portfolio’s Risk Level of beta =1.0 if Compensation for Time Preference Equals if LO4 Security Market Line 1.0 Risk Level (beta) 17-14 The Security Market Line • Risk levels determine average Average expected rate of return expected rates of return Security Market Line Y Risk Premium for this Asset’s Risk Level of beta = X if Compensation for Time-Preference Equals i f X Risk Level (beta) LO4 17-15 The Security Market Line Average expected rate of return • Arbitrage and the security market A Y Security Market Line B C X Risk Level (beta) LO5 17-16 The Security Market Line • An increase in the risk-free rate Average expected rate of return SML SML A After Increase Y2 A Before Increase Y1 X Risk Level (beta) LO5 17-17 ... 1 7-1 1 Risk • Risk and average expected rates of • LO3 return • Positively related The risk-free rate of return • Short-term U.S government bonds • Greater than zero • Time preference • Risk-free... Broader than economic investment • Buying or building an asset for financial gain • New or old asset • Financial or real asset 1 7-2 • Present Value Present day value of future returns or costs Compound... that compensates for risk risk premium 1 7-1 3 Average expected rate of return The Security Market Line Market Portfolio A Risk-Free Asset (i.e., a short-term U.S Government bond) Risk Premium for