A truck has a useful life of 5 years.

Maintenance cost s during the first year is

$1000. Maintenance cost s expected to
increase at a rate of $250 per year over
the remaining life. Maintenance account
earns 12% annual interest. How much
does the firm have to deposit in the
account now?

Step
2

Step
1

A young engineer deposits an annual bonus

into a savings accounts that pays 7% interest
compounded annually. The size of the
bonuses increases by $2500 each year, and
the initial bonus amount was $12,000.
Determine how much will be in the account
immediately after the fifth deposit.

Linear gradient series future worth factor

(F/G,i,N)

P = A1 (F/A,7%,5) + G(P/G,7%,5)(F/P,7%,5)
12,000(5.7507)+2500(7.6467)(1.4026)

Airplane ticket price will increase 8% in

each of the next four years. The cost at
the end of the first year will be $180.
How much should be put away now to
cover a students travel home at the end
of each year for the next four years? Use
an interest rate of 5% per year.

Geometric gradient series present worth

factor (P/A,g,i,N)

1 (1 g ) n (1 i ) n
P A
ig

1 (1.08) 4 (1.05) 4
180
.05 .08

0.11928
180
$715.67
0.03

Engineers at Sea World have completed an innovation

on an existing water sports with a modifications costs
only $80000 and is expected to last 6 years with a
$13000 salvage value. The maintenance cost is
expected to be high at $17000 the first year, increasing
by 11% per year thereafter. Determine the equivalent
resent worth of the modification and maintenance cost.
Use the interest rate of 5% per year.
Geometric gradient series present worth factor
Pg = (P/A,g,i,N).
Pt = -80000 Pg + 1300(P/F,8%,6)
= - 80000 17000 [1-(1.11/1.08)6]/[0.08-0.11] +1300(P/F,0.08,6)
= -80000 17,000(5.9559) + 81926 = 173,058

Ah Long the loan shark lends money on the

following terms.
Yo, If gua gib you 50 dolla on Wednesday,
den lu guys owes me 60 dolla da following
Wednesday.
int. rate
= 20%rate,
a week
1. Nominal
What is the
effective
ia ? x 52
weeks =1040% per year
Effective interest rate =(1+r/m)m
i = (1+10.4/52)52 = 13104 or
1,310,400%

Suppose Ah long can keep the $50, as well as all

the money he receives in payments, out in loans
at all times? How much would Ah Long have at
the end
the year?
n
F = of
P(1+i)
to get F = 50(1.2)52
$655,232
Not bad but probably illegal

Ah Long the loan shark lends money on the

following terms.
Yo, If gua gib you 50 dolla on Wednesday,
den lu guys owes me 60 dolla da following
Wednesday.
1. What is the effective rate, ia ?

Suppose Ah long can keep the $50, as well as all

the money he receives in payments, out in loans
at all times? How much would Ah Long have at
the end of the year?

A lender requires that monthly mortgage

payments be no more than 25% of gross
monthly income with a maximum term of 30
yrs. If you can make 20% down payment,
what is the minimum monthly income
needed to purchase a $325,000 link house
when the interest rate is 6% compounded
monthly.
$325,000 65000 = $260,000
260000(A/P, 0.50%,360)
260000(0.0060) = 1560
1560/0.25 = $6,240

Investing in Financial Assets

Lecture No.11b

Ekonomi, Kewangan, & Jurutera

Kxex2162

A. Investment Basics
The 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

Basic Concept - How to

Determine Your Expected
Return U.S. Treasury BillsReal Return
Risk-free
real return

Very safe

Risk
Inflation premium
Very risky
An internet stock

2%

Inflation

4%

Risk premium

0%

Total expected
return

6%

Real Return

2%

Inflation

4%

Risk premium

20
%

Total expected
return

26
%

Contemporary Engineering Economics, 5th edition, 2010

Figuring Average Versus

Compound Return
5%

12%

10%

Average rate of return Compound Rate of Return

Contemporary Engineering Economics, 5th edition, 2010

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%

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%

Contemporary Engineering Economics, 5th edition, 2010

How to Determine Expected

Financial Risk
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 funds

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. Contemporary Engineering Economics, 5th edition, 2010

