CMGT 547 – Managerial Engineering Economics

Week #3 – Chapters #3 & 4

This lecture will be recorded and posted to Blackboard.

 Lecture Overview
• Chapter 2 Review
• Engineer’s Impact on Financial Outcomes, Financial Statements,
Cash Flows, & Financial Ratios
• Chapter 3 Lecture
• Chapter Topics
• Example Problems
• Chapter 4 Lecture
• Chapter Topics
• Example Problems
Figure 2.3
Summary of major factors affecting stock price.

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Figure 2.2
Information reported on a company’s financial statements.

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Figure 2.5
The cash flow cycle in a typical manufacturing firm.

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Figure 2.9
Types of financial ratios used in evaluating a firm’s financial health.

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 Limitations of Financial Ratios
o Analysts should be aware of ever-changing
market conditions and make the necessary
adjustments.
o Difficult to generalize about whether a
particular ratio is good or bad
o Ratio analysis based on any one year may not
represent the true business condition.

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Chapter Opening Story —Take a Lump Sum or Annual Installments
• Winning the $1 billion jackpot ticket
sold on January 23, 2021.
• The winner had two options:
– Option 1: Take a lump sum cash
payment of $530M after tax.
– Option 2: Collect an initial
payment of $11.35M now and
take an annuity payment of
$11.35M a year for 29 years.
• Which option would you
recommend?

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What Do We Need to Know?
• Be able to compare the value of money at different points in
time.
• Need a method for reducing a sequence of benefits and costs
to a single point in time.

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Time Value of Money
• Money has a time value
because it can earn
more money over time
(earning power).
• Money has a time value
because its purchasing
power changes over
time (inflation).

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The Market Interest Rate
• Interest is the cost of money—a cost to the borrower and a
profit to the lender.
• Time value of money is measured in terms of market interest
rate, which reflects both earning and purchasing power in the
financial market.

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Cash Flow Diagram (A Graphical Representation of Cash
Transactions Over Time)

• Borrow $20,000 at 9%
interest over 5 years,
requiring $200 loan
origination fee upfront.
The required annual
repayment is $5,141.85
over 5 years.
– n = 0: $20,000
– n = 0: $200
– n 1~ 5 : $5,141.85

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End-of-Period Convention
• Convention: Any cash flows
occurring during the
interest period are
summed to a single
amount and placed at the
end of the interest period.
• Logic: This convention
allows financial institutions
to make interest
calculations easier.

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Methods of Calculating Interest
• Simple interest: Charging an interest rate only to an initial sum
(principal amount).
• Compound interest: Charging an interest rate to an initial sum
and to any previously accumulated interest that has not been
withdrawn.
– Note: Unless otherwise mentioned, all interest rates used
in engineering economic analyses are compound interest
rates.

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Simple Interest
• Formula: • P = $1,000, i = 10%, N = 3 years

F P  (iP )N
End of Beginning Interest Ending
Year Balance Earned Balance
where
0 $1,000
P = Principal amount
Blank Blank

1 $1,000 $100 $1,100

i = simple interest rate
2 $1,100 $100 $1,200
N = number of interest periods
3 $1,200 $100 $1,300
F = total amount accumulated at
the end of period N
• F $1,000  (0.10)($1,000)3
$1,300

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Compound Interest
• Formula: • P = $1,000, i = 10%, N = 3 years

n 0 : P
End of Beginning Interest Ending
n 1: F1 P (1  i ) Year Balance Earned Balance
0 $1,000
Blank Blank

n 2 : F2 F1(1  i ) P (1  i )2
1 $1,000 $100 $1,100
 2 $1,100 $110 $1,210
n N : F P (1  i )N 3 $1,210 $121 $1,331

• F $1,000(1  0.10)3 $1,331

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Compounding Process

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The Fundamental Law of Engineering Economy

F P (1  i )N

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Warren Buffett’s Berkshire Hathaway
• Went public in 1965: $18 per share
• Worth today (July 26, 2022):
$431,908 per share
• Annual compound growth: 19.35%
• Current market value: $634.71
billion
• If his company continues to grow at
the current pace, what will be his • Assume that the company’s stock will
company’s total market value when continue to appreciate at an annual
he reaches 100? (He is 91 years old rate of 19.35% for the next 9 years.
as of 2022.) The stock price per share at his 100th
birthday would be

