Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Investing in Financial Assets Lecture No. 14 Chapter 4 Contemporary Engineering Economics Copyright © 2016

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved A. Investment Basics The three basic investment objects are: growth, income, and liquidity. Liquidity: How accessible is your money? Risk: How much risk is 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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 A start-up company Very safe Very risky

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Figuring Average versus Compound Return %10% 12% Average rate of returnCompound Rate of Return

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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%

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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. How to Determine Expected Financial Risk

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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: 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 increases 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Dollar-Cost Averaging Concept Timing Amount Invested Fund Unit Price No. of Units Purchased Ending Fund Balance Month 1 $1,000$ $1,000 Month 2 $1,000$ $1,800 Month 3 $1,000$ $2,125 Month 4 $1,000$ $4,189 Month 5 $1,000$ $6,585 Totals $5,0001,317

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Broader Diversification Increases Return AmountInvestmentExpected Return $2,000Buying lottery tickets -100% (?) $2,000Under the mattress0% $2,000Term deposit (CD)5% $2,000Corporate bond10% $2,000Mutual fund (stocks)15%

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved C. Investing in Stocks Investing in stocks and bonds is one of the most common investment activities among American investors. Stocks: Ownership in a corporation Ownership: If a company issues one million shares, and you buy 10,000 shares, you own 10% of the company. Valuation: (1) cash dividend and (2) share appreciation at the time of sale

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Conceptual Stock Valuation  Given: Stock price as of May 1, 2015: $72/share Earnings growth for next 5 years: 8% Expected cash dividend in 2016: $2.00/share Expected stock price in 3 years: $95/share Required return on your investment: 10%  Find: Current value of stock

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Valuation Cash Flow $95 $2 0123

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved D. Investing in Bonds 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Types of Bonds and How They are Issued in the Financial Market

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Bond Price Notation Used in Financial Markets Corporate BondsTreasury Bonds 1/8=$1.255/8=$6.25 1/32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$6.25 1/4=$2.503/4=$7.50 6/32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$7.50 3/8=$3.75 9/32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$8.75 1/8=$5.001=$10 13/32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$ /32=$10

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How To Read a Bond Notation Coupon rate Maturity date 2020 No meaning, spacing

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Bond Quotes 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%

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 4.20: Yield to Maturity and Current Yield  Given: Par value = $1,000 Initial purchase price = $ Coupon rate = 9.625% per year paid semiannually Maturity = 10 years  Find: (a) Yield to maturity (b) Current yield

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution (a) Yield to maturity i = % per semiannual (b) Current yield

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 4.23: Bond Value Over Time  Given: 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 interest payable semiannually. Four years ago, $920 was paid for the bond. At least a 9% return (yield) in the investment is desired.  Find: What must be the minimum selling price?

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution Semiannual interest payment = $40 Required semiannual return = 4.5% Desired selling price of the bond (F)