Chapter 2

The Two Key Concepts in Finance

Prof. Rushen Chahal

Prof. Rushen Chahal

It s what we learn after we think we know it all that counts. - Kin Hubbard

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Outline
Introduction Time value of money Safe dollars and risky dollars Relationship between risk and return

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Introduction
The occasional reading of basic material in your chosen field is an excellent philosophical exercise
Do not be tempted to include that you know it all
E.g., what is the present value of a growing perpetuity that begins payments in five years

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Time Value of Money

Introduction Present and future values Present and future value factors Compounding Growing income streams

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Introduction
Time has a value
If we owe, we would prefer to pay money later If we are owed, we would prefer to receive money sooner The longer the term of a single-payment loan, the higher the amount the borrower must repay

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Present and Future Values

Basic time value of money relationships:
PV ! FV v DF FV ! PV v CF where PV = present value; FV = future value; DF = discount factor = 1/(1  R )t CF = compounding factor = (1  R )t R = interest rate per period; and t = time in periods
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Present and Future Values (cont d)

A present value is the discounted value of one or more future cash flows A future value is the compounded value of a present value The discount factor is the present value of a dollar invested in the future The compounding factor is the future value of a dollar invested today

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Present and Future Values (cont d)

Why is a dollar today worth more than a dollar tomorrow?
The discount factor:
Decreases as time increases
The farther away a cash flow is, the more we discount it

Decreases as interest rates increase

When interest rates are high, a dollar today is worth much more than that same dollar will be in the future

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Present and Future Values (cont d)

Situations:
Know the future value and the discount factor
Like solving for the theoretical price of a bond

Know the future value and present value

Like finding the yield to maturity on a bond

Know the present value and the discount rate

Like solving for an account balance in the future

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Present and Future Value Factors

Single sum factors How we get present and future value tables Ordinary annuities and annuities due

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Single Sum Factors

Present value interest factor and future value interest factor:
PV ! FV v PVIF FV ! PV v FVIF where 1 PVIF ! (1  R)t FVIF ! (1  R)t
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Single Sum Factors (cont d)

Example
You just invested $2,000 in a three-year bank certificate of deposit (CD) with a 9 percent interest rate. How much will you receive at maturity?

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Single Sum Factors (cont d)

Example (cont d)
Solution: Solve for the future value:

FV ! $2, 000 v1.09 ! $2,590

! $2, 000 v1.2950

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How We Get Present and Future Value Tables

Standard time value of money tables present factors for:
Present value of a single sum Present value of an annuity Future value of a single sum Future value of an annuity

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How We Get Present and Future Value Tables (cont d)

Relationships:
You can use the present value of a single sum to obtain:
The present value of an annuity factor (a running total of the single sum factors) The future value of a single sum factor (the inverse of the present value of a single sum factor)

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Ordinary Annuities and Annuities Due

An annuity is a series of payments at equal time intervals An ordinary annuity assumes the first payment occurs at the end of the first year An annuity due assumes the first payment occurs at the beginning of the first year
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Ordinary Annuities and Annuities Due (cont d)

Example
You have just won the lottery! You will receive $1 million in ten installments of $100,000 each. You think you can invest the $1 million at an 8 percent interest rate. What is the present value of the $1 million if the first $100,000 payment occurs one year from today? What is the present value if the first payment occurs today?

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Ordinary Annuities and Annuities Due (cont d)

Example (cont d)
Solution: These questions treat the cash flows as an ordinary annuity and an annuity due, respectively:

PV of ordinary annuity ! $100, 000 v 6.7100 ! $671, 000 PV of annuity due ! $100, 000  ($100, 000 v 6.2468) ! $724, 680

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Compounding
Definition Discrete versus continuous intervals Nominal versus effective yields

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Definition
Compounding refers to the frequency with which interest is computed and added to the principal balance
The more frequent the compounding, the higher the interest earned

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Discrete Versus Continuous Intervals

Discrete compounding means we can count the number of compounding periods per year
E.g., once a year, twice a year, quarterly, monthly, or daily