F 431,908(1  0.1935)9 $2,122,233

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Example 3.2 Comparing Simple With Compound Interest
In 1626, American Indians sold Manhattan Island to Peter Minuit
of the Dutch West Company for $24.
• Given: If they saved just $1 from the proceeds in a bank
account that paid 8% interest,
• Find:
– (a) how much would their descendants have in 2022?
– (b) As of 2022, the total US population would be close to
332 million. If the total sum would be distributed equally
among the population, how much would each person
receive?

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Solution
(a) P $1
i 8%
N 396
F $1(1  0.08)396
$17,211,042,333,784

$17,211,042,333,784
(b) Amount per person 
330,000,000
$51,840

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What is “Economic Equivalence?”

Economic equivalence exists between cash

flows that have the same economic effect and
could therefore be traded for one another.

Even though the amounts and timing of the

cash flows may differ, the appropriate interest
rate makes them equal in the economic sense.

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Equivalence Example: Compounding Concept

• If you deposit P F

dollars today for N

periods at interest F P(1  i) N

rate i, you will have

0
F dollars at the end N
of period N.

P
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Equivalence – Discounting Concept

• F dollars at the end P

of period N is equal
to a single sum P
dollars now, if your 0 N

earning power is F

measured in terms P F (1  i ) N
of interest rate i.
0 N

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 Equivalence Example 3.3
 Given: If you deposit
$2,042 today in a $2,042
savings account that
pays an 8% interest
annually, how much
would you have at 0 1 2 3 4 5
the end of 5 years? F
 Find: At an 8%
interest, what is the =
equivalent worth of
$2,042 now in 5
0 5
years?

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 Solution
Various dollar amounts that will be economically
equivalent to $3,000 in five years, at an interest
rate of 8%

F $2, 042(1  0.08)5

$3, 000

$2,042

0 1 2 3 4 5
F

=
0 5

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Equivalent Example 3.4: Cash Flows
Given: $2,042 today was equivalent to
receiving $3,000 in five years, at an
interest rate of 8%.
Find: Are these two cash flows are also
equivalent at the end of year 3?

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 Solution
 Equivalent cash flows are
equivalent at any common point
in time, as long as we use the
same interest rate (8%, in our
example).

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 Finding an Equivalent Value for Multiple
Payments
• Solution
 Compute the equivalent        Compounding
   Process:
 $511.90
       
V3 100(1  0.10)3  $80(1  0.10)2  $120(1  0.10)  $150
value of the cash flow series  $200(1
    0.10)
1
    $100(1
    0.10)
 
2

at n = 3, using i = 10%.
Discounting Process: $264.46

$511.90  $264.46
$776.36
V3
$200 V
$200
=
$150
$120
$100 $100 $150
$80
$120
$100 $100
$80
0 1 2 3 4 5 0 1 2 3 4 5

0 1 2 3 4 5

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 Comparing Two Different Cash Flows
 Find C, making the two cash flow  Approach
transactions equivalent at i = 10%. • Step 1: Select a base period to use, say n = 2.
• Step 2: Find the equivalent lump sum value at
n = 2 for both A and B.
$1,000 • Step 3: Equate both equivalent values and solve
$500 for the unknown, C.
A
$1,000
0 1 2 3 $500
For A: V2 $500(1  0.10)2  $1,000(1  0.10) 1 A
C C $1,514.09 0 1 2 3
For B: V2 C (1  0.10)  C
B 2.1C
C C
2.1C $1,514.09
0 1 2 3 C $721 B

0 1 2 3

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 Finding an Interest Rate that Establishes
an Economic Equivalence
 At what interest rate would you
be indifferent choosing between  Approach
the two cash flows? • Step 1: Select a base period to compute the
equivalent value (say, n = 3).
• Step 2: Find the equivalent worth of each cash flow
$1,000 series at n = 3.

