Chapter 17: Financial Economics

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

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Financial Economics McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Financial InvestmentEconomic investmentNew additions or replacements to the capital stockFinancial investmentBroader than economic investmentBuying or building an asset for financial gainNew or old assetFinancial or real assetLO1Present ValuePresent day value of future returns or costsCompound interestEarn interest on the interestX dollars today=(1+i)tX dollars in t years$100 today at 8% is worth:$108 in one year$116.64 in two years$125.97 in three yearsLO1Present Value ModelCalculate what you should pay for an asset todayAsset yields future paymentsAsset’s price should equal total present value of future paymentsThe formula:dollars today = X dollars in t yearsX( 1 + i)tLO1ApplicationsTake the money and runLottery jackpot paid over a number of yearsCalculating the lump sum valueSalary caps and deferred compensationCalculating the value of deferred salary paymentsLO1Popular InvestmentsWide variety available to investorsThree featuresMust pay to acquireChance to receive future paymentSome risk in future paymentsLO2LO2StocksBondsRepresents ownership in a companyBankruptcy possibleLimited liability ruleCapital gainsDividendsDebt contracts issued by government and corporationsPossibility of defaultInvestor receives interestPopular InvestmentsMutual FundsCompany that maintains a portfolio of either stocks or bondsCurrently more than 8,000 mutual fundsIndex fundsActively managed fundsPassively managed fundsLO2Calculating Investment ReturnsGain or loss stated as percentage rate of returnDifference between selling price and purchase price divided by purchase priceFuture series of payments also considered into returnRate of return inversely related to priceLO2ArbitrageBuying and selling process to equalize average expected returnsSell asset with low return and buy asset with higher return at same timeBoth assets will eventually have same rate of returnLO3RiskFuture payments are uncertainDiversificationDiversifiable riskSpecific to a given investmentNondiversifiable riskBusiness cycle effectsComparing risky investmentsAverage expected rate of returnBetaLO3RiskRisk and average expected rates of returnPositively relatedThe risk-free rate of returnShort-term U.S. government bondsGreater than zeroTime preferenceRisk-free interest rateLO3The Security Market LineAverage expectedrate of return=Rate that compensatesfor time preference+Rate that compensatesfor riskCompensate investors for: Time preference Nondiversifiable riskAverage expectedrate of return=i f+risk premiumLO4The Security Market LineLO4Security MarketLineMarketPortfolio ifAverage expected rate of returnRisk Level (beta)01.0Compensationfor Time PreferenceEquals ifRisk Premium forthe Market Portfolio’sRisk Level of beta =1.0A Risk-Free Asset(i.e., a short-term U.S.Government bond)The Security Market Line Risk levels determine average expected rates of returnLO4Security MarketLinei fAverage expected rate of returnRisk Level (beta)0XCompensationfor Time-PreferenceEquals i fRisk Premium forthis Asset’s RiskLevel of beta = XYThe Security Market LineSecurity MarketLineAverage expected rate of returnRisk Level (beta)0X Arbitrage and the security marketYABCLO5The Security Market LineSML 1Average expected rate of returnRisk Level (beta)0X An increase in the risk-free rateA Before IncreaseA After IncreaseSML 2Y1LO5Y2
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