Lecture 10 basic tools of finance

Macroeconomics

Lecture 10

Basic Tools of Finance

Questions

1. What are the two major stock markets in the U.S.?

2. Where is the NASDAQ located?

3. If the current stock price is $150 and the earnings over the past 12 months was $10, what is the P/E ratio?

4. How often can a share price change?

5. When a stock sells, how many values are there?

6. When a company has earnings what are the two things it can do?

7. Can a company declare a dividend, even though it does not have a profit?

8. You have three investment choices: U.S. Treasury Bond, a McDonalds Bond, or McDonalds stock. Which one would you buy and why? Which one you you recommend that your grandma buy?

9. Why are bonds that mature out in the future more risky than bonds that mature in the near future?

10. What are two financial intermediaries?

11. How do banks make money?

12. Name two reasons to invest in a mutual fund.

NYSE and NASDAQ

Computer

$150 ÷ $12 = 12.5

With every sale

Two

retain earnings or declare dividend

yes

consider circumstances, time horizon, and appetite for risk

Time is risky

banks and mutual funds

spread

low cash and diversity of risk

What is the definition of

patience?

Patience means active waiting and enduring. It

means staying with something and doing all that we can—working, hoping, and exercising

faith; bearing hardship with fortitude, even when the desires of our hearts are delayed. Patience is not

simply enduring; it is enduring well!

How many marshmallows you would have after 24 hours if you start with one and the number

doubles every 15 minutes?

295

39,614,081,257,132,200,000,000,000,000

No. Amount 0 1 1 2 2 4 3 8 4 16 5 32 6 64 7 128 8 256 9 512 10 1,024 11 2,048 12 4,096 13 8,192 14 16,384 15 32,768 16 65,536 17 131,072 18 262,144 19 524,288 20 1,048,576 21 2,097,152 22 4,194,304 23 8,388,608 24 16,777,216 25 33,554,432 26 67,108,864 27 134,217,728 28 268,435,456 29 536,870,912 30 1,073,741,824 31 2,147,483,648 32 4,294,967,296 33 8,589,934,592 34 17,179,869,184 35 34,359,738,368 36 68,719,476,736 37 137,438,953,472 38 274,877,906,944 39 549,755,813,888 40 1,099,511,627,776 41 2,199,023,255,552 42 4,398,046,511,104 43 8,796,093,022,208 44 17,592,186,044,416 45 35,184,372,088,832 46 70,368,744,177,664 47 140,737,488,355,328 48 281,474,976,710,656 49 562,949,953,421,312 50 1,125,899,906,842,620

No. Amount 51 2,251,799,813,685,250 52 4,503,599,627,370,500 53 9,007,199,254,740,990 54 18,014,398,509,482,000 55 36,028,797,018,964,000 56 72,057,594,037,927,900 57 144,115,188,075,856,000 58 288,230,376,151,712,000 59 576,460,752,303,423,000 60 1,152,921,504,606,850,000 61 2,305,843,009,213,690,000 62 4,611,686,018,427,390,000 63 9,223,372,036,854,780,000 64 18,446,744,073,709,600,000 65 36,893,488,147,419,100,000 66 73,786,976,294,838,200,000 67 147,573,952,589,676,000,000 68 295,147,905,179,353,000,000 69 590,295,810,358,706,000,000 70 1,180,591,620,717,410,000,000 71 2,361,183,241,434,820,000,000 72 4,722,366,482,869,650,000,000 73 9,444,732,965,739,290,000,000 74 18,889,465,931,478,600,000,000 75 37,778,931,862,957,200,000,000 76 75,557,863,725,914,300,000,000 77 151,115,727,451,829,000,000,000 78 302,231,454,903,657,000,000,000 79 604,462,909,807,315,000,000,000 80 1,208,925,819,614,630,000,000,000 81 2,417,851,639,229,260,000,000,000 82 4,835,703,278,458,520,000,000,000 83 9,671,406,556,917,030,000,000,000 84 19,342,813,113,834,100,000,000,000 85 38,685,626,227,668,100,000,000,000 86 77,371,252,455,336,300,000,000,000 87 154,742,504,910,673,000,000,000,000 88 309,485,009,821,345,000,000,000,000 89 618,970,019,642,690,000,000,000,000 90 1,237,940,039,285,380,000,000,000,000 91 2,475,880,078,570,760,000,000,000,000 92 4,951,760,157,141,520,000,000,000,000 93 9,903,520,314,283,040,000,000,000,000 94 19,807,040,628,566,100,000,000,000,000 95 39,614,081,257,132,200,000,000,000,000

295

Index Fund

Buy one share of all the companies in the

market

Exchange IndexesDow Jones Industrial Average

(DJIA)30 biggest U.S. Companies

S&P 500500 biggest U.S. companies

NASDAQ

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0 100 200 300 400 500 600 700 800 900 1000

InterestProfitRate

%

Loanable Funds

Supply

Demand

Market for Loanable Funds

Intellectual

Financial Physical

Human

Culture

Entrepreneur

trust knowledge skills personality health relationships

natural resources time buildings equipmentthings than make things

money and risksavers and borrowers time is money

(1+r)n

insurance   limited liability corporations

ideas technologymethods

Basic Toolsof

Finance

AWin $100 Dollars

What would you prefer?