$500
$1,000
A 3
Option A : F3 $500(1  i)  $1,000
$500
2
0 1 2 3 Option B: F3 $502(1  i)  $502(1  i)  $502
A
0 1 2 3
i = 8%
$502 $502 $502 Option A : F3 $500(1.08)3  $1,000
$502 $502 $502
$1,630
B
Option B : F3 $502(1.08)2  $502(1.08)  $502 B
$1,630
0 1 2 3 0 1 2 3

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 Types of Common
Cash Flows in
Engineering
Economics
 Single cash flow
 Equal (uniform) payment
series at regular intervals
 Linear gradient series
 Geometric gradient series
 Irregular (random)
payment series

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 Equivalence Relationship Between P and F

Compounding Process
Finding an equivalent
future value of a current
cash payment

 Discounting Process
Finding an equivalent
present value of a future
cash payment

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 Singe Cash Flow Formula
Compound Amount Factor

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Example 3.7: Find F, Given i, N, and P
Given: P = $2,000,  Excel Solution
i = 10%, N = 8 years

Find: F

F $2,000(1  0.10)8
$2,000(F / P ,10%,8)
$4,287.18

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 A Typical Compound Interest Table at 12%

To find the compound

interest factor when the
interest rate is 12% and
the number of interest
periods is 10, we could
evaluate the following
equation using the
interest table.

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 Single Cash Flow Formula
Present Worth Amount Factor

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 Example 3.8: Find P, Given i, N, and F
Given: F = $1,000, i = 12%, N Excel Solution
= 5 years
Find: P

P $1,000(1  0.12) 5
$1,000(P / F ,12%,5)
$567.43

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 Example 3.9: Find i, Given P, F, and N
Given: F = $20, P = $10,
• Cash Flow Diagram
N = 5 years
Find: i

 Excel Solution

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 Example 3.10: Find N, Given P, F, and i
Given: P = $6,000, F • Solving for N
= $12,000, i = 20%
Find: N
F 2P P(1  0.20)N
2 1.2N
log2 N log1.2
log2
N
log1.2
3.80 years

 Excel Solution

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Rule of 72
Approximating how long it • Number of Years Required to Double an
will take for a sum of money Initial Investment at Various Interest Rates
to double

72
N
interest rate (%)
72

20
3.6 years

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 Equal Payment Series
F
u re Wo rth
u i val e nt Fut
Eq

0 1 2 N
A A A

0 1 2 N

Equivalent Present Worth 0 N

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Equal-Payment Series Compound
Amount Factor
• Formula

A A A

0 1 2 N
0 1 2 N

=
0 1 2
N

A A A

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 An Alternate Way of Calculating the
Equivalent Future Worth, F
F

A(1+i)N-2
A A A

A(1+i)N-1

0 1 2 N 0 1 2 N

N
N 1 N 2  (1  i )  1
F A(1  i)  A(1  i)    A A  
 i 
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 Example 3.11: Uniform Series:
Find F, Given i, A, and N
 Given: A = $3,000, N = 10 years, and i = 7%
per year

 Find: F

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 Solution

 Excel Solution

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 Example 3.12: Handling Time Shifts:
Find F, Given i, A, and N
 Given: A = $3,000, N = 10 years, and i =
7% per year where the first deposit is
made at n = 0
Find: F

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 Solution

Excel Solution:

o Each payment has been shifted to one year

earlier, thus each payment would be compounded
for one extra year.

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 Sinking-Fund Factor:
Find A, Given i, A, and F

F
A A A

0 1 2 N 1 2 N

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 Example
• Formula to use
 Given: F = $5,000, N = 5
years, and i = 7% per year

 Find: A
A $5,000(A / F ,7%,5)
A $5,000(A / F ,7%,5) $869.50
$869.50
$5,000

0 1 5
 Excel Solution

=PMT(7%,5,0,5000)
A

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 Example 3.14: Comparison of Three Different
Retirement Plans

Given: Three
investment plans and
i = 8%
 Find: Balance on
65th birthday

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 Solution

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Example 3.16: Deferred Loan Repayment

 Given: P = $250,000,
N = 6 years, and i =
8% per year, but the
first payment occurs
at the end of year 2

 Find: A

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 Solution
• Step 1. Find the
equivalent amount of
borrowing at the end of
year 1:

• Step 2. Use the capital

recovery factor to find
the size of the annual
installment:

