34 Financial Economics McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Investment Economic investment New additions or replacements to the capital stock Financial investment Broader than economic investment Buying or building an asset for financial gain New or old asset Financial or real asset LO1 34-2

Present Value Present day value of future returns or costs Compound interest Earn interest on the interest X dollars today=(1+i) t X dollars in t years $100 today at 8% is worth: $108 in one year $ in two years $ in three years LO1 34-3

Present Value Model Calculate what you should pay for an asset today Asset yields future payments Assets price should equal total present value of future payments The formula: dollars today = X dollars in t years X ( 1 + i) t LO1 34-4

Applications Take the money and run Lottery jackpot paid over a number of years Calculating the lump sum value Salary caps and deferred compensation Calculating the value of deferred salary payments LO1 34-5

Popular Investments Wide variety available to investors Three features Must pay to acquire Chance to receive future payment Some risk in future payments LO2 34-6

LO2 StocksBonds Represents ownership in a company Bankruptcy possible Limited liability rule Capital gains Dividends Debt contracts issued by government and corporations Possibility of default Investor receives interest Popular Investments 34-7

Mutual Funds Company that maintains a portfolio of either stocks or bonds Currently more than 8,000 mutual funds Index funds Actively managed funds Passively managed funds LO2 34-8

Calculating Investment Returns Gain or loss stated as percentage rate of return Difference between selling price and purchase price divided by purchase price Future series of payments also considered into return Rate of return inversely related to price LO2 34-9

Arbitrage Buying and selling process to equalize average expected returns Sell asset with low return and buy asset with higher return at same time Both assets will eventually have same rate of return LO

Risk Future payments are uncertain Diversification Diversifiable risk Specific to a given investment Nondiversifiable risk Business cycle effects Comparing risky investments Average expected rate of return Beta LO

Risk Risk and average expected rates of return Positively related The risk-free rate of return Short-term U.S. government bonds Greater than zero Time preference Risk-free interest rate LO

The Security Market Line Average expected rate of return = Rate that compensates for time preference + Rate that compensates for risk Compensate investors for: Time preference Nondiversifiable risk Average expected rate of return = i f + risk premium LO

The Security Market Line LO4 Security Market Line Market Portfolio i f Average expected rate of return Risk Level (beta) Compensation for Time Preference Equals i f Risk Premium for the Market Portfolios Risk Level of beta =1.0 A Risk-Free Asset (i.e., a short-term U.S. Government bond) 34-14

The Security Market Line Risk levels determine average expected rates of return LO4 Security Market Line i f Average expected rate of return Risk Level (beta) 0 X Compensation for Time-Preference Equals i f Risk Premium for this Assets Risk Level of beta = X Y 34-15

The Security Market Line Security Market Line Average expected rate of return Risk Level (beta) 0 X Arbitrage and the security market Y A B C LO

The Security Market Line SML 1 Average expected rate of return Risk Level (beta) 0 X An increase in the risk-free rate A Before Increase A After Increase SML 2 Y1Y1 LO5 Y2Y