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Chapter 2

The Two Key Concepts in Finance
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Its what we learn after we think we know it
all that counts.

- Kin Hubbard
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Outline
Introduction
Time value of money
Safe dollars and risky dollars
Relationship between risk and return
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Introduction
The occasional reading of basic material in
your chosen field is an excellent
philosophical exercise
Do not be tempted to include that you know it
all
E.g., what is the present value of a growing
perpetuity that begins payments in five years
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Time Value of Money
Introduction
Present and future values
Present and future value factors
Compounding
Growing income streams
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Introduction
Time has a value
If we owe, we would prefer to pay money later
If we are owed, we would prefer to receive
money sooner
The longer the term of a single-payment loan,
the higher the amount the borrower must repay
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Present and Future Values
Basic time value of money relationships:

1/(1 )
(1 )
t
t
PV FV DF
FV PV CF
where PV = present value;
FV = future value;
DF = discount factor = R
CF = compounding factor = R
R = interest rate per perio
=
=
+
+
d; and
t = time in periods
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Present and Future Values
(contd)
A present value is the discounted value of
one or more future cash flows
A future value is the compounded value of
a present value
The discount factor is the present value of a
dollar invested in the future
The compounding factor is the future value
of a dollar invested today

9
Present and Future Values
(contd)
Why is a dollar today worth more than a
dollar tomorrow?
The discount factor:
Decreases as time increases
The farther away a cash flow is, the more we discount it
Decreases as interest rates increase
When interest rates are high, a dollar today is worth much
more than that same dollar will be in the future
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Present and Future Values
(contd)
Situations:
Know the future value and the discount factor
Like solving for the theoretical price of a bond
Know the future value and present value
Like finding the yield to maturity on a bond
Know the present value and the discount rate
Like solving for an account balance in the future

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Present and Future Value
Factors
Single sum factors
How we get present and future value tables
Ordinary annuities and annuities due
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Single Sum Factors
Present value interest factor and future
value interest factor:

where
1
(1 )
(1 )
t
t
PV FV PVIF
FV PV FVIF
PVIF
R
FVIF R
=
=
=
+
= +
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Single Sum Factors (contd)
Example

You just invested $2,000 in a three-year bank certificate
of deposit (CD) with a 9 percent interest rate.

How much will you receive at maturity?






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Single Sum Factors (contd)
Example (contd)

Solution: Solve for the future value:






3
$2, 000 1.09
$2, 000 1.2950
$2, 590
FV =
=
=
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How We Get Present and
Future Value Tables
Standard time value of money tables present
factors for:
Present value of a single sum
Present value of an annuity
Future value of a single sum
Future value of an annuity
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How We Get Present and
Future Value Tables (contd)
Relationships:
You can use the present value of a single sum
to obtain:
The present value of an annuity factor (a running
total of the single sum factors)

The future value of a single sum factor (the inverse
of the present value of a single sum factor)
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Ordinary Annuities
and Annuities Due
An annuity is a series of payments at equal
time intervals

An ordinary annuity assumes the first
payment occurs at the end of the first year

An annuity due assumes the first payment
occurs at the beginning of the first year
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Ordinary Annuities
and Annuities Due (contd)
Example

You have just won the lottery! You will receive $1 million
in ten installments of $100,000 each. You think you can
invest the $1 million at an 8 percent interest rate.

What is the present value of the $1 million if the first
$100,000 payment occurs one year from today? What is
the present value if the first payment occurs today?






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Ordinary Annuities
and Annuities Due (contd)
Example (contd)

Solution: These questions treat the cash flows as an
ordinary annuity and an annuity due, respectively:








of ordinary annuity $100, 000 6.7100 $671, 000
of annuity due $100, 000 ($100, 000 6.2468) $724, 680
PV
PV
= =
= + =
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Compounding
Definition
Discrete versus continuous intervals
Nominal versus effective yields
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Definition
Compounding refers to the frequency with
which interest is computed and added to the
principal balance
The more frequent the compounding, the higher
the interest earned
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Discrete Versus
Continuous Intervals
Discrete compounding means we can count the
number of compounding periods per year
E.g., once a year, twice a year, quarterly, monthly, or
daily

Continuous compounding results when there is
an infinite number of compounding periods
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Discrete Versus
Continuous Intervals (contd)
Mathematical adjustment for discrete
compounding:

(1 / )
annual interest rate
number of compounding periods per year
time in years
mt
FV PV R m
R
m
t
= +
=
=
=
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Discrete Versus
Continuous Intervals (contd)
Mathematical equation for continuous
compounding:

2.71828
Rt
FV PVe
e
=
=
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Discrete Versus
Continuous Intervals (contd)
Example

Your bank pays you 3 percent per year on your savings
account. You just deposited $100.00 in your savings
account.