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Example 3.17: Uniform Series: Find P, Given A,
i, and N

 Given: A = • Present Worth Factor

$9,791,667, N = 30
years, and i = 5%
per year
 Find: P

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 Solution
Formula to use:
• Cash Flow Diagram

 Excel Solution

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 Linear Gradient Series
Gradient Series as a Composite Series of a
A Strict Gradient Series Uniform Series of N Payments of A1 and the
Gradient Series of Increments of Constant
Amount G

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Example 3.18: Linear Gradient: Find P, Given A1, G, N, and i

 Given: A1 = $1,000, G = $250, N = 5 years, and i = 12%

per year
 Find: P

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 Solution

Excel Solution

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 Gradient-to-Equal-Payment Series
Conversion Factor, (A/G, i, N)
• Cash Flow Series
 Given: G = $1,000,
N = 10 years, i =
12%
 Find: A

Solution
• Factor Notation
A $1,000(A / G ,12%,10)
$1,000(3.5847)
$3,584.70

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Example 3.19: Linear Gradient: Find A, Given A1, G, i, and
N
 Given: A1 = $1,000, G = $300, N = 6 years, and i = 10% per year

 Find: A

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 Solution

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Example 3.20: Declining Linear Gradient Series: Find F, Given A1,
G, I, and N

 Given: A1 = $1,200,
G = -$200, N = 5 years,
and i = 10% per year

 Find: F

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 Solution
 Strategy: Since we have no
interest formula to compute
the future worth of a linear
gradient series directly, we first
find the equivalent present
worth of the gradient series
and then convert this P to its
equivalent F.
 Solution

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 Present Worth of Geometric
Gradient Series
 Formula

 Factor Notation

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Example 3.21: Geometric Gradient Series

 Given: A1 = $54,600,
g = 7%, N = 5 years,
and i = 12% per year

 Find: P

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 Solution

 1  (1  0.07)5 (1  0.12) 5 
POld $54,600  
 0.12  0.07 
$222,937
PNew $54,600(1  0.23)(P / A,12%,5)
$42,042(3.6048)
$151,552
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Example 3.22: Retirement Plan: Saving $1 Million

 Given:
o F = $1,000,000,
o g = 6%,
o i = 8%, and
o N = 20

 Find: A1

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 Solution

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 Example 3.23: Uneven Payment Series
How much do you need to
deposit today (P) to withdraw
$25,000 at n = 1, $3,000 at n = 2,
and $5,000 at n = 4, if your
account earns 10% annual
interest?

$25,000

$3,000 $5,000
0
1 2 3 4

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Check to see if $28,622 is indeed sufficient.
0 1 2 3 4
Beginning 0 28,622 6,484.20 4,132.62 4,545.88
Balance
Interest 0 2,862 648.42 413.26 454.59
Earned
(10%)
Payment +28,622 −25,000 −3,000 0 −5,000

Ending $28,622 6,484.20 4,132.62 4,545.88 0.47

Balance

Rounding error.
It should be “0.”

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Example 3.25: Future Value of an Uneven Series with
Varying Interest Rates
 Given: Deposit series as given over 5 years

 Find: Balance at the end of year 5

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 Solution

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 Composite Cash Flows
 Situation 1: If you make 4 annual
deposits of $100 in your savings
account, which earns 10% annual
interest, what equal annual amount
(A) can be withdrawn over 4
subsequent years?
 Situation 2: What value of A
would make the two cash flow
transactions equivalent if i = 10%?

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 Establishing Economic Equivalence
Method 1: At n = 0 Method 2: At n = 4

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 Example 3.28: Calculating an Unknown Interest Rate

 Given: Two payment options

o Option 1: Take a lump sum payment in the amount of $192,373,928.
o Option 2: Take the 30-installment option ($9,791,667 a year).

