Finance And

Investment

Dr Mohsen Rashad
 Time Value Of Money
• Future Value
• Present Value
• Annuities
• Rate Of Return
• Amortization
 Time Lines

0 1 2 3
I%

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

• Tick marks occur at the end of periods, so Time 0
is today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second
period.
5-3
 What is the future value (FV) of an initial $100
after 3 years, if I/YR = 10%?

• Finding the FV of a cash flow or series of

cash flows is called compounding.
• FV can be solved by using the step-by-
step, financial calculator, and spreadsheet
methods.
0 1 2 3
10%

100 FV = ?

5-4
 Solving for FV:
The Step-by-Step and Formula Methods

• After 1 year:
FV1 = PV(1 + I) = $100(1.10) = $110.00
• After 2 years:
FV2 = PV(1 + I)2 = $100(1.10)2 = $121.00
• After 3 years:
FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10
• After N years (general case):
FVN = PV(1 + I)N
5-5
 Classifications of Interest Rates
• Effective (or equivalent) annual rate (EAR =
EFF%) – the annual rate of interest actually
being earned, accounting for compounding.
– EFF% for 10% semiannual investment
EFF% = ( 1 + INOM/M )M – 1
= ( 1 + 0.10/2 )2 – 1 = 10.25%
– Should be indifferent between receiving 10.25%
annual interest and receiving 10% interest,
compounded semiannually.

5-6
 Why is it important to consider effective
rates of return?
• See how the effective return varies
between investments with the same
nominal rate, but different compounding
intervals.
EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
5-7
 What is the FV of $100 after 3 years under 10%
semiannual compounding? Quarterly compounding?

MN
 INOM 
FVN  PV1  
 M 

23
 0.10 
FV3S  $1001  
 2 
FV3S  $100(1.05) 6  $134.01
12
FV3Q  $100(1.025 )  $134.49
5-8
 Solving for FV:
The Calculator Method
• Solves the general FV equation.
• Requires 4 inputs into calculator, and will
solve for the fifth. (Set to P/YR = 1 and END
mode.)

INPUTS 3 10 -100 0

N I/YR PV PMT FV

OUTPUT 133.10

5-9
What is the present value (PV) of $100 due
in 3 years, if I/YR = 10%?
• Finding the PV of a cash flow or series of
cash flows is called discounting (the reverse
of compounding).
• The PV shows the value of cash flows in
terms of today’s purchasing power.
0 1 2 3
10%

PV = ? 100

5-10
 Solving for PV
The Formula Method
• Solve the general FV equation for PV:
PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.10)3
= $75.13

5-11
 Solving for I: What interest rate would cause
$100 to grow to $125.97 in 3 years?

• Solves the general FV equation for I.

• Hard to solve without a financial calculator
or spreadsheet.

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV

OUTPUT 8

5-12
 Solving for N: If sales grow at 20% per year,
how long before sales double?

• Solves the general FV equation for N.

• Hard to solve without a financial calculator
or spreadsheet.

INPUTS 20 -1 0 2

N I/YR PV PMT FV

OUTPUT 3.8

5-13
 Solving for FV
3-Year Ordinary Annuity of $100 at 10%

• $100 payments occur at the end of each

period, but there is no PV.

INPUTS 3 10 0 -100

N I/YR PV PMT FV

OUTPUT 331

5-14
 Solving for PV
3-year Ordinary Annuity of $100 at 10%

• $100 payments still occur at the end of

each period, but now there is no FV.