BFlip a coin:

50 percent chance you win $200 dollars

50 percent chance you win nothing.

ALose $100 Dollars

What would you prefer?

BFlip a coin:

50 percent chance you lose $200 dollars

50 percent chance you lose nothing.

SurveyMost people avoid risk

on gains

but prefer to take risks to avoid loss

Key Termsfinancepresent valuefuture valuecompoundingdiscountingrisk aversiondiversification

firm-specific riskmarket riskfundamental analysisefficient market hypothesisinformation efficiencyrandom walk

Key Formulas

(1+r)N

r = rate N = number of periods

Compounding Future Value or FVmultiplying

Discounting Present Value or PVdividing

(1+r)N1

Finance

Time and Risk

Tomorrow

One Year

Ten Years

Discount the future

Today is worth more than tomorrow

Promissory Note

Trading paper for paper

I.O. U.

$1Dr. Gale

Rates and

Compounding Linear versus

Exponential

0

8

16

24

32

40

48

56

64

1 2 3 4 5 62

48

16

32

64

24

68

1012

Linear versus ExponentialAdding versus Compounding

+

^

N Start Add End

0 100.00 7.00 107.00

1 107.00 7.00 114.00

2 114.00 7.00 121.00

3 121.00 7.00 128.00

4 128.00 7.00 135.00

5 135.00 7.00 142.00

Fixed Amount

Grow by a percentage each year,

not a fixed amount

Compounding

Compounding

The process of finding the future value of a

present sum of money

multiplying

Discounting

The process of finding the present value of a future sum of money

dividing

compounding is the inverse of discounting

discounting is the inverse of compounding

7%

N Start Add End

0 100.00 7.00 107.00

1 107.00 7.49 114.49

2 114.49 8.01 122.50

3 122.50 8.58 131.08

4 131.08 9.18 140.26

5 140.26 9.82 150.07

Compounding

CAGR

Compounded AnnualGrowth

Rate

Fixed 7%

N Start Add End Start Add End

0 100.00 7.00 107.00 100.00 7.00 107.00

1 107.00 7.00 114.00 107.00 7.49 114.49

2 114.00 7.00 121.00 114.49 8.01 122.50

3 121.00 7.00 128.00 122.50 8.58 131.08

4 128.00 7.00 135.00 131.08 9.18 140.26

5 135.00 7.00 142.00 140.26 9.82 150.07

Fixed vs. Compounding

Compounding8%

4%

2%

time

amount

Rate Amount in 30 years

1% 136.13

2% 184.76

4% 337.31

8% 1,086.77

16% 9,958.59

32% 546,753.87

Rate Amount in 30 years

1% 136.13

2% 184.76

4% 337.31

8% 1,086.77

16% 9,958.59

32% 546,753.87

What would you rather have?

A. 100 dollars today

B. 500 dollars in 5 years

C. 1,000 dollars in 10 years

38%

26%

CAGR

Key Formulas

(1+r)N

r = rate N = number of periods

Compounding Future Value or FVmultiplying

Discounting Present Value or PVdividing

(1+r)N1

Present Future

r = growth rateN = number of periods

?

(1+r)N

Future Value ?

Present Future

r = growth rateN = number of periods

?

Present Value ?

(1+r)N1

Quiz 4 Name ___ ID____

1. Future Value (FV) of 500 in 5 years at 5 percent.2. FV of 100 in 10 years at 8 percent.3. FV of 500 in 20 years at 8 percent.4. FV of 100 in 10 years at 8 percent.5. FV of 300 in 3 years at 20 percent.

6. Present Value (PV) of 500 in 5 years at 5 percent.7. PV of 1000 in 10 years at 10 percent.8. PV of 5000 in 7 years at 4 percent.9. PV of 1,000,000 in 20 years at 3 percent.10. PV of 500,000 in 12 years at 8 percent.

Future ValueThe amount of money in the future, using an

growth rate, that a present amount will

produce

Key Formula 1

(1+r)N

r = rate N = number of periods

Future Value or FV

(1+r)N

r = 10% FV =?

1 1.1002 1.2103 1.3314 1.4645 1.611

N FV

Present ValueThe amount of money need today, using an

growth rate, to produce a future

amount

Key Formula 2

(1+r)N

r = rate N = number of periods

Present Value or PV1 Reciprocal

of the FV formula

(1+r)N

r = 10% N = 5PV =?

1 .9092 .8263 .7514 .6835 .621 3.791

N PV

1

Worth less and less due to time and risk

1 0.935

2 0.873

3 0.816

4 0.763

5 0.713

6 0.666

7 0.623

8 0.582

9 0.54410 0.508

7% discount

Insurance

Sharing risk

Does not eliminate riskSpread around risk

Risk Aversion

A dislike of uncertainty

Colonization for ProfitJoint Stock Companies to raise

financial capitalLots of small investors

Insurance Companies to cover losses

share the risk

Pool the Risk

ScenarioCost: 1000

Risk: 1 in 100 or 1%Expected cost =

cost x risk = 1000 x .01=10

Get 10 people to give 10

ScenarioExpected cost =10Total Cost = 1000

Get 100 people to give 10 each to fund the

account10 x 100 = 1000