Chapter 11 Week 1Today’s Learning ObjectivesWhat is the Difference between Return Of and Return On an Investment?Return on InvestmentWhat is rate of return?Rate of Return (RoR)Rate of ReturnPowerPoint PresentationWhat is Risk?Risk-Return RelationshipsSlide 11How are Risk and Return Related?Types of Risk?AnnouncementsChapter 11 Week 1-2Slide 16What is the Difference between Simple and Compound Interest?Slide 18Slide 19Slide 20More Frequent Compound InterestSlide 22What happens when we compound more frequently?Slide 24What are the Time Value of Money Components?What is the Future Value of $1?Slide 27Using the Future Value of $1 TableFV of $1 TableWhat is the Present Value of $1?Present ValuePresent Value/Future Value Using the TablesSlide 33Slide 34Present Value/Future Value using the Tables$4,967 -- Does this make sense?Slide 37Slide 38Slide 39Slide 40Slide 41McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter 11 Week 1Chapter 11 Week 1The Time Value of MoneyAinsworth6e11BAR_nm2Ainsworth6e11BAR_nm211-2Today’s Learning ObjectivesToday’s Learning Objectives•LO1 Explain the risk/return relationship.•LO2 Use the time value of money concepts to solve present and future value problems.11-3What is the Difference between Return Of and Return On an Investment?What is the Difference between Return Of and Return On an Investment?•Return OFReturn of the initial amount invested•Return ONAdditional amount returned in excess (or less than) the amount invested11-4Return on InvestmentReturn on InvestmentBob invested $100Bob invested $100and after a yearand after a yearreceived $111.received $111.Bob received a return Bob received a return OFOF his investment of $100 his investment of $100and a return and a return ONON his investment of $11 his investment of $1111-5•Any amount you get back in excess of your original investment is your “return on investment.”•Investment #1: On January 1 you invest $10,000 and on December 31 the investment is worth $11,000.•Investment #2: On January 1 you invest $5,000 and on December 31 the investment is worth $5,800. •Which investment is better?What is rate of return?What is rate of return?11-6Rate of Return(RoR)Rate of Return(RoR)•RoR is a common-size ratio that allows us to rank and compare different investments regardless of size. return return onon investment investment Rate of Return = ------------------------ Rate of Return = ------------------------ the amount invested the amount invested•RoR is a percentage measure of the return on investment relative to the amount invested.11-71,00010,000=10%8005,000=16%RoRRoR•Investment #1: On January 1 you invest $10,000 and on December 31 the investment is worth $11,000.Return on investment = $1,000.•Investment #2: On January 1 you invest $5,000 and on December 31 the investment is worth $5,800. Return on investment = $800.Now which investment is better?Now which investment is better? Rate of Return Rate of Return11-8What is Risk ? Investment AInvestment AInvestment BInvestment BLikelihood Return Likelihood Return100% $15,000 50% $30,00050% $0Average ExpectedAverage Expected ReturnReturn$15,000$15,000Average Expected Average Expected ReturnReturn$15,000$15,000Which investment do you prefer?Which investment do you prefer?11-9With investment A, the return is certain. With investment B, there is a risk of receiving no return for the period—and a chance to receive a greater return. (No right answer)If you prefer investment Aprefer investment A you areIf you prefer investment Bprefer investment B you areIf you are like both equallylike both equally you areRisk AverseRisk SeekingRisk NeutralWhat is Risk?What is Risk?11-10•Generally, the average investor is risk averse.•Risk adverse investors don’t like to take risks and require compensation in order to take on risk.•“Compensation” in this setting means a “risk premium” --- meaning higher rates of return.Risk-Return RelationshipsRisk-Return Relationships11-11•Consider our two investments again . . .Investment AInvestment AInvestment BInvestment BLikelihood Return Likelihood Return100% $15,000 50% $30,00050% $0Average ExpectedAverage Expected ReturnReturn$15,000$15,000Average ExpectedAverage Expected ReturnReturn$15,000$15,000At a price of $100,000, At a price of $100,000, Investment A would yield an Investment A would yield an expected rate of return of 15% expected rate of return of 15% ($15,000/$100,000).($15,000/$100,000).If a 17% expected return is If a 17% expected return is demanded on Investment B demanded on Investment B (2% risk premium), the price of (2% risk premium), the price of Investment B would be less Investment B would be less than $100,000 ($88,200 to be than $100,000 ($88,200 to be exact).exact).Ex 11.1Ex 11.1Risk-Return RelationshipsRisk-Return Relationships11-12How are Risk and Return Related?How are Risk and Return Related?•Expected rate of returnEstimated rate of return on an investment•Risk premiumExpected rate of return adjusted for inflation, business, and liquidity risk•Note: The greater the risk, the higher the expected rate of return.11-13Types of Risk?Types of Risk?•RiskThe chance of an unfavorable outcome•Inflation riskRisk of changing price levels•Business riskRisk of a particular company going out of business•Liquidity riskRisk that an investment cannot be converted into cash when needed11-14AnnouncementsAnnouncements•If you did not sign in today, please make sure you sign in on Thursday.•If you have a role tablet, please return to me.•Review syllabus and desire2learn website.•Read (or re-read) Chapter 11.•Print off Chapter 11 slides…both days! Add your notes from today.•Print off present value tables and bring to class for next few weeks.McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter 11 Week 1-2Chapter 11 Week 1-2The Time Value of Money11-16Today’s Learning ObjectivesToday’s Learning Objectives•LO1 Explain the risk/return relationship.•LO2 Use the time value of money concepts to solve present and future value problems.11-17What is the Difference between Simple and Compound Interest?What is the Difference between Simple and Compound Interest?•What is interest?The cost of borrowing money (2 kinds of interest)b SIMPLE/COMPOUND•Simple InterestInterest is calculated on principal onlyInterest (1) =