INPUTS 3 10 100 0

N I/YR PV PMT FV

OUTPUT -248.69

5-15
 Solving for FV
3-Year Annuity Due of $100 at 10%
• Now, $100 payments occur at the beginning of
each period.
FVAdue= FVAord(1 + I) = $331(1.10) =$364.10
• Alternatively, set calculator to “BEGIN” mode
and solve for the FV of the annuity:
BEGIN
INPUTS 3 10 0 -100

N I/YR PV PMT FV

OUTPUT 364.10

5-16
 Solving for PV
3-Year Annuity Due of $100 at 10%
• Again, $100 payments occur at the beginning of
each period.
• PVAdue = PVAord(1 + I) =
$248.69(1.10)=$273.55
• Alternatively, set calculator to “BEGIN” mode and
solve for the PV of the annuity:
BEGIN
INPUTS 3 10 100 0

N I/YR PV PMT FV

OUTPUT -273.55

5-17
What is the PV of this uneven cash flow
stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
5-18
 Solving for PV
Uneven Cash Flow Stream
• Input cash flows in the calculator’s “CFLO”
register:
– CF0 = 0
– CF1 = 100
– CF2 = 300
– CF3 = 300
– CF4 = -50
• Enter I/YR = 10, press NPV button to get
NPV = $530.087. (Here NPV = PV.)
5-19
 Using Financial Table
PV = FV (factor)
PVA = PMT (factor)
FV = PV (factor)
FVA = PMT(factor)
PVA Due = PMT (factor ) X (1+i)
Present value of perpetuity
*Perpetuity:
PV = FV → Constant per period cash flow
i → Constant interest (discount) rate.
Table 5-1

5-21
Table 5-2

5-22
5-23
Figure 5-4

5-24
Figure 5-5

5-25
 Loan Amortization
• Amortization tables are widely used for
home mortgages, auto loans, business
loans, retirement plans, etc.
• Financial calculators and spreadsheets are
great for setting up amortization tables.

• EXAMPLE: Construct an amortization

schedule for a $1,000, 10% annual rate
loan with 3 equal payments.
5-26
 Step 1:
Find the Required Annual Payment
• All input information is already given, just
remember that the FV = 0 because the
reason for amortizing the loan and making
payments is to retire the loan.

INPUTS 3 10 -1000 0

N I/YR PV PMT FV

OUTPUT 402.11

5-27
 Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan
YEAR BEG BAL PMT INT PRIN END BAL
1 $1,000 $ 402 $100 $ 302 $698
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL – $1,206 $206 $1,000 –

• Interest paid declines with each payment

as the balance declines.

5-28
Table 5-4
 • Relationship between risk and return
Return
SML

Return i

Risk
Risk i
• The higher the Risk , The higher the required
return.
• SML can be used to generate risk-adjusted
discount rates to be used in Financial
decisions.
 Determinants of Interest Rates
R = r* + IP + DRP + LP + MRP

R = required return on a debt security

r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= maturity risk premium
6-31
Premiums Added to r* for Different
Types of Debt

IP MRP DRP LP
S-T Treasury 

L-T Treasury  

S-T Corporate   

L-T Corporate    

6-32
 Yield Curve and the Term Structure of
Interest Rates

• Term structure –
relationship between
interest rates (or yields)
and maturities.
• The yield curve is a
graph of the term
structure.
• Treasury yield curve is
shown at the right.

6-33
 Constructing the Yield Curve: Inflation
Assume inflation is expected to be 5% next year, 6% the
following year, and 8% thereafter.

IP1  5% /1  5.00%
IP10  [5%  6%  8%(8)]/10  7.50%
IP20  [5%  6%  8%(18)]/20  7.75%
Must earn these IPs to break even vs. inflation; these IPs
would permit you to earn r* (before taxes).

6-34
 Constructing the Yield Curve:
Maturity Risk
• Step 2 – Find the appropriate maturity risk
premium (MRP). For this example, the
following equation will be used to find a
security’s appropriate maturity risk premium.

MRP = 0.1% (t – 1)

6-35
 Constructing the Yield Curve:
Maturity Risk
Using the given equation:
MRP1  0.1%  (1  1)  0.0%
MPP10  0.1%  (10  1)  0.9%
MRP20  0.1%  (20  1)  1.9%

Notice that since the equation is linear, the

maturity risk premium is increasing as the time to
maturity increases, as it should be.

6-36
 Add the IPs and MRPs to r* to Find the
Appropriate Nominal Rates

Step 3 – Adding the premiums to r*.