Continuous compounding results when there is an infinite number of compounding periods

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Discrete Versus Continuous Intervals (cont d)

Mathematical adjustment for discrete compounding:
FV ! PV (1  R / m) mt R ! annual interest rate m ! number of compounding periods per year t ! time in years
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Discrete Versus Continuous Intervals (cont d)

Mathematical equation for continuous compounding:
FV ! PVe Rt e ! 2.71828

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Discrete Versus Continuous Intervals (cont d)

Example
Your bank pays you 3 percent per year on your savings account. You just deposited $100.00 in your savings account. What is the future value of the $100.00 in one year if interest is compounded quarterly? If interest is compounded continuously?

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Discrete Versus Continuous Intervals (cont d)

Example (cont d)
Solution: For quarterly compounding:

FV ! PV (1  R / m) mt ! $100.00(1  0.03 / 4) ! $103.03

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Discrete Versus Continuous Intervals (cont d)

Example (cont d)
Solution (cont d): For continuous compounding:

FV ! PVe

Rt 0.03

! $100.00 v e ! $103.05
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Nominal Versus Effective Yields

The stated rate of interest is the simple rate or nominal rate
3.00% in the example

The interest rate that relates present and future values is the effective rate
$3.03/$100 = 3.03% for quarterly compounding $3.05/$100 = 3.05% for continuous compounding

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Growing Income Streams

Definition Growing annuity Growing perpetuity

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Definition
A growing stream is one in which each successive cash flow is larger than the previous one
A common problem is one in which the cash flows grow by some fixed percentage

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Growing Annuity
A growing annuity is an annuity in which the cash flows grow at a constant rate g:
C C (1  g ) C (1  g )2 C (1  g )n PV !    ...  2 3 (1  R) (1  R) (1  R) (1  R) n 1 1  g N C1 ! 1  R  g 1 R

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Growing Perpetuity
A growing perpetuity is an annuity where the cash flows continue indefinitely:
C C (1  g ) C (1  g ) 2 C (1  g )g    ...  PV ! g 2 3 (1  R) (1  R ) (1  R) (1  R) Ct (1  g ) ! (1  R)t t !1
g t 1

C1 ! Rg

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Safe Dollars and Risky Dollars

Introduction Choosing among risky alternatives Defining risk

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Introduction
A safe dollar is worth more than a risky dollar
Investing in the stock market is exchanging bird-inthe-hand safe dollars for a chance at a higher number of dollars in the future

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Introduction (cont d)
Most investors are risk averse
People will take a risk only if they expect to be adequately rewarded for taking it

People have different degrees of risk aversion

Some people are more willing to take a chance than others

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Choosing Among Risky Alternatives

Example
You have won the right to spin a lottery wheel one time. The wheel contains numbers 1 through 100, and a pointer selects one number when the wheel stops. The payoff alternatives are on the next slide. Which alternative would you choose?

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Choosing Among Risky Alternatives (cont d)

A [1-50] $110 [1-50] B $200 [1-90] C $50 [1-99] D $1,000

[51-100]

$90 [51-100]

$0 [91-100]

$500 [100]

-$89,000

Avg. payoff

$100

$100

$100

$100

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Choosing Among Risky Alternatives (cont d)

Example (cont d)
Solution:  Most people would think Choice A is safe.  Choice B has an opportunity cost of $90 relative to Choice A.  People who get utility from playing a game pick Choice C.  People who cannot tolerate the chance of any loss would avoid Choice D.

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Choosing Among Risky Alternatives (cont d)

Example (cont d)
Solution (cont d):  Choice A is like buying shares of a utility stock.  Choice B is like purchasing a stock option.  Choice C is like a convertible bond.  Choice D is like writing out-of-the-money call options.