 Find: i at which the two options are equivalent

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 Solution
$192,373,928 $9,791,667(P / A, i ,30)
(P / A, i ,30) 22.3965

 Excel Solution:

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 Chapter #3 Example Problems

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Nominal and Effective Interest Rates

Lecture No. 10
Chapter 4
Contemporary Engineering Economics
Copyright © 2016

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 Nominal Versus Effective
Interest Rates

Nominal Interest Rate: rate quoted based

on an annual period

Effective Interest Rate: actual interest

earned or paid in a year or some other
time period

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 Financial Jargon

18% Compounded Monthly

Interest
Nominal
period
interest rate

Annual
percentage
rate (APR)

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 18% Compounded Monthly
• What It Really Means? • Example: Suppose that you
– Interest rate per month (i) = 18%/12 invest $1 for 1 year at 18%
= 1.5% compounded monthly. How
– Number of interest periods per year
much interest would you earn?
(N) = 12
• In words:
– Bank will charge 1.5% interest each
month on your unpaid balance, if F $1(1  i)12 $1(1  0.015)12
you borrowed money. $1.1956
– You will earn 1.5% interest each I $1.1956  $1.00 $0.1956

month on your remaining balance, if

you deposited money.
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 Effective Annual Interest Rate (Yield)
• Formula • Example
• 18% compounded monthly
r M
ia (1  )  1
M 
ia  1 
 12 
12
0.18 
  1 19.56%
r = nominal interest rate per year • What it really means
ia = effective annual interest rate • 1.5% per month for 12 months
M = number of interest periods per year • 19.56% compounded once per year

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 Practice Problem
• Solution
Suppose your savings account
pays 9% interest compounded (a) Interest rate per quarter:
quarterly. 9%
i  2.25%
(a) Interest rate per quarter 4
(b) Annual effective interest (b) Annual effective interest rate:
rate (ia) ia (1  0.0225)4  1 9.31%
(c) If you deposit $10,000 for (c) Balance at the end of one year (after 4 quarters)
one year, how much
F $10,000(F / P ,2.25%,4)
would you have?
$10,000(F / P ,9.31%,1)
$10,931

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Nominal and Effective Interest Rates with
Different Compounding Periods
Effective Rates
Nominal Compounding Compounding Compounding Compounding Compounding
Rate Annually Semi-annually Quarterly Monthly Daily

4% 4.00% 4.04% 4.06% 4.07% 4.08%

5 5.00 5.06 5.09 5.12 5.13

6 6.00 6.09 6.14 6.17 6.18

7 7.00 7.12 7.19 7.23 7.25

8 8.00 8.16 8.24 8.30 8.33

9 9.00 9.20 9.31 9.38 9.42

10 10.00 10.25 10.38 10.47 10.52

11 11.00 11.30 11.46 11.57 11.62

12 12.00 12.36 12.55 12.68 12.74

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 Why Do We Need an Effective
Interest Rate per Payment Period?
Whenever payment and compounding periods differ from
each other, you need to find the equivalent interest rate so
that both conform to the same unit of time.

Payment period

Interest period

Payment period

Interest period

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 Effective Interest Rate per Payment Period (i)

C
 r 
i  1   1
 CK 

 C = number of interest periods per payment period

 K = number of payment periods per year
 CK = total number of interest periods per year, or M
 r/K = nominal interest rate per payment period

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 Equivalence Calculations using
Effective Interest Rates
St • Identify the payment period (e.g.,
ep annual, quarter, month, week, etc.).
1
St • Identify the interest period (e.g.,
ep annually, quarterly, monthly, etc.).
2
St • Find the effective interest rate that
ep covers the payment period.
3
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Case I: When Payment Period is Equal to
Compounding Period

St • Identify the number of

ep compounding periods (M) per year.
1
St • Compute the effective interest rate
ep per payment period (i).
2
St • Determine the total number of
ep payment periods (N).
3

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Example 4.4: Calculating Auto Loan Payments

 Given:
o MSRP = $20,870
o Discounts & Rebates = $2,443
o Net sale price = $18,427
o Down payment = $3,427
o Dealer’s interest rate = 6.25% APR
o Length of financing = 72 months

 Find: the monthly payment (A)

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 Solution

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Case II: When Payment Periods Differ from Compounding
Periods
 Step 1: Identify the following parameters.
• M = No. of compounding periods
• K = No. of payment periods per year
• C = No. of interest periods per payment period
 Step 2: Compute the effective interest rate per payment
period. i [1  r / CK ]C  1
• For discrete compounding
i er /K  1
• For continuous compounding

 Step 3: Find the total no. of payment periods.