R,= r* + IP + MRP
Assume r* = 3%,
rRF, 1  3%  5.0%  0.0%  8.0%
rRF , 10  3%  7.5%  0.9%  11.4%
rRF , 20  3%  7.75%  1.9%  12.65%

6-37
 Theories explaining shape of
yield curve
• Expectation theory ; shape of YC depends on
investors expectation about future inflation.
• Liquidity preference ;lenders prefer to make
short term loans hence they will lend short
term funds at lower interest rates.
• Market segmentation theory ; each lender
and borrower has a preferred maturity and
slope of YC depends on supply and demand
of funds in ST relative to LT tenor
 Hypothetical Yield Curve
• An upward sloping
Interest
yield curve.
Rate (%)
15 Maturity risk premium
• Upward slope due
to an increase in
10 Inflation premium expected inflation
and increasing
5
maturity risk
premium.
Real risk-free rate
Years to
0 Maturity
1 10 20
6-39
Illustrating the Relationship Between
Corporate and Treasury Yield Curves
Interest
Rate (%)
15

BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%

Years to
0 Maturity
0 1 5 10 15 20

6-41
 Risk and Rate of Return
 Portfolio Rate of Return : Average
weighted return on the portfolio as a whole.
 Standard deviation : reflection of risk
inherent in the portfolio.

It measures the extent of possible

outcomes are likely to be different from the
mean outcome
• Total Return :All incoming cash flow
(interest/dividend) and capital gain/loss
• Dividend Yield : annual stock dividend as
a percentage of initial stock price
• Capital Gain Yield : the change in stock
price as percentage of initial stock price
• Total Percent Return : ROI measured as a
percentage that accounts for all cash flows
 Effective Annual Return
• (1+holding period percentage return)n -1
• ( 1+ i/n)n -1
• Average return = arithmetic mean
• Risk free return : return on riskless asset
• Risk premium : extra return on risky
asset over risk free return
 Table : Average annual return
• Investment 1926-2006
• Large co. Stock 12.3 %
• Small co stock 17.4%
• LT Corp.Bond 6.2%
• LT.Gov.Bond 5.8%
• US T/Bills 3.8%
• Inflation 3.1%
Geometric average return
 Arithmetic average return
• Arithmetic Average : the return earned in
average year over a multiyear period
• Example: return of investment in 4 years is
10%,12%,3%,-9%
• Arithmetic return : (.10+.12+.03-.09)/4
=4%
 Arithmetic vs Geometric
• Arithmetic average return is probably too
high for long periods while Geometric
average return is probably too low for
short periods.
• Combining the two average (Blume’s
formula)
• R(T) = T-1 / N-1x Geometric average +
N-T / N-1 x Arithmetic average
 Combined average return
• Example: from 25 years investment the
calculated arithmetic average is 12% & the
geometric average for same period is 9%
• R (5) = 5-1/24 x 9% + 25-5/24 x 12% =
11.5% &
• R(10) = 10-1/24 x9% + 25-10/24
x12%=10.875%
 Return Variability
• Frequency distributions & variability
• Variance : a common measure of volatility.
• Standard deviation : the square root of the
variance.
• Normal distribution : A symmetric bell-
shaped frequency distribution that is
completely defined by its average and
standard deviation.
 Risk ,Return & SML
- Two basic parts of return :
Expected and unexpected
-Impact of announcement on return depends
on comparing with previous expectations
( Forecast)
-Market (systematic) vs. unique
(unsystematic, diversifiable ) Risk.
 Risk , Return,& SML
• Portfolio Beta and Average return
• A security beta is a measure of how
sensitive the security return is to overall
market movements . Such sensitivity
depends on :- 1- how closely correlated
the security’s return is with the overall
market’s return .2- How volatile the
security is relative to the market.
 Risk ,Return & SML
• Bj = Corr (Rj & Rm) x
Standard Deviation of return j /
Standard deviation of return m.
• Slope of Return Risk = ER j – R f./ B j
• Example: Asset a return 16% , B 1.6 & risk
free return is 4%
• Slope of return/risk = ,16-,04 / 1.6 = 7.50%
• ( reward to risk ratio)
 Risk ,Return & SML

