New Seating ChartFront of Room

Coach L’s Desk

Middle Aisle

MONEY MAKES MONEY. AND THE MONEY THAT MONEY MAKES MAKES MORE MONEY. — BENJAMIN FRANKLIN

CHAPTER 27 – THE BASIC TOOLS OF FINANCE

Finance – field that studies how people make decisions regarding the management of money or “funds” management and the handling of financial risk.

PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY

Future Value – amount of money in the future that an amount of money today will yield, given prevailing interest rates $100 today is equal to $103 in a year at

3% prevailing interest rates Present Value – the present discounted value,

current worth of money today of a future payment 100 dollars in a year is equal to $97 today

if interest rates in the market are currently 3%

PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY

Simple Interest - calculated only on the principal amount Formula for Simple Interest = P x R x T P =Principal R = Interest rate T = Time

Compounding – ability of an asset to generate earnings on interest, which can then generate their own earnings Both principal and Interest earn interest “The most powerful force in the universe is

compound interest” Albert Einstein

Formula FV = P (1 + r) P = Principal Number of times compounded = n Interest Rate = r

n

DETERMINING FUTURE VALUES APPLICATION

Determine the future value of $1000, using simple interest and compounding interest and the following information: Principal - $1000.00 Interest – 20% 10 years

FV = $1000 x .20 x 10 = $2000 (interest) Value of the asset $2000 + $1000 = $3000

FV = $1000 (1 + .20) = $6,191.74 $5,191.74 interest

10

SIMPLE VS. COMPOUNDING INTEREST

SIMPLE AND COMPOUNDING INTEREST PRACTICE

1. $1000 x .15 x 9 = $13502. $400 x .03 x 2 = $243. $1250 x .05 x 4 = $2504. $1400 x .09 x .5 = $635. $300 x .25 x 8 = $6006. $600(1.04)^10 = $888.157. $750(1.19)^13 = $7197.348. $100 (1.10)^10 = $259.379. $250 (1.04)^4 = $292.4610. $4250 (1.05)^3 = $4919.91

The coupon is the regular payment made to the holder of a bond.A bond's yield = annual coupon amount / price paid for the bond.The bond's yield is essentially the interest rate that is paid for borrowing money, because bonds are just loans.Note that the bond's price is in the denominator of the above equation.If I buy a 10 yr bond for $1000, and receive a coupon of $100, then the bond has a 10% yield (what a deal!).However, let's say that interest rates in general rise over the next few years. Also, let's say that I decide that I need cash to buy a motorcycle, and want to sell my bond prior to maturity, in year 5. Krugman, the potential buyer of my bond, will not pay $1,000 for it, because he wants a yield more in line with the prevailing, higher rates.So I sell the bond to Krugman for $900. This gives him a yield of $100/$900, or 11%.Note that when the bond price fell, the yield rose, and that this occurred as a result of interest rates in general rising. Hence bond prices and interest rates are inversely related.

TAKE THE LUMP SUM OR FUTURE PAYMENTS?

You just won $1,000,000 in a lottery to be paid over 10 years. You are told you can collect a lump sum payment $510,000 of today. What do you do?

Assuming prevailing interest rates will average 7% on financial investments would you take the lump sum or the annual payments?

PRESENT VALUE OF A FUTURE PAYMENTDiscounting – process of finding a

present value of a future sum of moneyFormula

PV = X/(1 + r) X – amount to be received in N years

(future value)Determine the present value of $200 in

10 years at 5% + 8% interest rates respectively

$200/(1.05) = $123$200/(1.08) = $93

n

10

10

TAKE THE LUMP SUM OR FUTURE PAYMENTS?

