Lecture No.14 Chapter 4 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010

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

Real Return2% Inflation4% Risk premium0% Total expected return 6% Real Return2% Inflation4% Risk premium20% Total expected return 26% Basic Concept - How to Determine Your Expected Return Risk-free real return Inflation Risk premium U.S. Treasury Bills An internet stock Very safe Very risky

Figuring Average Versus Compound Return Contemporary Engineering Economics, 5th edition, © %10% 12% Average rate of returnCompound Rate of Return

Contemporary Engineering Economics, 5th edition, © 2010 Compound Versus Average Rate of Return InvestmentCase 1Case 2Case 3Case 4Case 5 Case 6 Average return9.00% Balance at the end of year 3 $1,295$1,294$1,284$1,270$1,264$1,224 Compound return9.00%8.96%8.69%8.29%8.13%6.96% Annual Investment Yield (Base investment of $1,000) InvestmentCase 1Case 2Case 3Case 4Case 5 Case 6 Year 19%5%0% -1%-5% Year 29%10%7%0%-1%-8% Year 39%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. Contemporary Engineering Economics, 5th edition, © 2010 How to Determine Expected Financial Risk

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 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

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

C. Investing in Stocks Investing in stocks and bonds is one of the most common investment activities among 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 Stock Valuation  Given:  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 of stock Valuation: Contemporary Engineering Economics, 5th edition, © 2010 $95 $2 $2(1+0.08) $2(1+0.08)

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

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

Bond Quotes 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 Closing Market price $1, $70/ = 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 = % per semi-annual (b) Current yield Contemporary Engineering Economics, 5th edition, © 2010 Cash Flow Transaction Associated with Investing in Delta Corporate Bond

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? Solution: Semiannual interest payment = $40 Required semiannual return = 4.5% Desired selling price of the bond (F): Contemporary Engineering Economics, 5th edition, © 2010