• N = K (no. of years)

 Step 4: Use i and N in the appropriate equivalence formula.

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 Example 4.5: Compounding Occurs More
Frequently than Payments Are Made
(Discrete Case)
 Given: o Effective interest rate per
o A = $1,500 per quarter
quarter, 3
o r = 6% per year,  0.06 
i  1   1
o M = 12  12 
compounding
periods per year,
1.5075% per quarter
and
o N = 2 years o N = 4(2) = 8 Quarters

 Find: F
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 Solution
Cash flow diagram

F = $1,500 (F/A, 1.5075%, 8)

= $14,216.24

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Example 4.6: Compounding Is Less Frequent than
Payments
 Given:
o A = $500 per month
o M = 4 compounding periods/year
o K = 12 payment periods/year
o C = 1/3 interest period per quarter
o N = 10 years or 120 months 1/3
 0.10 
i  1   1
 Find: F  4 
0.826%

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 Solution

Cash Flow Diagram

F = $500 (F/A, 0.826%, 120)

= $101,907.89
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 Key Points
o Financial institutions often quote interest rate
based on an APR.
o In all financial analyses, we need to convert the
APR into an appropriate effective interest rate
based on a payment period.
o When payment period and interest period differ,
calculate an effective interest rate that covers the
payment period. Then use the appropriate interest
formulas to determine the equivalent values.

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 Single-Payment Transactions with
Continuous Compounding: Future Worth
F

N
F P(1  i)
0
r N
P(1  e  1) N

rN
Pe
P

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 Practice Problem
If you invest $1,000 in a savings account that pays 6% annual interest
compounded continuously, what would be the balance at the end of 3 years?

F =?

0
1 2 3

$1,000

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 Solution

0.06
ia e 1
6.18%
F $1, 000( F / P, 6.18%,3)
$1,197.09

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Single-Payment Transactions with Continuous
Compounding: Present Worth
F

N
P F (1  i)
r N 0
F (1  e  1) N
 rN
Fe
P

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 Continuous-Funds Flow

P    ft( )t e  rt
t  0
N
 ft( )e  rt dt
0

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Summary of Interest Factors for Typical Continuous Cash Flows with
Continuous Compounding

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 Example 4.10: Continuous Flows and
Continuous Compounding

 Given: A = $200
per day, r = 6% per
year, M = 365
compounding
periods per year,
and N = 455 days

Note: A 15-month period

 Find: F is 1.25 years.

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 Solution

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 Example 4.11: Continuous Flows and
Continuous Compounding

 Given: A = $200
per day, r = 6% per
year, M = 365
compounding
periods per year,
and N = 455 days

Note: A 15-month period

 Find: F is 1.25 years.

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 Solution

• Find G:

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 Solution

• Find P:

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Example 4.14: Loan Balance, Principal, and Interest

 Given:
o P = $5,000,
o i = 12% APR,
o N = 24 months

 Find: A

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 Solution

 Monthly Payment:
A = $5,000(A/P, 1%, 24)
= $235.37

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Calculating the Remaining Loan Balance after Making the
nth Payment

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 Example 4.15: Loan Balance at End of Period 6

Given: P = $5,000,
i = 12% APR, N = 24
months

 Find: Loan
balance, principal,
and interest
payment for the 6th
payment

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 Solution
 Monthly payment: $235.37
 Interest payment at n = 6

• Loan balance at the end

of n = 5, or beginning of
n=6

• Interest payment

• Principal payment

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Example 4.17: Financing Your Vehicle
 Given:
• Three financing
options
• r = 4.5%
• Payment period =
monthly
• Compounding period
= monthly

 Find: Which option

is best?
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 Solution
• Option A: Conventional Debt Financing:
Pdebt = $4,500 + $736.53(P/A, 4.5%/12, 42)
− $17,817(P/F, 4.5%/12, 42)
= $17,847

• Option B: Cash Financing

Pcash = $31,020 − $17,817(P/F,4.5%/12,42)
= $15,845

• Option C: Lease Financing

Please = $1,507.76 + $513.76(P/A, 4.5%/12,
42)
+ $395(P/F, 4.5%/12, 42)
= $21,336

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 Home Mortgage
Types of Home Mortgages The Cost of a
Mortgage

• Fixed-rate mortgage • Loan amount

• Adjustable-rate mortgage • Loan term
• Hybrid mortgage • Payment frequency
• Points (prepaid interest)
• Fees
• Types of mortgages

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 Example 4.16: An Interest-Only Versus a Fully Amortized
Mortgage
 Given:

• P = $200,000,
– APR = 6.6% or 0.55% per month, and
– N = 30 years

 Find: (a) monthly payment; (b) interest payments during the first year of
ownership of the home.