You just won $1,000,000 in a lottery. You are told you can collect a lump sum payment $510,000 of today. What do you do? Assuming a 7% average real interest rate on investment returns.Formula

PV = X/(1 + r) n

• 1,000,000/(1 + .07) 10

• PV = 508349.29

• We should take the $510,000 today instead of $1,000,000 over 10 years because you have a gain of $1611.59

DISCOUNTING PRACTICE1. $1,000,000 /(1.10) = $15,091.132. $20,000/(1.08) = $15,876.64

443

Years in the Future 2 Percent 8 Percent 20 Percent

1

2

3

4

10

20

30

$98.0496.12

94.23

92.38

82.03

67.30

55.21

92.59

85.73

79.38

73.50

46.32

21.45

9.94

83.33

69.44

57.87

48.23

16.15

2.61

.42

DETERMINING THE PRESENT VALUE

Year Expected Future Income Received at Year-End

Present Value of Future Income Payment

1 $12,000

2 12,000

3 12,000

4 12,000

Total -

Suppose you are in the business of truck rentals. You are contemplating the purchase of a new $40,000 truck. Past experience indicates that after figuring in the truck’s operational and maintenance expenses, you can rent it out for net revenue of $12,000 (received at the end of each year. You will be able to do this every year for four years (the expected life of the vehicle). The current prevailing real interest rate is 8% so you will use this when discounting the future expected income. Illustrate in the table below how much $12,000 is worth at year-end for each of the next four years, in present value. Then determine if the project should be undertaken.

$11,111.11

10,288.07

9,525.99

8,820.36

$39,745.53

CHAPTER 27 PRACTICEa.

Year 1 $40,000/1.12 = $35,714.29

Year 2 $40,000/(1.12)^2 = $31,887.76

Year 3 $40,000/(1.12)^3 = $28,471.21

b. No, the cost is $100,000 but the present value of the return is only $96,073.26

c.

Year 1 $40,000/1.07 = 37383.18

Year 2 $40,000/(1.07)2 = 34937.55

Year 3 40,000/(1.07)3 = 32,651.92

d. Yes. Although the cost is still $100,000, the present value of the returns is now the sum of $104,972.65.

MANAGING RISK Risk aversion – is a dislike of uncertainty; dislike “bad things” more than

comparable “good things” In finance, risk averse people will invest in less risky financial instruments It is more likely a person with more wealth will have less risk aversion,

person with less wealth will have more

THE TRADE-OFF BETWEEN RISK AND RETURN Risk-return trade-off –

potential return rises with an increase in risk Low risk, low return (bonds,

savings accounts, etc.)High risk, high potential

returns (stocks, real estate, etc.)

Stocks vs. BondsOver past 200 years,

stocks returned an avg. 8% Bonds averaged 3%

RISK AVERSION AND THE FINANCIAL MARKETS Diversification – reduce risk by replacing a single risk with a large

number of smaller, unrelated risks “Don’t put all of your eggs in one basket.” Can eliminate firm-specific risk Cannot eliminate market risk

Firm-specific risk – uncertainty associated with investing in a single company

Market risk – uncertainty associated with entire stock market

EFFICIENT MARKET HYPOTHESIS The efficient markets hypothesis - stock prices are what they should be at any

given time based on supply and demand “Markets work” Stocks reflect all publicly available information about the value of an asset It is therefore impossible to beat the market because stocks are never under

or overvalued

SPECULATIVE BUBBLES Speculative Bubble – whenever the price of an asset

rises above what the typical value of the asset is. Values are highly inflationary Experience major price corrections when they “Pop” Tulipmania, Tulip Bulb Bubble –

1634-1637, one of the first ever bubbles Dot-com (Internet) Bubble – 1997 - 2000 Real Estate Bubble – 2000 - 2005

SPECULATIVE BUBBLES Comic Book Bubble – 1985 – 1993 Student Loan/Education Bubble

– 1995 to current

http://www.npr.org/blogs/money/2013/04/23/178612386/has-the-cupcake-bubble-finally-popped

TULIP BULB BUBBLE

REAL ESTATE BUBBLE

EDUCATION BUBBLE

DOT-COM BUBBLE

CHINA’S SPECULATIVE BUBBLE

http://www.youtube.com/watch?v=ei0FpwI1dqg

How Does Insurance Work?

Accident = $5000 Accident = $4500

Pool of People Pool of MoneyAuto Insurance

Deductible = $500

THE MARKETS FOR INSURANCE One way to deal with risk is to buy insurance

Person facing a risk pays a fee to an insurance company to absorb all or part of risk

Auto, fire, health, dental, annuity, flood, etc. Insurance is a gamble

You may not face the risk (may never be in a car accident, get sick, house flood, etc.)