• Due to the price return relation ( moving to

opposite direction ) the reward to risk ratio
must be the same for all assets in a
competitive financial market.
 Risk , Return & SML
• SML : graphical representation of the
linear relationship between systematic risk
and expected return in financial markets.
• Reward /risk slope of the SML =
• ER m - Rf / B m = Erm – Rf /1 =
• ER m – R f
 Risk, Return & SML

• Market Risk Premium : the risk premium

on a market portfolio – a portfolio made of
all assets in the market.
 Constructing the Beta
Coefficient
• 1-Calculate the expected average return ,
Variance of return and the Standard
deviation(SD) of return.
• 2- Covariance = Deviation return J x
Deviation of market return to average
• 3- Correlation = covariance JM/ SDJxSDM
• 4-Beta J = Corr.JM x SDJ/SD.M
 Risk , Return and Diversification
Return
Probability

Assets A 10% 45%

20% 55%

Assets B 7% 65%

12% 35%
• Asset A average return
0.10 X0.45 +0.20X0.55 = 15.5%

Standard deviation of Return

(0.10-0.155 )2X0.45+(0.20-0.155)2X0.55
Variance = 0.00247
∴standard deviation = σ√0.00247 = 4.97%
* Asset B
average Return
8.75%
Asset B Standard Deviation 2.39%
 The correlation coefficient , the
covariance
Direct way to find portfolio risk by dealing with the
interrelatedness of Assets returns.

It is a number that can take values from -1 (perfect

negative relatedness) to +1
( perfect positive relatedness).
*The more positively related securities in portfolio,
the less gain from diversification.
 Summery Portfolio Risk
1- Portfolio risk is not likely the average risk of
underlying Assets.
2-Measurment of relatedness of individual Assets
returns is the correlation coefficient of paired
return of assets within the portfolio.
 Portfolio performance
evaluation
• 1- Sharp Ratio = Rp – Rf / SDp

• 2-Treynor Ratio = Rp – Rf / Bp

• 3- Jensen Alpha = Rp –
Expected(required) Return
(CAPM)
= Rp –( Rf +(Erm – Rf)x Bp
Diversifiable & Un-diversifiable Risk
Risk of Average Portfolio

Risk (M)

Number of Securities in Portfolio

 Beta Coefficient ( Regression
coefficient)
B coefficient express relationship between the return expected
from security and that expected from the market as whole

ßj=
Standard deviation Correlation of j
of return j X with the Market
Standard deviation of Market Return
i.e = σj Pjm
σm

Same as σj σm Pjm
σ 2m

∴ß j = σ j m Covariance j with Market

σ 2m variance of Market
• Example:

If Market return move from 12% to 14% a

security with return of 15% and ß of 1.3
will move to 15% +1.3 (14%-12%) =
17.6%
Security Market line (SML) the Market Model
Objective : having quantitative mechanism for setting risk
adjusted returns necessary for co. investment decision

ERj SML

M
Er (M)

1.0

E ( rj) = rf +{ E(rm) –rF } X ßj

-SML allows estimating discount rates and opportunity cost
for co. investment
 Learning Points
1- Total risk can be separated to diversifiable and
systematic (Market) Risk.
2- Un-diversifiable Risk is related to underlying market
factors that is common to all assets and securities.
3- Systematic Risk is measured by Beta coefficient
(standard deviation X Correlation with Market) /SDM
4-SML dictate set of risk adjusted returns available in the
market
5- SML form basis for evaluating internal co. investment
where it should offer returns in excess of capital supplier
opportunity .
• Finance:-
The Economics of allocating resources across
time or reallocation of recourses in time , Such
as borrowing and Lending money raising capital.

• Financial Investment:-
Borrowing / Lending / Buying shares ……etc
( Needs provision of funds)

* Real Assets Investment → Building factories, buying

equipment to be used in production. (needs information) that
financial markets provide to interested investors.
*Financial Markets allow participants to reallocate resources
across time
The Present Value (Discount value) :
amount of money you must invest or lend at the
present time to end up with a particular amount of
money in the future .

