Chapter 2

The Two Key Concepts in Finance

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It’s what we learn after we think we know it
all that counts.

- Kin Hubbard

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 Outline
 Introduction
 Time value of money
 Safe dollars and risky dollars
 Relationship between risk and return

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 Introduction
 The occasional reading of basic material in
your chosen field is an excellent
philosophical exercise
• Do not be tempted to include that you “know it
all”
– E.g., what is the present value of a growing
perpetuity that begins payments in five years

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 Time Value of Money
 Introduction
 Present and future values
 Present and future value factors
 Compounding
 Growing income streams

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 Introduction
 Time has a value
• If we owe, we would prefer to pay money later
• If we are owed, we would prefer to receive
money sooner
• The longer the term of a single-payment loan,
the higher the amount the borrower must repay

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 Present and Future Values
 Basic time value of money relationships:
PV  FV  DF
FV  PV  CF
where PV = present value;
FV = future value;
DF = discount factor = 1/(1  R )t
CF = compounding factor = (1  R )t
R = interest rate per period; and
t = time in periods
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 Present and Future Values
(cont’d)
 A present value is the discounted value of
one or more future cash flows
 A future value is the compounded value of
a present value
 The discount factor is the present value of a
dollar invested in the future
 The compounding factor is the future value
of a dollar invested today
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 Present and Future Values
(cont’d)
 Why is a dollar today worth more than a
dollar tomorrow?
• The discount factor:
– Decreases as time increases
• The farther away a cash flow is, the more we discount it
– Decreases as interest rates increase
• When interest rates are high, a dollar today is worth much
more than that same dollar will be in the future

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 Present and Future Values
(cont’d)
 Situations:
• Know the future value and the discount factor
– Like solving for the theoretical price of a bond
• Know the future value and present value
– Like finding the yield to maturity on a bond
• Know the present value and the discount rate
– Like solving for an account balance in the future

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 Present and Future Value
Factors
 Single sum factors
 How we get present and future value tables
 Ordinary annuities and annuities due

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 Single Sum Factors
 Present value interest factor and future
value interest factor:
PV  FV  PVIF
FV  PV  FVIF
where
1
PVIF 
(1  R)t
FVIF  (1  R)t
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 Single Sum Factors (cont’d)
Example

You just invested $2,000 in a three-year bank certificate

of deposit (CD) with a 9 percent interest rate.

How much will you receive at maturity?

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 Single Sum Factors (cont’d)
Example (cont’d)

Solution: Solve for the future value:

FV  $2, 000 1.093

 $2, 000 1.2950
 $2,590

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 How We Get Present and
Future Value Tables
 Standard time value of money tables
present factors for:
• Present value of a single sum
• Present value of an annuity
• Future value of a single sum
• Future value of an annuity

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 How We Get Present and
Future Value Tables (cont’d)
 Relationships:
• You can use the present value of a single sum
to obtain:
– The present value of an annuity factor (a running
total of the single sum factors)

– The future value of a single sum factor (the inverse

of the present value of a single sum factor)

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 Ordinary Annuities
and Annuities Due
 An annuity is a series of payments at equal
time intervals

 An ordinary annuity assumes the first

payment occurs at the end of the first year

 An annuity due assumes the first payment

occurs at the beginning of the first year
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 Ordinary Annuities
and Annuities Due (cont’d)
Example

You have just won the lottery! You will receive $1 million
in ten installments of $100,000 each. You think you can
invest the $1 million at an 8 percent interest rate.

What is the present value of the $1 million if the first

$100,000 payment occurs one year from today? What is
the present value if the first payment occurs today?
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 Ordinary Annuities
and Annuities Due (cont’d)
Example (cont’d)

Solution: These questions treat the cash flows as an

ordinary annuity and an annuity due, respectively:

PV of ordinary annuity  $100, 000  6.7100  $671, 000

PV of annuity due  $100, 000  ($100, 000  6.2468)  $724, 680

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 Compounding
 Definition
 Discrete versus continuous intervals
 Nominal versus effective yields

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 Definition
 Compounding refers to the frequency with
which interest is computed and added to the
principal balance
• The more frequent the compounding, the higher
the interest earned

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 Discrete Versus
Continuous Intervals
 Discrete compounding means we can count the
number of compounding periods per year
• E.g., once a year, twice a year, quarterly, monthly, or
daily

 Continuous compounding results when there is

an infinite number of compounding periods

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 Discrete Versus
Continuous Intervals (cont’d)
 Mathematical adjustment for discrete
compounding:
FV  PV (1  R / m) mt

R  annual interest rate

m  number of compounding periods per year
t  time in years
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 Discrete Versus
Continuous Intervals (cont’d)
 Mathematical equation for continuous
compounding:

FV  PVe Rt

e  2.71828

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 Discrete Versus
Continuous Intervals (cont’d)
Example

Your bank pays you 3 percent per year on your savings

account. You just deposited $100.00 in your savings
account.