Pay the insurance premium to receive peace of mind

WHAT IS INSURANCE VIDEO?

http://www.youtube.com/watch?v=nXfGeMNnBsM&list=PL968B2B122D16DFEE&index=13&feature=plpp_video

http://www.youtube.com/watch?v=3WnS96NVlMI&list=PL968B2B122D16DFEE&index=14

Role of insurance Not to eliminate the risks, but to spread the risks around more

efficiently Two problems with the markets for insurance:

Adverse selection – a high-risk person is more likely to apply for insurance than a low-risk person

Moral hazard – after people buy insurance they have less incentive to be careful

Price of Insurance is reflective of the risk of the individual and market Auto insurance in SFLA is higher than in SGA

THE MARKETS FOR INSURANCE

- Answer each of the following by showing your work or providing a response

1. Eric received a $2,000 bonus from his employer. He deposited the entire amount in a one-year certificate of deposit with a simple interest rate of 5%. When the CD matured, how much interest had Eric earned?

2. 20-year-old Britney makes a one-time $5,000 contribution to her Roth IRA and earns an average 8%, compounded annually for 45 years. What is the future value of her investment?

3. How much would it cost her if she waited until she was 25 to make the same investment (compounding only for 40 years).

4. An investor purchases a 20-year municipal bond with a face amount of $20,000. When the bond matures, the investor receives the full, face amount, $20,000. The compounded interest, is 5.5%. How much did they have to pay in present value for the bond?

5. Why is $100 dollars today worth more than $100 dollars 5 years from now?

6. Jorge is considering two investments; purchasing a home for $250,000 or investing in U.S. Treasury Bonds. The speculative rate of return on a home in 5 years is 14%, but there has been volatility in the housing industry of late. The fixed rate of interest is on a 5 year bond is 5%. If Jorge tends to be risk averse, which of the aforementioned investments is he likely to put his money towards? Explain your answer.

CHAPTER 27 ONLINE QUIZ

$2000x.05x1 = $100.00

$5000(1+.08)^45 = $159,602.28

FV = $5000(1+.08)^40 = $108,622.61 Cost = 50,979.67

$20000/(1+.055)^20 = $6854.58

n

n

FV = PV (1 + r)

PV = X/(1 + r)

Time value of money, you can invest and earn interest

nFV = PV (1 + r)

Interest = PxRxT

Bond, with a 5% fixed interest rate. The risk in the housing market deters him frommaking this type of investment, vs. a safe investment in the bond market

CHAPTER 27 – BINDER CHECK1. The Crash of 19932. Notes Chapter 27 3. Daily Tens 4. Terms

CHAPTER 27 PRACTICE

12. e. 70/2 = 35 years.f. 8000

g. 70/1 = 70 years.

h. 4,000

i. Fastcountry adds $2,000 to its GDP/person in the first 35 years. Growing at the same percent, it adds $4,000 to its GDP over the next 35 years because the same growth rate is now applied to a larger base.

j. Another 70 years.

CHAPTER 27 PRACTICE

13. k. Moral hazard, because after she obtained the insurance, she is less careful with her health.

l. Adverse selection, because after he knows that his probability of death is higher than average, he seeks life insurance.

m. Moral hazard, because after she obtains the insurance, she becomes less careful with fire.

CHAPTER 27 PRACTICE

14. n. No. She dislikes bad food more than she likes good food.

o. Rachel is risk averse because she exhibits

diminishing marginal utility of wealth (she dislikes spending, say, $30 on a meal she is likes more than she enjoys spending $30 on a meal she loves.)

p. She can diversify her risk at a buffet – she does not "put all of her eggs in one basket" at a buffet. This reduces her standard deviation of meals because her meals are always adequate but never terrible or great. A buffet is like an investment fund of food.

EXTRA CREDIT1. Do you tend to be risk averse? Give an example to support your answer.

2. Baseball, Inc can purchase batting cages today for $40,000. They will earn a $15,000 return on the rafts at the end of each of the next three years. If the interest rate were 4 percent, what is the present value of each of the future

returns that Baseball, Inc expects to receive? Year 1 ______________________________________________________ Year 2 ______________________________________________________ Year 3 ______________________________________________________ Total ______________________________________________________ If the interest rate were 12 percent, should Baseball, Inc invest in the batting

cages? Explain.