Basics of Finance

Time Value of Money

Seminar 3
TIME VALUE OF MONEY
FUTURE VALUE
Depends on three factors

 Size of Investment
 Time Period
 Interest Rate
TIME VALUE DEFINED
• A dollar/Euro/HUF received today is better than a dollar/Euro/HUF to be received
after a year. Why?
• Because the dollar received today will start earning profit right from today
• FV = (Investment, Time, Interest Rate)
• This can be written as
• FV = PV x (1 + r)t
• (1 + r) t is known as Future Value Interest Factor (FVIF)
• r = Rate of Interest
• t = Time period
• Example
You invest $ 1000 today and will get $ 1100 at the end of one year, if interest rate is 10%
p.a.
FV = PV x (1 + r)t
= 1000 X (1 + 0.10)= 1100
• LONG PERIOD EXAMPLE : (Future Value)
An investment opportunity pays 12% pa and a business entity intends to invest $ 500,000.
What will be the worth of this investment in 7 years time? How much interest will the
company earn in this period? What portion of total interest represents compound interest?

PRESENT VALUE
PRESENT VALUE
You know that you will get 10000 at the end of 3rd
year from now. The interest rate is 10%. What is the
PV of 10000 now?
FV = PV x (1+r)3
10000= PV x (1.10)3
PV = 10000/ (1.10)3= 7513.14
We can find PV the other way too:
PV = FV / (1 + r)t
1 / (1.10)3 = known as PVDF
PV = FV X PVDF
PV = 10000 X 0.7513*
= 7513
Finding interest rate
 An opportunity requires 1000 investment today that will double at the end of 8 th year.
What is the implicit interest rate?
PV = FV / (1 +r)8
1000 = 2000 / (1 +r)8
(1 +r)8 = 2000/1000
(1 +r)8 = 2
r =9%
PERPETUITY
Defined: Stream of equal cash payments equally spaced that continues for ever.
If you wish to help a welfare trust by providing 100,000/- per annum forever and the interest
rate is 10%, how much amount must be set-aside today?
Formula:
PV of Perpetuity = C/r
= 100000/0.10
 = 1,000,000/-
And if you wish to start payments after 3rd year, then what is the PV of this delayed Perpetuity?
Present value of delayed perpetuity = C * (1 / r) * ((1 + r) ^t
PV of Delayed Perpetuity = 100,000 / 0.10*(1.10)3
PV of Delayed Perpetuity = 1,000,000/(1.10)3
= 751315
ANNUITIES
Series of equal amount and equally spaced payments but only for a limited period of time.
Valuation of Annuities:
 Using FV/PV tables
 Using formula
 Example:
You want to buy an asset for your business that will cost you 4000 per year for next
three years.
Assume interest rate of 10%. Find out the PV of this annuity?
 Using table
4000 x 1/(1.10)
4000 x 1/(1.10)2
4000 x 1/(1.10)3 = 9947.41
PERPETUITIES

Economic Indicators
Seminar 6
Indicators Measure Economic Performance
• A nation’s overall levels of income, employment, and prices are determined by the
interaction of spending and production decisions made by households, firms,
government agencies, foreign markets, and others in the economy.
• Economic goals include :
 • full employment, which is measured by the
• unemployment rate
• stable prices, measured by indices such as the
• Consumer Price Index
• economic growth, measured by real gross domestic product (GDP).
What is gross domestic product (GDP)?
Economic growth is measured by the percentage change in real gross domestic product (GDP).
A percentage change is calculated by dividing the change in the value of a variable by its initial
or starting value.
GDP is the total market value of all final goods and services produced within the borders of a
country in a given year.
GDP
Gross domestic product (GDP) is a basic measure of a nation’s economic output and income. It
is the total market value of all final goods and services produced in the economy in one year.
GDP is typically measured by adding together the spending of four sectors: household (C,
consumption expenditures), business (I, gross investment expenditures, including new home
construction), government (G, federal/state/local government expenditures), and foreign (Net
exports [NX] = Exports minus imports).
C+I+G+NX=GDP

Structure of GDP
Expenditure flows
Consumer spending
Households
Income from selling productive resources
Corporate profits
Foreign buyers
GDP does not include financial transactions, transfers, secondhand sales, non-market goods and
services, or the production of illegal goods.
Nominal GDP = GDP not adjusted for inflation.
Real GDP = nominal GDP adjusted for inflation.
Real GDP per capita = Real GDP divided by the population of the country
Real vs Nominal GDP
 Nominal GDP is measured in current dollars; thus an increase in GDP may reflect not
only increases in the production of goods and services, but also increases in prices.
 GDP adjusted for price changes is called real GDP.
 Economic growth is measured by real gross domestic product.
GDP per capita
 ⚫ Real GDP per capita is a measure that permits comparison of material living standards
over time and among people in different nations.

