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Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

Equivalence Analysis using


Effective Interest Rates
Continue Chapter 4

Debt Management

Debt Management

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

Example:
Amortized Loan
Given: P = $5,000, i = 12% APR, N = 24 months
Find: A
A = $5,000(A/P, 1%, 24) = $235.37

Loan Repayment Schedule

Calculating the Remaining Loan Balance


after Making the nth Payment

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

Example:
Computing the Outstanding Loan Balance after
making the 6th payment

Example

Consider the 7th payment ($235.37)


a)
b)

How much is the interest payment?


What is the amount of principal payment?

Solution
A $5, 000( A / P ,1% , 24)
$235.37

$5,000

i = 1% per month
1

22 23 24

A = $235.37

Interest payment = ?
Principal payment = ?

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

Solution:

Outstanding balance at the end of period 6:


(Note: 18 outstanding payments)
B6 $235.37(P/ A,1%,18) $3,859.66
Interest payment for period 7:
IP7 $3,859.66(0.01) $38.60
Principal payment for period 7:
PP7 $235.37$38.60 $196.77
Note: IP7 PP7 $235.37
10

Example:
Three Different Ways to Finance Your Vehicle
Option A
Debt Financing

Option B
Paying Cash

Option C
Lease Financing

Price

$32,508

$32,508

$32,508

Down payment

$4,500

APR (%)

5.65%

Monthly payment
Length

$736.53

$513.76

42 months

42 months

Fees

$994

Cash due at lease end

$395

Purchase option at lease end


Cash due at signing

$17,817
$4,500

$31,020

$1,507.76
11

Which Interest Rate to Use to Compare These


Options?

12

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

Your Earning Interest Rate = 4.5%

Option A: Conventional Debt Financing:


Pdebt = $4,500 + $736.53(P/A, 4.5%/12, 42)
- $17,817(P/F, 4.5%/12, 42)
= $17,847
Option B: Cash Financing:
Pcash = $31,020 - $17,817(P/F,4.5%/12,42)
= $15,845
Lease Financing:
Please = $1,507.76 + $513.76(P/A, 4.5%/12, 42)
+ $395(P/F, 4.5%/12, 42)
= $21,336

13

Investing in Financial Assets

14

A. Investment Basics

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?

15

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

How to Determine Your Expected Return


Real Return

2%

Inflation

4%

Risk premium

0%

Total expected
return

6%

Real Return

2%

U.S. Treasury Bills


Very safe
Risk-free
real return

Inflation

Risk
premium
Very risky
Google.com

Inflation

4%

Risk premium

20%

Total expected
return

26%

16

B. Investment Strategies

Trade-Off between Risk and Reward

Cash: the least risky with the lowest returns


Debt: moderately risky with moderate returns
Equities: the most risky but offering the
greatest payoff

Dollar-cost averaging concept


Broader diversification reduces risk
Broader diversification increase expected
return

20

Broader Diversification Increases Return


Amount

Investment

Expected Return

$2,000

Buying lottery tickets

$2,000

Under the mattress

0%

$2,000

Term deposit (CD)

5%

$2,000

Corporate bond

10%

$2,000

Mutual fund (stocks)

15%

-100% (?)

22

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

Expected Value in 25 Years


Option

Amount

$10,000

Bond

$2,000

Lottery tickets

$2,000

Mattress

$2,000

Term deposit (CD)

5%

$6,773

$2,000

Corporate bond

10%

$21.669

$2,000

Mutual fund
(stocks)

15%

$65,838

Investment

Expected
Return
7%
-100%
0%

Value in 25
years
$54,274
$0
$2,000

$96,280

23

C. Investing in Stocks

Stocks: Ownership in a corporation


Ownership: If a company issues 1M shares,
and you buy 10,000 shares, you own 10% of
the company.
Valuation: (1) cash dividend and (2) share
appreciation at the time of sale

24

Conceptual Stock Valuation


Exxon:
Given:
Stock price as of October 18, 2006: $72/share
Earnings growth for next 5 years: 8%
Expected cash dividend in 2007: $2.00/share
Expected stock price in 3 years: $95/share
Required return on your investment: 10%
Find: Current value of stock

$2
$2(1 0.08) $2(1 0.08)2 $95

(1 0.10) (1 0.10)2
(1 0.10)3
$76.73 $72, underpriced

25

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

What Are Your Odds?


Source: Newsweek, November 10, 1997

Your chance of making return on your


investment per year
If you hold
stocks for

Your chance
of losing
money

0-10%

10-20%

20+ %

1 year

26%

18%

20%

37%

3 years

14%

28%

39%

19%

5 years

10%

31%

49%

10%

10 years

4%

42%

53%

1%

20 years

37%

63%

26

D. Investing in Bond

Bonds: Loans that


investors make to
corporations and
governments.
Face (par) value:
Principal amount
Coupon rate: yearly
interest payment
Maturity: the length of the
loan
27

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

31

Presented by: Dr. Magdy Akladios

Chapter 4: Understanding Money & Its


Management-Part II

1/14/2013

Bond Value Over Time

Mr. 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?
36

Solution:

Semiannual interest payment = $40


Required semiannual return = 4.5%
Desired selling price of the bond (F):

920 = $40(P / A,4.5%,8) F(P / F,4.5%,8)


F $933.13

37

Summary

The three basic investment objects are: growth, income, and


liquidity.
The two greatest risks investors face are inflation and market
volatility.
Portfolios with long-term horizons need equities to offset
inflation while short time frames requires debt and/or cash
investments to reduce volatility
Dollar-cost averaging is a planned transfer, over a period, of
equal amounts from one assets to another.
Diversification by combining assets with different patterns of
return, it is possible to achieve a higher rate of return without
increasing significant risk.
Investing in stocks and bonds is one of the most common
investment activities among the American investors.
38

Presented by: Dr. Magdy Akladios