Lecture No.14Chapter 4

Contemporary Engineering EconomicsCopyright © 2010

Contemporary Engineering Economics, 5th edition, © 2010

A. Investment BasicsThe three basic investment objects are: growth,

income, and liquidity.Liquidity – How accessible is your money?Risk – What is the safety involved?Return – How much profit will you be able to expect

from your investment?The two greatest risks investors face are inflation

and market volatility.

Contemporary Engineering Economics, 5th edition, © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Real Return 2%

Inflation 4%

Risk premium 0%

Total expected return

6%

Real Return 2%

Inflation 4%

Risk premium 20%

Total expected return

26%

Basic Concept - How to Determine Your Expected Return

Risk-free real return

InflationRisk

premium

U.S. Treasury Bills

An internet stock

Very safe

Very risky

Figuring Average Versus Compound Return

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0 1 2 3

5% 10% 12%

Average rate of return Compound Rate of Return

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Compound Versus Average Rate of Return

Investment Case 1 Case 2 Case 3 Case 4 Case 5 Case 6

Average return 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%

Balance at the end of year 3

$1,295 $1,294 $1,284 $1,270 $1,264 $1,224

Compound return 9.00% 8.96% 8.69% 8.29% 8.13% 6.96%

Annual Investment Yield (Base investment of $1,000)

Investment Case 1 Case 2 Case 3 Case 4 Case 5 Case 6

Year 1 9% 5% 0% 0% -1% -5%

Year 2 9% 10% 7% 0% -1% -8%

Year 3 9% 12% 20% 27% 29% 40%

Risk refers to the chance that some unfavorable event will occur.

Volatility measures the deviation from the expected value, or sudden swings in value—from high to low, or the reverse.

Standard deviation measures the degree of volatility when you have the probabilistic information about the uncertain event.

Beta measures how closely a fund’s performance correlates with broader stock market movement.

Alpha shows whether a fund is producing better or worse returns than expected, given the risk it takes.

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How to Determine Expected Financial Risk

B. Investment StrategiesTrade-Off between Risk and Reward

Cash: the least risky with the lowest returnsDebt: moderately risky with moderate returnsEquities: the most risky but offering the greatest payoff

Broader diversification reduces risk - by combining assets with different patterns of return, it is possible to achieve a higher rate of return without increasing significant risk.

Broader diversification increase expected returnPortfolios with long-term horizons need equities to offset

inflation while short time frames requires debt and/or cash investments to reduce volatility

Contemporary Engineering Economics, 5th edition, © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Broader Diversification Increases Return

Expected Value in 25 Years Option 1: Invest $10,000 in one asset category (say, bond with 7% interest ) Option 2: Invest $10,000 in five different classes of assets.

Contemporary Engineering Economics, 5th edition, © 2010

Option Amount Investment Expected Return

Value in 25 years

1 $10,000 Bond 7% $54,274

$2,000 Lottery tickets -100% $0

$2,000 Mattress 0% $2,000

2 $2,000 Term deposit (CD) 5% $6,773

$2,000 Corporate bond 10% $21.669

$2,000 Mutual fund (stocks)

15% $65,838

$96,280

C. Investing in StocksInvesting in stocks and bonds is one of the most

common investment activities among investors.Stocks: Ownership in a corporationOwnership: If a company issues 1M shares, and you buy

10,000 shares, you own a 10% of the company.Valuation: (1) cash dividend and (2) share appreciation at

the time of sale

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Conceptual Stock Valuation

Given: Stock price as of May 1 , 2010: $72/shareEarnings growth for next 5 years: 8%Expected cash dividend in 2010: $2.00/shareExpected stock price in 3 years: $95/shareRequired return on your investment: 10%

Find: Current value of stock

Valuation:

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$95

$2$2(1+0.08)

$2(1+0.08)2

0 1 2 3

D. Investing in BondBonds: Loans that investors

make to corporations and governments.

Face (par) value: Principal amount (typically $1,000 or $10,000)

Coupon rate: Nominal interest rate quoted on par value

Maturity: the length of the loan

Contemporary Engineering Economics, 5th edition, © 2010

Types of Bonds and How They are Issued in the Financial Market

Contemporary Engineering Economics, 5th edition, © 2010

How Do Prices and Yields Work?Yield to Maturity: The actual interest earned

from a bond over the holding period

Current Yield: The annual interest earned as a percentage of the current market price

Contemporary Engineering Economics, 5th edition, © 2010

Contemporary Engineering Economics, 5th edition, © 2010

AT&T 7s20 6.5% 5 million 108 1/4

Coupon rate of 7%

Maturity (2020)

Current yield

Trading volume

ClosingMarket price

$1,082.50$70/1082.5= 6.47%

Example 4.20 Yield to Maturity and Current Yield Given: Initial purchase price = $996.25, coupon rate = 9.625% per year paid semi-annually, and 10-year maturity with a par value of $1,000 Find: (a) Yield to maturity and (b) current yield Solution:(a) Yield to maturity

i = 4.8422% per semi-annual(b) Current yield

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Cash Flow Transaction Associated with Investing in Delta Corporate Bond

Bond Value Over TimeMr. Gonzalez wishes to sell a bond that has a face value of $1,000. The bond bears an interest rate of 8% with bond interests payable semiannually. Four years ago, $920 was paid for the bond. At least a 9% return (yield) in investment is desired. What must be the minimum selling price?

Solution:Semiannual interest payment = $40Required semiannual return = 4.5%Desired selling price of the bond (F):

Contemporary Engineering Economics, 5th edition, © 2010