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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