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 - a planned transfer,

over a period, of equal amounts from one asset to

another.
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 return
Portfolios 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

Dollar-Cost Averaging
Concept
Amount
Invested

Fund
Unit Price

No. of
Units
Purchased

Ending
Fund
Balance

Month 1

$1,000

$5.00

200

$1,000

Month 2

$1,000

$4.00

250

$1,800

Month 3

$1,000

$2.50

400

$2,125

Month 4

$1,000

$3.75

267

$4,189

Month 5

$1,000

$5.00

200

$6,585

Totals

$5,000

Timing

1,317

Contemporary Engineering Economics, 5th edition, 2010

Broader Diversification
Increases Return
Amount

Investment

$2,000

Buying lottery
tickets
Under the
mattress
Term deposit
(CD)
Corporate
bond
Mutual fund
(stocks)

$2,000
$2,000
$2,000
$2,000

Contemporary Engineering Economics, 5th edition, 2010

Expected
Return
-100% (?)
0%
5%
10%
15%

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

C. Investing in Stocks
Investing in stocks and bonds is one of

the most common investment activities

among the American investors.
Stocks: Ownership in a corporation
Ownership: 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

Contemporary Engineering Economics, 5th edition, 2010

Conceptual
Given:
Stock
Valuation

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

Find: Current value

Valuation:

$95

$2

$2

$2

of stock

Contemporary Engineering Economics, 5th edition, 2010

D. Investing in Bond
Bonds: 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

Bond Price Notation Used in

Financial Markets
Corporate Bonds

Treasury Bonds

1/8=$1.25

5/8=$6.25

1/32=$0.3125
2/32=$0.6250
3/32=$0.9375
4/32=$1.25

17/32=$5.3125
18/32=$5.6250
19/32=$5.9375
20/32=$6.25

1/4=$2.50

3/4=$7.50

6/32=$1.5625
7/32=$1.8750
7/32=$2.1875
8/32=$2.50

21/32=$6.5625
22/32=$6.8750
23/32=$7.1875
24/32=$7.50

9/32=$2.8125
10/32=$3.1250
11/32=$3.4375
12/32=$3.75

25/32=$7.8125
26/32=$8.1250
27/32=$8.4375
28/32=$8.75

13/32=$4.0625
14/32=$4.375
15/32=$4.6875
16/32=$5.00

29/32=$9.0625
30/32=$9.3750
31/32=$9.6875
32/32=$10

3/8=$3.75

1/8=$5.00

1=$10

Contemporary Engineering Economics, 5th edition, 2010

How To Read a Bond Notation

No meaning,
Spacing

Maturity date
2020

AT&T 7s20
Closing price: 108 1/4
$1,082.50

Contemporary Engineering Economics, 5th edition, 2010

Coupon rate

How Do Prices and Yields Work?

Yield to Maturity: The actual

interest earned from a bond over

the holding period
P = A(P/A,i , n) +P(P/F,i, n)
Current Yield: The annual interest
earned as a percentage of the
current market price
Nominal current Yield = A/P
i = (1 + A)n
Contemporary Engineering Economics, 5th edition, 2010

Bond Quotes
Maturity (2020)

AT&T 7s20

Trading volume

6.5%

5 million 108 1/4

Coupon rate of 7%
Current yield
$70/108.25
= 6.47%
Contemporary Engineering Economics, 5th edition, 2010

Closing
Market price
$1,082.50

Example 4.20 Yield

to Maturity and
Current Yield
Cash Flow Transaction Associated

with Investing in Delta Corporate

Bond
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
Contemporary Engineering Economics, 5th edition, 2010

Mr. Gonzalez

wishes to sell a
bond that has a
Bond
Value
face value
of
$1,000.Time
The bond
Over
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 = $40
Required semiannual
return = 4.5%
Desired selling price of the
bond (F):

Contemporary Engineering Economics, 5th edition, 2010