How do Investors decide how much is enough? One thing is inflation. –If I put off buying my Dairy Queen Blizzard and you give me extra money but the price of a Dairy Queen Blizzard goes up - I can still only gratify myself with one Dairy Queen Blizzard. If the price of the Blizzard goes up more than the extra money I got - now I can’t even buy one Blizzard - Now I am PISS_ _ All investors need enough money to keep up with inflation.

What Else Does it Take If all I get is to keep up with inflation then in the end all I get is a Blizzard now or a Blizzard later I need extra buying power –This is called the “safe rate” –Free market economies have been paying people about the same amount extra for delayed gratification for hundreds of years (except the 90s)

The Woops Factor If you don’t take your money now - how do you really know I’m going to come up with the cash when you graduate? Delaying gratification means taking a risk that someone might not come through for you –What if you bought stock in a company that sells florescent carrots over the internet and then they were found to be radio-active?

How Risky? The riskier the investment, the more likely the company or government is to fail (anyone for Russian Treasury bonds?), the more likely the bank is to close the bigger the “Risk Premium”

The One Upmanship Factor Ever noticed how a gas station puts gas a penny cheaper than the station next door or the bank sets the interest rate a little higher than the next bank, or offers a cooler alarm clock if you deposit at their bank Many times investments are a dime a dozen –projects will often try to do a one upmanship to be just a little bit cooler than the next opportunity

Putting Together a Rate of Return Four components to a Rate of Return –Lets say inflation is 3.5% –The “safe rate” is 2% –This investment is real risky because their building a factory to make beef flavored sawdust patties for a new line of low calorie hamburgers at Wendy’s 30% –and.1% one upmanship premium

What is my Required Rate of Return or Cost of Capital? Lets see – = 35.6% –Right! Wrong - Sucker –(1.035)*(1.02)*(1.30)*(1.001) = –37.37% Why? –The 3.5% was needed just to keep the same buying power

Compounding I want a return on my delayed gratification - because I will need a $1.03 (and a half) next year to buy the same as a dollar now I want my delayed gratification payment on the same buying power –It compounds Because sawdust hamburger paddies sound pretty risky I might loose my money my keep up with inflation and my delayed gratification payment –I want a risk premium on everything I might loose

An aside about Rate of Return When we are trying to project the cash flow that we will get back from an investment sometimes we don’t know what the rate of inflation will be in 5 years –(If you do, Alan Greenspan has a job for you) We write down the cash flows as if there were no inflation –(ok we do that a lot in engineering economic analysis)

Unscrewing the Rate of Return Now I have a rate of return that tells how much I need for inflation and a cash flow with no inflation I fix the problem by dropping out the inflation factor from by ROR Thus we have two kinds of RORs –Real rate of return means both the cash flow and the ROR ignored inflation (even though its fake we call it real because it measures real buying power) –Nominal rate of return considers inflation in both the cash flow and the ROR If inflation is included in one and not the other - you screwed up