What is the future value of the $100.00 in one year if
interest is compounded quarterly? If interest is
compounded continuously?






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Discrete Versus
Continuous Intervals (contd)
Example (contd)

Solution: For quarterly compounding:







4
(1 / )
$100.00(1 0.03/ 4)
$103.03
mt
FV PV R m = +
= +
=
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Discrete Versus
Continuous Intervals (contd)
Example (contd)

Solution (contd): For continuous compounding:







0.03
$100.00
$103.05
Rt
FV PVe
e
=
=
=
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Nominal Versus
Effective Yields
The stated rate of interest is the simple rate
or nominal rate
3.00% in the example
The interest rate that relates present and
future values is the effective rate
$3.03/$100 = 3.03% for quarterly compounding
$3.05/$100 = 3.05% for continuous
compounding
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Growing Income Streams
Definition
Growing annuity
Growing perpetuity
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Definition
A growing stream is one in which each
successive cash flow is larger than the
previous one
A common problem is one in which the cash
flows grow by some fixed percentage
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Growing Annuity
A growing annuity is an annuity in which
the cash flows grow at a constant rate g:

2
2 3 1
1
(1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
1
1
1
n
n
N
C C g C g C g
PV
R R R R
C g
R g R
+
+ + +
= + + + +
+ + + +
(
+
| |
=
(
|
+
\ .
(

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Growing Perpetuity
A growing perpetuity is an annuity where
the cash flows continue indefinitely:

2
2 3
1
1
1
(1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
(1 )
(1 )
t
t
t
t
C C g C g C g
PV
R R R R
C g C
R R g

=
+ + +
= + + + +
+ + + +
+
= =
+

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Safe Dollars and Risky Dollars
Introduction
Choosing among risky alternatives
Defining risk
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Introduction
A safe dollar is worth more than a risky
dollar
Investing in the stock market is exchanging
bird-in-the-hand safe dollars for a chance at a
higher number of dollars in the future
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Introduction (contd)
Most investors are risk averse
People will take a risk only if they expect to be
adequately rewarded for taking it

People have different degrees of risk
aversion
Some people are more willing to take a chance
than others
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Choosing Among
Risky Alternatives
Example

You have won the right to spin a lottery wheel one time.
The wheel contains numbers 1 through 100, and a pointer
selects one number when the wheel stops. The payoff
alternatives are on the next slide.

Which alternative would you choose?






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Choosing Among
Risky Alternatives (contd)

A

B

C

D
[1-50] $110 [1-50] $200 [1-90] $50 [1-99] $1,000
[51-100] $90 [51-100] $0 [91-100] $500 [100] -$89,000
Avg.
payoff

$100

$100

$100

$100
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Choosing Among
Risky Alternatives (contd)
Example (contd)
Solution:
Most people would think Choice A is safe.
Choice B has an opportunity cost of $90 relative
to Choice A.
People who get utility from playing a game pick
Choice C.
People who cannot tolerate the chance of any
loss would avoid Choice D.

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Choosing Among
Risky Alternatives (contd)
Example (contd)

Solution (contd):
Choice A is like buying shares of a utility stock.
Choice B is like purchasing a stock option.
Choice C is like a convertible bond.
Choice D is like writing out-of-the-money call
options.