What is the future value of the $100.00 in one year if

interest is compounded quarterly? If interest is
compounded continuously?
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 Discrete Versus
Continuous Intervals (cont’d)
Example (cont’d)

Solution: For quarterly compounding:

FV  PV (1  R / m) mt
 $100.00(1  0.03 / 4) 4
 $103.03

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 Discrete Versus
Continuous Intervals (cont’d)
Example (cont’d)

Solution (cont’d): For continuous compounding:

FV  PVe Rt

 $100.00  e0.03
 $103.05
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 Nominal Versus
Effective Yields
 The stated rate of interest is the simple rate
or nominal rate
• 3.00% in the example
 The interest rate that relates present and
future values is the effective rate
• $3.03/$100 = 3.03% for quarterly compounding
• $3.05/$100 = 3.05% for continuous
compounding
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 Growing Income Streams
 Definition
 Growing annuity
 Growing perpetuity

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 Definition
 A growing stream is one in which each
successive cash flow is larger than the
previous one
• A common problem is one in which the cash
flows grow by some fixed percentage

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 Growing Annuity
 A growing annuity is an annuity in which
the cash flows grow at a constant rate g:

C C (1  g ) C (1  g ) 2 C (1  g ) n
PV     ... 
(1  R ) (1  R ) 2
(1  R) 3
(1  R) n 1
C1   1 g  
N

 1    
R  g   1  R  

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 Growing Perpetuity
 A growing perpetuity is an annuity where
the cash flows continue indefinitely:

C C (1  g ) C (1  g ) 2 C (1  g ) 
PV     ... 
(1  R ) (1  R ) 2
(1  R ) 3
(1  R) 

Ct (1  g )t 1 C1
 
t 1 (1  R) t
Rg

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Safe Dollars and Risky Dollars
 Introduction
 Choosing among risky alternatives
 Defining risk

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 Introduction
 A safe dollar is worth more than a risky
dollar
• Investing in the stock market is exchanging
bird-in-the-hand safe dollars for a chance at a
higher number of dollars in the future

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 Introduction (cont’d)
 Most investors are risk averse
• People will take a risk only if they expect to be
adequately rewarded for taking it

 People have different degrees of risk

aversion
• Some people are more willing to take a chance
than others
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 Choosing Among
Risky Alternatives
Example

You have won the right to spin a lottery wheel one time.
The wheel contains numbers 1 through 100, and a pointer
selects one number when the wheel stops. The payoff
alternatives are on the next slide.

Which alternative would you choose?

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 Choosing Among
Risky Alternatives (cont’d)
A B C D

[1-50] $110 [1-50] $200 [1-90] $50 [1-99] $1,000

[51-100] $90 [51-100] $0 [91-100] $500 [100] -$89,000

Avg.
payoff $100 $100 $100 $100

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 Choosing Among
Risky Alternatives (cont’d)
Example (cont’d)
Solution:
 Most people would think Choice A is “safe.”
 Choice B has an opportunity cost of $90 relative
to Choice A.
 People who get utility from playing a game pick
Choice C.
 People who cannot tolerate the chance of any
loss would avoid Choice D.

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 Choosing Among
Risky Alternatives (cont’d)
Example (cont’d)

Solution (cont’d):
 Choice A is like buying shares of a utility stock.
 Choice B is like purchasing a stock option.
 Choice C is like a convertible bond.
 Choice D is like writing out-of-the-money call
options.