⚫ It is calculated by dividing real GDP by the population.

⚫ The potential GDP for a nation is determined by the quantity and quality of its natural
resources, the size and skills of its labor force, and the size and quality of its capital
resources.
Measure of Price Changes
• The consumer price index (CPI) is the most commonly used measure of price-level
changes.
• It can be used to compare the price level in one year with price levels in earlier or later
periods.
• CPI an indicator used to track changes in the prices of basic household goods and
services.
• Market Basket- representative group of goods and services used to compile the CPI.
Examples: food, housing, transportation, apparel, education, recreation, medical care
and personal care. Every 10 years the basket is updated with new items.
What measures inflation
• A general rise in prices due to a decrease in the value of money.
• Inflation is natural and even necessary. But when inflation increases too quickly, it has
dangerous effects on the economy
Demand-Pull Inflation:
When the demand for products exceeds the supply, prices rise. Too many dollars, too few
goods. This is a natural result of expansion of the Business Cycle.
Cost-Push Inflation:
When scarcity causes the cost of production to increase, prices rise. Ex. Gas prices increase the
cost of fuel for airplanes, so ticket prices increase
Type of Inflation
Creeping Inflation- in the U.S. we have to expect a certain amount of gradual inflation every
year. Since 1914 the average rate of inflation has been about 3.4%.
Hyperinflation-runaway inflation. (50% or higher). No one can predict how high price will go
and people lose confidence in their currency.
U.S.- 10% in late 1970’s
Germany after WWI-300% per month
Russia- 874% between 1993-2004
Deflation- when prices go down over time. Good for consumers, bad for businesses.
Stagflation- Slower growth (stagnation) and rise in prices (Inflation)
Measure of Unemployment
• The unemployment rate indicates the level of unemployment in the country.
• The unemployment rate is the percentage of the labor force (not population) who are
not working and are actively seeking paid work.
• The labor force includes persons over age 16 who are working for pay or actively
seeking paid work.
Unemployment
• Unemployment—A condition where people at least 16 years old are not currently
employed but are actively seeking a job.
• Natural rate of unemployment—The rate of unemployment that denotes full
employment of resources such that unemployment is at its “optimal” level (debated to
be between 5 and 7%).
Four Types of Unemployment
• Frictional unemployment—The “good” unemployment:
short-term unemployment associated with normal turnover in the labor market, such as
new entrants into the workforce and people changing jobs.
• Structural unemployment—Job loss due to changes in the business structure (e.g., the
introduction of new technologies or a change in the location of manufacturing).
• Cyclical unemployment—Job loss due to a downturn in the business cycle (e.g., caused by a
recession or natural disaster).
• Seasonal unemployment—Job loss due to a change in the season/time of year (e.g., after the
Christmas shopping season or summer vacation season).
Wealth strategy for entrepreneurs and business owners
Wealth strategy for entrepreneurs and business owners
"When your values are clear to you, making decisions becomes easier." – Roy E. Disney
The uniqueness of business owners
• Perhaps the most obvious and clear area of differentiation between business owners
and everyone else is the large, concentrated, and generally illiquid position business
owners have on their balance sheets.
• On average, non-financial assets account for nearly two-thirds of business owner's total
assets.

Financial asset
Non-financial
Athletes and business owners
Business owners might look to another group of investors that have to manage large, illiquid,
concentrated positions: Athletes. Business owners use their human capital to build large,
successful enterprises. Athletes use their human capital to perform at the highest level in their
sport.
Business owners face a similar scenario, although it typically occurs much later in life. After
spending years or decades building a company (in effect, converting their human capital into a
valuable business), they need to exit the business with sufficient liquid assets to pay for their
future spending. The exit tends to occur in fast succession or all at once.
Athletes can have sharp spikes and declines in human capital
Business owners can also have fast exits