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Defining Risk
Risk versus uncertainty Dispersion and chance of loss Types of risk

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Risk Versus Uncertainty

Uncertainty involves a doubtful outcome
What you will get for your birthday If a particular horse will win at the track

Risk involves the chance of loss

If a particular horse will win at the track if you made a bet

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Dispersion and Chance of Loss

There are two material factors we use in judging risk:
The average outcome The scattering of the other possibilities around the average

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Dispersion and Chance of Loss (cont d)

Investment value

Investment A Investment B

Time
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Dispersion and Chance of Loss (cont d)

Investments A and B have the same arithmetic mean Investment B is riskier than Investment A

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Types of Risk
Total risk refers to the overall variability of the returns of financial assets Undiversifiable risk is risk that must be borne by virtue of being in the market
Arises from systematic factors that affect all securities of a particular type

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Types of Risk (cont d)

Diversifiable risk can be removed by proper portfolio diversification
The ups and down of individual securities due to company-specific events will cancel each other out The only return variability that remains will be due to economic events affecting all stocks

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Relationship Between Risk and Return

Direct relationship Concept of utility Diminishing marginal utility of money St. Petersburg paradox Fair bets The consumption decision Other considerations
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Direct Relationship
The more risk someone bears, the higher the expected return The appropriate discount rate depends on the risk level of the investment The risk-less rate of interest can be earned without bearing any risk

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Direct Relationship (cont d)

Expected return

Rf 0
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Risk
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Direct Relationship (cont d)

The expected return is the weighted average of all possible returns
The weights reflect the relative likelihood of each possible return

The risk is undiversifiable risk

A person is not rewarded for bearing risk that could have been diversified away
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Concept of Utility
Utility measures the satisfaction people get out of something
Different individuals get different amounts of utility from the same source
Casino gambling Pizza parties CDs Etc.

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Diminishing Marginal Utility of Money

Rational people prefer more money to less
Money provides utility Diminishing marginal utility of money
The relationship between more money and added utility is not linear I hate to lose more than I like to win

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Diminishing Marginal Utility of Money (cont d)

Utility

$
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St. Petersburg Paradox

Assume the following game:
A coin is flipped until a head appears The payoff is based on the number of tails observed (n) before the first head The payoff is calculated as $2n

What is the expected payoff?

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St. Petersburg Paradox (cont d)

Number of Tails Before First Head 0 1 2 3 4 n Total Probability (1/2)1 = 1/2 (1/2)2 = 1/4 (1/2)3 = 1/8 (1/2)4 = 1/16 (1/2)5 = 1/32 (1/2)n + 1 1.00
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Payoff $1 $2 $4 $8 $16 $2n

Probability x Payoff $0.50 $0.50 $0.50 $0.50 $0.50 $0.50 g

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St. Petersburg Paradox (cont d)

In the limit, the expected payoff is infinite How much would you be willing to play the game?
Most people would only pay a couple of dollars The marginal utility for each additional $0.50 declines

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Fair Bets
A fair bet is a lottery in which the expected payoff is equal to the cost of playing
E.g., matching quarters E.g., matching serial numbers on $100 bills

Most people will not take a fair bet unless the dollar amount involved is small
Utility lost is greater than utility gained

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The Consumption Decision

The consumption decision is the choice to save or to borrow
If interest rates are high, we are inclined to save
E.g., open a new savings account

If interest rates are low, borrowing looks attractive

E.g., a higher home mortgage

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The Consumption Decision (cont d)

The equilibrium interest rate causes savers to deposit a sufficient amount of money to satisfy the borrowing needs of the economy

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Other Considerations
Psychic return Price risk versus convenience risk

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Psychic Return
Psychic return comes from an individual disposition about something
People get utility from more expensive things, even if the quality is not higher than cheaper alternatives
E.g., Rolex watches, designer jeans

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Price Risk Versus Convenience Risk

Price risk refers to the possibility of adverse changes in the value of an investment due to:
A change in market conditions A change in the financial situation A change in public attitude

E.g., rising interest rates and stock prices, a change in the price of gold and the value of the dollar

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Price Risk Versus Convenience Risk (cont d)

Convenience risk refers to a loss of managerial time rather than a loss of dollars
E.g., a bond s call provision
Allows the issuer to call in the debt early, meaning the investor has to look for other investments

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