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Defining Risk
Risk versus uncertainty
Dispersion and chance of loss
Types of risk
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Risk Versus Uncertainty
Uncertainty involves a doubtful outcome
What you will get for your birthday
If a particular horse will win at the track

Risk involves the chance of loss
If a particular horse will win at the track if you
made a bet
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Dispersion and Chance of Loss
There are two material factors we use in
judging risk:
The average outcome

The scattering of the other possibilities around
the average
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Dispersion and Chance of Loss
(contd)
Investment A
Investment B
Time
Investment value
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Dispersion and Chance of Loss
(contd)
Investments A and B have the same
arithmetic mean

Investment B is riskier than Investment A
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Types of Risk
Total risk refers to the overall variability of
the returns of financial assets

Undiversifiable risk is risk that must be
borne by virtue of being in the market
Arises from systematic factors that affect all
securities of a particular type
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Types of Risk (contd)
Diversifiable risk can be removed by proper
portfolio diversification
The ups and down of individual securities due
to company-specific events will cancel each
other out
The only return variability that remains will be
due to economic events affecting all stocks

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Relationship Between Risk and
Return
Direct relationship
Concept of utility
Diminishing marginal utility of money
St. Petersburg paradox
Fair bets
The consumption decision
Other considerations
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Direct Relationship
The more risk someone bears, the higher the
expected return
The appropriate discount rate depends on
the risk level of the investment
The risk-less rate of interest can be earned
without bearing any risk
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Direct Relationship (contd)
Risk
Expected return
R
f
0
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Direct Relationship (contd)
The expected return is the weighted
average of all possible returns
The weights reflect the relative likelihood of
each possible return

The risk is undiversifiable risk
A person is not rewarded for bearing risk that
could have been diversified away

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Concept of Utility
Utility measures the satisfaction people get
out of something
Different individuals get different amounts of
utility from the same source
Casino gambling
Pizza parties
CDs
Etc.
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Diminishing Marginal
Utility of Money
Rational people prefer more money to less
Money provides utility

Diminishing marginal utility of money
The relationship between more money and added
utility is not linear

I hate to lose more than I like to win
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Diminishing Marginal
Utility of Money (contd)
$
Utility
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St. Petersburg Paradox
Assume the following game:
A coin is flipped until a head appears
The payoff is based on the number of tails
observed (n) before the first head
The payoff is calculated as $2
n

What is the expected payoff?
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St. Petersburg Paradox
(contd)
Number of Tails
Before First
Head


Probability


Payoff

Probability
x Payoff
0 (1/2)1 = 1/2 $1 $0.50
1 (1/2)
2
= 1/4 $2 $0.50
2 (1/2)
3
= 1/8 $4 $0.50
3 (1/2)
4
= 1/16 $8 $0.50
4 (1/2)
5
= 1/32 $16 $0.50
n (1/2)
n + 1
$2
n
$0.50
Total 1.00
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St. Petersburg Paradox
(contd)
In the limit, the expected payoff is infinite

How much would you be willing to play the
game?
Most people would only pay a couple of dollars
The marginal utility for each additional $0.50
declines
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Fair Bets
A fair bet is a lottery in which the expected
payoff is equal to the cost of playing
E.g., matching quarters
E.g., matching serial numbers on $100 bills

Most people will not take a fair bet unless
the dollar amount involved is small
Utility lost is greater than utility gained
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The Consumption Decision
The consumption decision is the choice to
save or to borrow
If interest rates are high, we are inclined to save
E.g., open a new savings account

If interest rates are low, borrowing looks
attractive
E.g., a higher home mortgage
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The Consumption
Decision (contd)
The equilibrium interest rate causes savers
to deposit a sufficient amount of money to
satisfy the borrowing needs of the economy
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Other Considerations
Psychic return
Price risk versus convenience risk
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Psychic Return
Psychic return comes from an individual
disposition about something
People get utility from more expensive things,
even if the quality is not higher than cheaper
alternatives
E.g., Rolex watches, designer jeans
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Price Risk Versus
Convenience Risk
Price risk refers to the possibility of adverse
changes in the value of an investment due to:
A change in market conditions
A change in the financial situation
A change in public attitude

E.g., rising interest rates and stock prices, a
change in the price of gold and the value of the
dollar
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Price Risk Versus
Convenience Risk (contd)
Convenience risk refers to a loss of
managerial time rather than a loss of dollars
E.g., a bonds call provision
Allows the issuer to call in the debt early, meaning
the investor has to look for other investments