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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

## 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

## Calculating the Remaining Loan Balance

after Making the nth Payment

## Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

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

Example

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 = ?

## 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
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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

\$395

## Purchase option at lease end

Cash due at signing

\$17,817
\$4,500

\$31,020

\$1,507.76
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Options?

12

## Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

## 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

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## 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

## Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

Real Return

2%

Inflation

4%

0%

Total expected
return

6%

Real Return

2%

## U.S. Treasury Bills

Very safe
Risk-free
real return

Inflation

Risk
Very risky

Inflation

4%

20%

Total expected
return

26%

16

B. Investment Strategies

## Cash: the least risky with the lowest returns

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

return

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Amount

Investment

Expected Return

\$2,000

\$2,000

0%

\$2,000

5%

\$2,000

Corporate bond

10%

\$2,000

15%

-100% (?)

22

## Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

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

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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

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## 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

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## Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

Source: Newsweek, November 10, 1997

## Your chance of making return on your

investment per year
If you hold
stocks for

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%

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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
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## 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

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## Chapter 4: Understanding Money & Its

Management-Part II

1/14/2013

## 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):

F \$933.13

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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.
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