Asset allocation for business owners

• Business owners are best served by allocating their pre-exit financial assets based on the
ultimate purpose of those assets. Our Liquidity. Longevity. Legacy. approach to
structuring wealth across time can provide the guidance necessary for those decisions.
• Since most of the risk inherent in a private company is idiosyncratic, public equity
market exposure actually diversifies the overall balance sheet. This process provides a
bottom-up method for allocating the overall portfolio in a dynamic way, based on the
spending needs of the family and the total investable assets they have available. The
concentrated business position matters, but so does the ratio of investable assets to
annual spending.
Capacity for equity risk increases with financial assets
2. stage: Core concepts for the sale
The sale price: Is it enough?
• One of the first considerations most business owners focus on when they start
considering an exit is whether or not the proceeds will be suitable to fund their future
spending goals.
• Almost all families have a minimum price at which it is practical to sell their business.
That floor represents the asset pool needed to pay for their future lifetime spending
(i.e., fully fund their Liquidity and Longevity strategies).
• In addition to quantifying the current cost of personal spending needs, some families
have specific Legacy objectives they prioritize. This might include funding trusts, specific
philanthropic gifts, or multigenerational bequests.
Post-sale considerations
• Following the sale of a business, families need to transition from thinking like business
owners to thinking like long-term asset managers. Along with that transition come a
number of possible challenges.
• Two are investment specific: (1) selecting a prudent, sustainable asset allocation that
best meets the family’s needs and (2) timing the implementation in a responsible way.
• The exit itself can be seen as a swap out of the business position into liquid assets, which
(a) fulfills the Longevity target value to provide for the living expenses of the family and
 (b) usually results in some level of Legacy assets the family can use for gifting or
philanthropic purposes.
Strategic asset allocation
• The optimal portfolio lies somewhere in between all-cash and all-equity:
• An all-cash strategy reduces the likelihood the fortune will be sustained over multiple
generations, and unexpected high inflation presents a specific risk.
• An all-equity strategy has more upside than an all-cash strategy but also runs the risk
that a severe bear market will permanently impair the net worth of the family.
Liquidity strategy
• Post-sale, a Liquidity strategy serves three main functions:

to help avoid
forced or panic
as a funding source selling during bear
during periods of markets
to match cash flow market distress
to expenses

Longevity strategy
• Considerations of the Longevity portfolio's asset allocation are:

Risk tolerance –
particularly as it
Portfolio relates to a pain
drawdowns, in threshold that
would result in
The volatility of an particular, present a
meaningful risk. selling equities
investor’s combined during a downturn –
Liquidity and looms large for
Longevity portfolio long-term success.
directly impacts the
volatility of their
future spending.

Legacy strategy
 • Legacy asset allocations are idiosyncratic: many investors have various structures, like
trusts, educational accounts, and philanthropic accounts. Each needs to be managed in a
specific way to best meet its objectives.
• Perhaps the most important concept for investors to think about with regard to Legacy
portfolios is the interplay between time horizon and investment risk.
Liquidity. Longevity. Legacy
• LIQUIDITY: Resources to help maintain your lifestyle
• LONGEVITY: Resources to help improve your lifestyle
• LEGACY: Resources to help improve the lives of others
Succession and inheritance
• Many wealthy families face a tricky balancing act. On the one hand, they want to
conceal important details even from adult children for fear of creating a sense of
entitlement. But when parents are too secretive, it can make it much more difficult for
the children when they eventually inherit those investments.
The question of inheritance
• How much to disclose—and when—will depend on each family’s dynamics and wealth
situation.
• “A lot of times, there’s a myth that talking about money means revealing the balance
sheet. Instead, it’s this series of conversations and typically the very last thing that’s
shared is the distribution of the estate plan.” (Stacy Allred, managing director and head
of Merrill Lynch’s Ultra High Net Worth Strategic Wealth Advisory Group and Center for
Family Wealth Dynamics and Governance)
• The key is give them the right information at the right time.
Some age-appropriate strategies
 Many agree that the tween years are a good time to start. At this age, children only need to
know the family has money; not the specifics of their wealth or how the money is invested.
Tee Then tell them the family history—ideally as a story.
ns

In their 20s, they may begin earning a salary, paying rent and other bills. Financial
professionals say this can be a good time to discuss the various components of the family’s
In wealth.
thei Tell them they’re now mature enough to have in-depth discussions about the family’s
r successes in saving and investing.
20s
Once children reach maturity, and perhaps are starting families of their own, then it’s time
to share specific details about your wealth, professionals say.
In The approach depends on the child. But a family meeting facilitated with help from a
thei financial adviser, accountant or estate-planning attorney can be an effective way to broach
r the discussions.
30s

Personal income tax

Calculate the yearly tax liability for a couple that lives in a certain country, assuming that the
father's monthly salary is EUR 2,500, the mother's monthly salary is EUR 1000, and they raise 2
dependent children!
Disregard the wage differences among countries, as in this exercise we are examining only the
effect of taxes on the welfare of families.
The Financial Crisis and the Great Recession
The housing bubble in the U.S.
 increase in demand for real estate
 increase in real estate prices
 increase in home prices fed a speculative frenzy
– millions rushed to buy, believing that prices could only go up
 speculative flurry was fed by:
– the “dot-com bubble”
– the unprecedented access to credit in the form of mortgages
– very low mortgage rates among other factors
Historical housing prices in the U.S.
 Shiller Housing Price Index
Shiller Housing Price

1 9
100
110
120
130
140
150
160
170
180
190
200
Index

1 2
18

100
150
200
250

0
50
9
19 0
12
19 9 1

Mortgage-backed security (MBS)

