Lecture 10 basic tools of finance

1. Macroeconomics
Lecture 10
Basic Tools of Finance

2. Questions

3. 1.What are the two major stock markets in the U.S.?
2.Where is the NASDAQ located?
3. If the current stock price is $150 and the earnings over the past 12 months was $10, what is
the P/E ratio?
4. How often can a share price change?
5.When a stock sells, how many values are there?
6.When a company has earnings what are the two things it can do?
7. Can a company declare a dividend, even though it does not have a profit?
8.You have three investment choices: U.S.Treasury Bond, a McDonalds Bond, or McDonalds stock.
Which one would you buy and why? Which one you you recommend that your grandma buy?
9.Why are bonds that mature out in the future more risky than bonds that mature in the near
future?
10. What are two financial intermediaries?
11. How do banks make money?
12. Name two reasons to invest in a mutual fund.
NYSE and NASDAQ
Computer
$150 ÷ $12 = 12.5
With every sale
Two
retain earnings or declare dividend
yes
consider circumstances, time horizon, and appetite for risk
Time is risky
banks and mutual funds
spread
low cash and diversity of risk

4. What is the
definition of
patience?
Patience means active
waiting and enduring. It
means staying with
something and doing all
that we can—working,
hoping, and exercising
faith; bearing hardship with
fortitude, even when the
desires of our hearts are
delayed. Patience is not
simply enduring; it is
enduring well!

5. How many marshmallows you
would have after 24 hours if you
start with one and the number
doubles every 15 minutes?
2
95
39,614,081,257,132,200,000,000,000,000

6. No. Amount
0 1
1 2
2 4
3 8
4 16
5 32
6 64
7 128
8 256
9 512
10 1,024
11 2,048
12 4,096
13 8,192
14 16,384
15 32,768
16 65,536
17 131,072
18 262,144
19 524,288
20 1,048,576
21 2,097,152
22 4,194,304
23 8,388,608
24 16,777,216
25 33,554,432
26 67,108,864
27 134,217,728
28 268,435,456
29 536,870,912
30 1,073,741,824
31 2,147,483,648
32 4,294,967,296
33 8,589,934,592
34 17,179,869,184
35 34,359,738,368
36 68,719,476,736
37 137,438,953,472
38 274,877,906,944
39 549,755,813,888
40 1,099,511,627,776
41 2,199,023,255,552
42 4,398,046,511,104
43 8,796,093,022,208
44 17,592,186,044,416
45 35,184,372,088,832
46 70,368,744,177,664
47 140,737,488,355,328
48 281,474,976,710,656
49 562,949,953,421,312
50 1,125,899,906,842,620
No. Amount
51 2,251,799,813,685,250
52 4,503,599,627,370,500
53 9,007,199,254,740,990
54 18,014,398,509,482,000
55 36,028,797,018,964,000
56 72,057,594,037,927,900
57 144,115,188,075,856,000
58 288,230,376,151,712,000
59 576,460,752,303,423,000
60 1,152,921,504,606,850,000
61 2,305,843,009,213,690,000
62 4,611,686,018,427,390,000
63 9,223,372,036,854,780,000
64 18,446,744,073,709,600,000
65 36,893,488,147,419,100,000
66 73,786,976,294,838,200,000
67 147,573,952,589,676,000,000
68 295,147,905,179,353,000,000
69 590,295,810,358,706,000,000
70 1,180,591,620,717,410,000,000
71 2,361,183,241,434,820,000,000
72 4,722,366,482,869,650,000,000
73 9,444,732,965,739,290,000,000
74 18,889,465,931,478,600,000,000
75 37,778,931,862,957,200,000,000
76 75,557,863,725,914,300,000,000
77 151,115,727,451,829,000,000,000
78 302,231,454,903,657,000,000,000
79 604,462,909,807,315,000,000,000
80 1,208,925,819,614,630,000,000,000
81 2,417,851,639,229,260,000,000,000
82 4,835,703,278,458,520,000,000,000
83 9,671,406,556,917,030,000,000,000
84 19,342,813,113,834,100,000,000,000
85 38,685,626,227,668,100,000,000,000
86 77,371,252,455,336,300,000,000,000
87 154,742,504,910,673,000,000,000,000
88 309,485,009,821,345,000,000,000,000
89 618,970,019,642,690,000,000,000,000
90 1,237,940,039,285,380,000,000,000,000
91 2,475,880,078,570,760,000,000,000,000
92 4,951,760,157,141,520,000,000,000,000
93 9,903,520,314,283,040,000,000,000,000
94 19,807,040,628,566,100,000,000,000,000
95 39,614,081,257,132,200,000,000,000,000
2
95

7. Index Fund
Buy one share of all the
companies in the
market

8. Exchange Indexes
Dow Jones Industrial Average
(DJIA)
30 biggest U.S. Companies
S&P 500
500 biggest U.S. companies
NASDAQ

9. 0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
0 100 200 300 400 500 600 700 800 900 1000
Interest
Profit
Rate
%
Loanable Funds
Supply
Demand
Market for Loanable Funds

10. Intellectual
Financial Physical
Human
Culture
Entrepreneur
trust
knowledge
skills
personality
health
relationships
natural resources
time
buildings
equipment
things than make things
money and risk
savers and borrowers
time is money
(1+r)n
insurance
limited liability corporations
ideas
technology
methods

11. Basic Tools
of
Finance

12. A
Win $100 Dollars
What would you prefer?
B
Flip a coin:
50 percent chance you
win $200 dollars
50 percent chance you
win nothing.