M.B. finding a present value of future cash

flow is called discounting cash flow.
-Present value is an accurate representation of what
the financial market does when it sets a price on a
financial asset.
*Opportunity costs : alternative to buying
certain security or doing certain
investment. The Cost OF Doing This
Instead of Something Else (Opportunity
Foregone)

*Present Wealth:- Present value of all

present and future resources (cash Flow).
 Investing
Investing in real assets: productive machinery,
product line ... Etc to create new future cash flows
that did not previously exist.
-We must give up some resources in order to
undertake investment.

-If the present value of the amounts we give up is

greater than the present value of what we gain from
investment (i.e Bad investment ) the investment will
decrease our present wealth.

Investment decision depends on the effect on

present value of wealth
 Net Present Value.
Present value of difference between an investments
cash inflows and outflows.
Example: Investing $550,-- that generated $770,-- in a year
NB. Risk Free return is 10%
a) Net present value
$770/1.10 -$550 = 700 – 550 = $ 150
which is = change in present wealth

b) NPV is a reflection of how much investment differs from

its opportunity cost or NPV is the present value of the
future amount by which the returns from the investment
exceed opportunity cost of the investor.
In Our Example:-
The investment cost ( @10%) = $ 550 X 1.1 = $ 605

While investment returned $ 770

i.e. difference is $ 770 - $ 605 = $ 165.00
PV of difference = $ 165/1.1 = $ 150.00
Which is once again the NPV
 ∴ NPV of Investment
1- Present value of all investment present and
future cash flow discounted at the opportunity cost
of cash flow

2- Is the change in present wealth of investor who

choose a positive NPV investment.

3- Is the discounted value of the amount by which the

investment cash flow differs from those of its
opportunity cost.
 Internal Rate of Return (IRR)
1- IRR is the average per-period rate of
return on money invested.

2-IRR is calculated by finding the discount

rate that would cause NPV of investment
to be Zero.

3-To use IRR, we compare it with the return

available on an equal Risk investment of
comparable cash flow timing.
In Our Example:-

NPV = O = -£ 550 + £ 770 / (1 + IRR)

∴ ( 1 + IRR) = £ 770 / £ 550
( 1 + IRR) = 1.4
IRR = 0.4 i.e. 40%

∴ IRR is larger than opportunity cost which is 10%

from comparable Risk and timing investment.
IN case investment of 550.,,Generated 594.,
1 + IRR = £ 594/ £550
= 1.08

IRR= 0.08 or 8%
(i.e. Less the opportunity cost of 10%)

∴ Investment should be rejected

 Multiple – Period Finance

t0 Period 1 t1 period 2 t2
Ii
=10%
m =2
Cf2 = CF0(1+i)2 CF0 = £ 100
CF2= 100 (1.21) = £ 121.00
PV = CF2 / (1+i)2 = £121/(1.10)2 = £ 100

∴ FV = PV (1 + i)n
PV = FV/ (1 +i)n
 - Compound Interest
Exchange rate between two time points where interest is not
only earned on original investment (principle) but also on
interest earned.
Example :
CF2= CF0 +CF0 (i1) + CF0 (i2) + CF0(i1)(I2)
i.e. £121 = £ 100 + £100 (10%)+ £100 (10%)(10%)
Or CF2 =CF0(1+i)2
2
)10%+ 1( 100 £ = £121
The general arithmetic of interest compounding (for- -
number of times per period)
=CF0 (1+ ⅰ/m)mt → Where m number of times per period
And – t- is–number of periods
 Multiple Period Cash Flow
The Present Value of Stream of future cash flow is the sum
of present values of each of the future cash flow.