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 Defining Risk
 Risk versus uncertainty
 Dispersion and chance of loss
 Types of risk

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 Risk Versus Uncertainty
 Uncertainty involves a doubtful outcome
• What you will get for your birthday
• If a particular horse will win at the track

 Risk involves the chance of loss

• If a particular horse will win at the track if you
made a bet

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Dispersion and Chance of Loss
 There are two material factors we use in
judging risk:
• The average outcome

• The scattering of the other possibilities around

the average

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Dispersion and Chance of Loss
(cont’d)
Investment value

Investment A
Investment B

Time
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Dispersion and Chance of Loss
(cont’d)
 Investments A and B have the same
arithmetic mean

 Investment B is riskier than Investment A

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 Types of Risk
 Total risk refers to the overall variability of
the returns of financial assets

 Undiversifiable risk is risk that must be

borne by virtue of being in the market
• Arises from systematic factors that affect all
securities of a particular type

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 Types of Risk (cont’d)
 Diversifiable risk can be removed by
proper portfolio diversification
• The ups and down of individual securities due
to company-specific events will cancel each
other out
• The only return variability that remains will be
due to economic events affecting all stocks

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Relationship Between Risk and
Return
 Direct relationship
 Concept of utility
 Diminishing marginal utility of money
 St. Petersburg paradox
 Fair bets
 The consumption decision
 Other considerations
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 Direct Relationship
 The more risk someone bears, the higher
the expected return
 The appropriate discount rate depends on
the risk level of the investment
 The risk-less rate of interest can be earned
without bearing any risk

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Direct Relationship (cont’d)
Expected return

Rf

0 Risk 49
 Direct Relationship (cont’d)
 The expected return is the weighted average
of all possible returns
• The weights reflect the relative likelihood of
each possible return

 The risk is undiversifiable risk

• A person is not rewarded for bearing risk that
could have been diversified away
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 Concept of Utility
 Utility measures the satisfaction people get
out of something
• Different individuals get different amounts of
utility from the same source
– Casino gambling
– Pizza parties
– CDs
– Etc.

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 Diminishing Marginal
Utility of Money
 Rational people prefer more money to less
• Money provides utility

• Diminishing marginal utility of money

– The relationship between more money and added
utility is not linear

– “I hate to lose more than I like to win”

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 Diminishing Marginal
Utility of Money (cont’d)
Utility

$
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 St. Petersburg Paradox
 Assume the following game:
• A coin is flipped until a head appears
• The payoff is based on the number of tails
observed (n) before the first head
• The payoff is calculated as $2n

 What is the expected payoff?

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 St. Petersburg Paradox
(cont’d)
Number of Tails
Before First Probability
Head Probability Payoff x Payoff
0 (1/2)1 = 1/2 $1 $0.50
1 (1/2)2 = 1/4 $2 $0.50
2 (1/2)3 = 1/8 $4 $0.50
3 (1/2)4 = 1/16 $8 $0.50
4 (1/2)5 = 1/32 $16 $0.50
n (1/2)n + 1 $2n $0.50
Total 1.00 
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 St. Petersburg Paradox
(cont’d)
 In the limit, the expected payoff is infinite

 How much would you be willing to play the

game?
• Most people would only pay a couple of dollars
• The marginal utility for each additional $0.50
declines

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 Fair Bets
 A fair bet is a lottery in which the expected
payoff is equal to the cost of playing
• E.g., matching quarters
• E.g., matching serial numbers on $100 bills

 Most people will not take a fair bet unless

the dollar amount involved is small
• Utility lost is greater than utility gained
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 The Consumption Decision
 The consumption decision is the choice to
save or to borrow
• If interest rates are high, we are inclined to save
– E.g., open a new savings account

• If interest rates are low, borrowing looks

attractive
– E.g., a higher home mortgage

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 The Consumption
Decision (cont’d)
 The equilibrium interest rate causes savers
to deposit a sufficient amount of money to
satisfy the borrowing needs of the economy

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 Other Considerations
 Psychic return
 Price risk versus convenience risk

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 Psychic Return
 Psychic return comes from an individual
disposition about something
• People get utility from more expensive things,
even if the quality is not higher than cheaper
alternatives
– E.g., Rolex watches, designer jeans

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 Price Risk Versus
Convenience Risk
 Price risk refers to the possibility of adverse
changes in the value of an investment due to:
• A change in market conditions
• A change in the financial situation
• A change in public attitude

 E.g., rising interest rates and stock prices, a

change in the price of gold and the value of the
dollar

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 Price Risk Versus
Convenience Risk (cont’d)
 Convenience risk refers to a loss of
managerial time rather than a loss of dollars
• E.g., a bond’s call provision
– Allows the issuer to call in the debt early, meaning
the investor has to look for other investments

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