53 34

Housing bubble and credit access

1 9 .8
5 9 75

2 Housing
1 9 .3

2
6 4 75

2 Price
1 9 .8
7 0 75
1 9 .3
7 5 75

2 Fed
1 9 .8
8 1 75

2
1 9 .3
8 6 75

2 Interest
1 9 .8
9 2 75

2 Rate2
1 9 .3
9 7 75
2 0 .8

2
0 3 75
2 0 .3

2
0 8 75

98 999 000 001 002 003 004 005 006 007 008 009 010 011
.8

0
1
2
3
4
5
6
7

75
Effective Federal Funds Rate
Credit default swap
credit default swap: a security that is effectively an insurance policy against defaults related to
MBS and CDOS

Investment bank
Credit default swap seller
The subprime crisis
 rising demand for bundled securities
 banks relaxed lending criteria
  subprime mortgage: a mortgage that does not meet the quality standards of traditional
mortgages
 2006: wave of subprime foreclosures hastened downward spiral of prices (glut in house
supply)
From housing crash to banking crisis
 falling house prices
 limited equity of home owners
 many mortgages became worthless
 losses in the value of MBSs and CDOs
 banks put part of their funds in CDOs
 presumption: every bank is a high-risk borrower
 banks stopped lending to each other and to customers
 output contracted sharply
Housing bubbles in Europe
 house prices increased tremendously in Ireland, Spain and Britain
 MBSs and CDOs played no role in European countries
 with the end of the U.S. housing bubble, real estate bubbles in Europe also burst
 banks in Europe became more careful in lending
 with falling house prices, households started to default on their mortgages and property
developers on their loans
 national banking crises in European countries
Economic Impacts of the Crisis
Unemployment and the vicious recessionary spiral
 in the industrialized world, 14 million jobs were lost
 households saw their wealth diminished
 vicious circle:
 Employment
Income falls
falls

Banks
Less
increase
aggregate
lending
demand
standards

Less credit

The Great Depression and the Great Recession compared

 both downturns were preceded by a period of economic strength
 but: consequences are different due to
– social safety net
– government regulations to protect ordinary citizens
– activist macroeconomic policy
 government programs kept current downturn from becoming far worse
Selected economic indicators for ten industrialized economies* in the Great Depression and
the Great Recessi

Selected economic indicators for ten industrialized economies* in the Great Depression
and the Great Recession
Inequality
 U.S.:
– since 1999, low and middle incomes started to decline
– majority of families faced difficulties to maintain level of consumption
– debt-financed consumption
 Germany:
– wages of the poorer half of the population declined
– consumption stagnated
– rich households and corporations earned more money than they could (or
would) spend
– net savings increased
Bank size and deregulation
 since the 1980s, bank mergers led to a growing number of large banks
 financial sector became deregulated
 “too big to fail”: when a company grows so large that its failure would cause
widespread economic harm in terms of lost jobs and diminished asset values
 “too big to fail” mentality of banks encouraged more risk taking
 governments had to bail out banks
Increasing bank size in the U.S.
 90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
84:1 85:4 87:3 89:2 91:1 92:4 94:3 96:2 98:1 99:4 01:3 03:2 05:1 06:4 08:3 10:2 12:1
Year: Quarter

Assets > $10 Billion Assets $1 Billion - $10 Billion

Assets $100 Million - $1 Billion Assets < $100 Million

Misguided corporate incentive structure

 CEO pay in the form of stock options
 performance related pay scheme encouraged short-term orientation
– focus on short-term gains
– ignoring long-term risks
Globalization and long-term economic trends
 distribution of gains and losses from globalization reinforce growing patterns of
inequality
– in the U.S.: debt financed consumption
– in Germany: increase in savings
 savings from other parts of the world contributed to U.S. housing boom and asset price
inflation
 investment banks and hedge funds possessed large amounts of capital, took on more
risk and debt to multiply returns
What to take home
 the financial crisis of 2007-2008 and its aftermath are widely referred to as the “Great
Recession”
 the crisis began in 2007 with a crisis in the subprime mortgage market in the U.S. and
developed into an international banking crisis
 many causes for the financial crisis have been suggested
 in the aftermath of the financial crisis, the financial sector was reregulated

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How do I create a new portfolio?
money
To create a new portfolio, access your Portfolio from your Account and click on the
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and the currency. You can then start adding securities to your basket.
How can I add securities to my portfolio?
Type the company name or code in the search function of your Portfolio summary page.
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Create Portfolio
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Name: write in your own name
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Click on your portfolio name for details; then you will see the Summary. Start building
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Find a company name (anything you like) and choose only its equity shares. Click on the
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Portfolio value results

You may follow the summary, details and transactions of your portfolio. At the
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your Total Gain/Loss to the coospace task.

Good luck!