In this PPT, you will learn about how you can value your money and relation between, risk and return.

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Introduction To Business Finance

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

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Outline – Mauneel Desai
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”

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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:
1/(1 )
(1 )
t
t
PV FV DF
FV PV CF
where PV = present value;
FV = future value;
DF = discount factor = R
CF = compounding factor = R
R = interest rate per perio
 
 


d; 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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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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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 A
Investment B
Time
Investment value

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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 (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)
Risk
Expected return
Rf
0

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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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