PV = CF1 + CF2 + CF3

(1+i1)1 (1+i2)2 (1+i3)3
Multiple period Investment Decision
NPV = (CF0) + CF1 + CF2 + CF3
(1 + i1)1 (1+i2)2 (1+i3)3

NPV must include all present and future cash flow

associated with investment
As IRR is the discount rate that causes NPV
to equal Zero.
Solving for IRR is the technique called
Trial & Error
NPV = 0 = (CF0) + CF1 + CF2 + CF3
(1+IRR)1 (1+IRR)2 (1+IRR)3
 Interest Rates (Spot & Forwards)
- Interest rate is rate of exchange used when
shifting resources across time.
- Spot interest rate: Begin at present and run to some
future time point.
Ex.
One period spot Interest Rate ( t0-t1) is 5%
Two period spot Interest Rate (t0,t2) is 6%
-Term Structure of Interest Rates :
Is the set of all spot rates in a financial Market and used
in calculating present value (prices) of securities such as
the table
(Where Inst. For t1 5% , t2 6% , t3 7%)
 *The Yield to Maturity
It is the IRR of the Bonds promised cash flow used to
discount promised cash flow to equal market price of
the Bond.
-The coupon effect on the YTM
Government Bonds
Coupon rate Maturity Price Yield

8% t1 £1029 5% A
8% t2 £1039 5.96% B
8% t3 £1029 6.90% C
4% t3 £983 6.9% D
12% t3 £1136 6.85% E

The yield curve → yield at various maturities

Forward Interest Rates:
Set of interest rates that begins at some future
point other than now (t0).

PV = CF1 + CF2
(1+i1) (1+i2)2

= £ 80 + £ 1080
(1.05) (1.06)2

= £ 76 + £ 961

= £ 1037
 i.e. of the £ 1037 invested at t0

£ 76.00 £ 961
Produces t 80 Produces t 1080
at t1 for 5% at t2 for 6%
 Forward interest Rates
Example:
t0 t1 t2
Bond 1037 £ 80 £1080

£ 1037 invested at t0 @ 5 %
∴ The amount invested at t1 ( before interest payment )
£1037 X 1.05 = £1089 after £80.00 payment at t1 the
amount invested is thus
£ 1089 - £ 80 = £ 1009 amount invested in bond B at t1

∴ Value at t1* ( 1+ 1∫2) = CF2

£ 1009 ( 1 + 1∫2) = £ 1080
∴ 1∫2 = 7%
 Relationship between spot interest rates and
forward interest rates
(1+ i 2)2 =(1+ ∫1) (1+ 1∫2 )
0

i.e.
(1+ spot Rate) = geometric means of (1+ Forward Rates)

Example :

(1+ i3)3 = (1+ 0∫1 ) (1+ 1∫2 )(1+ 2∫3 )

(1.07)3 = (1.05)(1.07)(1+ 2∫3 )
(1+ 2∫3) = (1.07)3 /[(1.05)(1.07)]
= 1.09
∫
2 3 = 9%
 Conclusion of Relationships
PV

= CF1/(1+i) + CF2/(1+i2)2 + CF3/(1+i3)3

= CF1/(1+ 0∫1) + CF2/(1+ 0∫1)(1+ 1∫2) + CF3/(1+ 0∫1 )(1+ 1∫2)(1+

2∫3)

=CF1/1+YTM + CF2/(1+YTM)2 + CF3/(1+YTM)3

)1.07(/£1040 + 2)1.06(/£40 + )1.05(/£40 = 923 £
3

£ 923 = £40/(1.05) + £40/(1.05)(1.07) +

£1040/(1.05)(1.07)(1.09)

£923 = £40/(1.069) + £40/(1.069)2 +

£1040/(1.069)3
Duration number of periods into future
where bonds value , on average is
generated .

The greater duration of bond the more

it react to changes in interest rates .

Calculation by weighting the time

points from which cash flow is
generated by proportion of total value
generated at each time.
Example:
Cash Flow
price
t0 t1 t2 t3
Bond c £1029 £80 £80 £1080
Bond D £ 923 £40 £40 £1040
Interest 5% 6% 7%

Duration Bond c
=1 [80/(1.05)/1029)+2[80/(1.06)2/1029]+
3 [1080/(1.07)3/1029]=2.78

Duration Bond D
=1 [40/(1.05)/923)+2[40/(1.06)2/923]+
3 [1040/(1.07)3/923]=2.88