13. A
Lose $100 Dollars
What would you prefer?
B
Flip a coin:
50 percent chance you
lose $200 dollars
50 percent chance you
lose nothing.

14. Survey
Most people avoid risk
on gains
but prefer to take risks
to avoid loss

15. Key Terms
finance
present value
future value
compounding
discounting
risk aversion
diversification
firm-specific risk
market risk
fundamental analysis
efficient market hypothesis
information efficiency
random walk

16. Key Formulas
(1+r)
N
r = rate
N = number of periods
Compounding
FutureValue or FV
multiplying
Discounting
PresentValue or PV
dividing
(1+r)N
1

17. Finance
Time and Risk

18. Tomorrow
OneYear
TenYears

19. Discount the future
Today is worth
more than
tomorrow

20. Promissory Note
Trading paper for paper
I.O. U.
$1
Dr. Gale

21. Rates
and
Compounding
Linear
versus
Exponential

22. 0
8
16
24
32
40
48
56
64
1 2 3 4 5 6
2
4
8
16
32
64
2
4
6
8
10
12
Linear versus Exponential
Adding versus Compounding
+
^

23. N Start Add End
0 100.00 7.00 107.00
1 107.00 7.00 114.00
2 114.00 7.00 121.00
3 121.00 7.00 128.00
4 128.00 7.00 135.00
5 135.00 7.00 142.00
Fixed Amount

24. Grow by a percentage
each year,
not a fixed amount
Compounding

25. Compounding
The process of finding
the future value of a
present sum of money
multiplying

26. Discounting
The process of finding
the present value of a
future sum of money
dividing

27. compounding is the
inverse of discounting
discounting is the
inverse of compounding

28. 7%
N Start Add End
0 100.00 7.00 107.00
1 107.00 7.49 114.49
2 114.49 8.01 122.50
3 122.50 8.58 131.08
4 131.08 9.18 140.26
5 140.26 9.82 150.07
Compounding

29. CAGR
Compounded
Annual
Growth
Rate

30. Fixed 7%
N Start Add End Start Add End
0 100.00 7.00 107.00 100.00 7.00 107.00
1 107.00 7.00 114.00 107.00 7.49 114.49
2 114.00 7.00 121.00 114.49 8.01 122.50
3 121.00 7.00 128.00 122.50 8.58 131.08
4 128.00 7.00 135.00 131.08 9.18 140.26
5 135.00 7.00 142.00 140.26 9.82 150.07
Fixed vs. Compounding

31. Compounding
8%
4%
2%
time
amount

32. Rate
Amount in 30
years
1% 136.13
2% 184.76
4% 337.31
8% 1,086.77
16% 9,958.59
32% 546,753.87

33. Rate
Amount in 30
years
1% 136.13
2% 184.76
4% 337.31
8% 1,086.77
16% 9,958.59
32% 546,753.87

34. What would you rather have?
A. 100 dollars today
B. 500 dollars in 5 years
C. 1,000 dollars in 10 years
38%
26%
CAGR

35. Key Formulas
(1+r)
N
r = rate
N = number of periods
Compounding
FutureValue or FV
multiplying
Discounting
PresentValue or PV
dividing
(1+r)N
1

36. Present Future
r = growth rate
N = number of periods
?
(1+r)
N
FutureValue ?

37. Present Future
r = growth rate
N = number of periods
?
PresentValue ?
(1+r)N
1

38. Quiz 4 Name ___ ID____
1. FutureValue (FV) of 500 in 5 years at 5 percent.
2. FV of 100 in 10 years at 8 percent.
3. FV of 500 in 20 years at 8 percent.
4. FV of 100 in 10 years at 8 percent.
5. FV of 300 in 3 years at 20 percent.
6. PresentValue (PV) of 500 in 5 years at 5 percent.
7. PV of 1000 in 10 years at 10 percent.
8. PV of 5000 in 7 years at 4 percent.
9. PV of 1,000,000 in 20 years at 3 percent.
10. PV of 500,000 in 12 years at 8 percent.

39. FutureValue
The amount of money
in the future, using an
growth rate, that a
present amount will
produce

40. Key Formula 1
(1+r)
N
r = rate
N = number of periods
FutureValue or FV

41. (1+r)
N
r = 10%
FV =?
1 1.100
2 1.210
3 1.331
4 1.464
5 1.611
N FV

42. PresentValue
The amount of money
need today, using an
growth rate, to
produce a future
amount

43. Key Formula 2
(1+r)N
r = rate
N = number of periods
PresentValue or PV
1 Reciprocal
of the
FV formula

44. (1+r)N
r = 10%
N = 5
PV =?
1 .909
2 .826
3 .751
4 .683
5 .621
3.791
N PV
1

45. Worth less and less
due to time and risk
1 0.935
2 0.873
3 0.816
4 0.763
5 0.713
6 0.666
7 0.623
8 0.582
9 0.544
10 0.508
7% discount

46. Insurance
Sharing risk
Does not eliminate risk
Spread around risk

48. Risk Aversion
A dislike of uncertainty

50. Colonization for Profit
Joint Stock Companies to raise
financial capital
Lots of small investors
Insurance Companies to cover
losses
share the risk

51. Pool the Risk

52. Scenario
Cost: 1000
Risk: 1 in 100 or 1%
Expected cost =
cost x risk =
1000 x .01=10
Get 10 people to give 10

53. Scenario
Expected cost =10
Total Cost = 1000
Get 100 people to give
10 each to fund the
account
10 x 100 = 1000