• Option 1: A fully amortized payment option.

• Option 2: A five-year interest-only option.
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 Solution
• (a) Monthly payments

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 Solution
• (b) Interest payments

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 Calculating the Monthly Payments with an Adjustable-
Rate Mortgage (ARMs)
• Index: a guide that lenders use to measure interest rate changes
• Margin: an interest rate that represents the lender’s cost of doing business plus
the profit
• Adjustment period: the period between potential interest rate adjustments (e.g.,
3/1 means your interest rate is fixed for the first 3 years, then could be adjusted
every year thereafter)
• Interest rate cap: a limit on the amount your interest can change (a periodic cap
and a lifetime cap)
• Payment cap: how much your monthly payment can increase at each adjustment

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 A. Investment Basics
The three basic investment objects are: growth, income, and liquidity.

– Liquidity: How accessible is your money?

– Risk: How much risk is involved?
– Return: How much profit will you be able to expect from your investment?

The two greatest risks investors face are inflation and market volatility.

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 Basic Concept: How to Determine
Your Expected Return
Real Return 2%
U.S. Treasury Bills
Inflation 4%

Risk-free Very safe Risk premium 0%

real return Total expected 6%
return

Risk Real Return 2%

Inflation premium Inflation 4%

Risk premium 20%

Very risky
Total expected 26%
A start-up company return

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Figuring Average versus Compound Return

Period Return 5% 10% 12%

Year 1 5%
Year 2 10%
Year 3 12% 0 1 2 3

Average rate of return Compound Rate of Return

5%  10%  12% F (1  0.05)(1  0.10)(1  0.12)
i 1.2936
3
(1  i)3 1.2936
9%
i 8.96%

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 How to Determine Expected Financial Risk
• Risk refers to the chance that some unfavorable event will occur.
• Volatility measures the deviation from the expected value, or
sudden swings in value, from high to low or the reverse.
• Standard deviation measures the degree of volatility when you
have the probabilistic information about the uncertain event.
• Beta measures how closely a fund’s performance correlates with
broader stock market movement.
• Alpha shows whether a fund is producing better or worse
returns than expected, given the risk it takes.

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 B. Investment Strategies
• Trade-off between risk and reward
– Cash: the least risky with the lowest returns
– Debt: moderately risky with moderate returns
– Equities: the most risky but offering the greatest payoff
• Dollar-cost averaging concept: planned transfer, over a
period, of equal amounts from one asset to another.
• Broader diversification reduces risk: by combining assets
with different patterns of return, it is possible to achieve
a higher rate of return without increasing significant risk.
• Broader diversification increases expected return.
• Portfolios with long-term horizons need equities to offset
inflation while short time frames requires debt and/or
cash investments to reduce volatility.
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 C. Investing in Stocks
Investing in stocks and bonds is one of the most common
investment activities among American investors.
– Stocks: Ownership in a corporation
– Ownership: If a company issues one million shares, and you buy
10,000 shares, you own 10% of the company.
– Valuation: (1) cash dividend and (2) share appreciation at the time
of sale

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 D. Investing in Bonds
• Bonds: Loans that investors make to
corporations and governments.
• Face (par) value: Principal amount (typically
$1,000 or $10,000)
• Coupon rate: Nominal interest rate quoted on
par value
• Maturity: The length of the loan

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Types of Bonds and How They are Issued in the Financial
Market

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 How Do Prices and Yields Work?

• Yield to Maturity: The actual interest earned

from a bond over the holding period

• Current Yield: The annual interest earned as a

percentage of the current market price

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 Bond Quotes

Maturity (2020) Trading volume

AT&T 7s20 6.5% 5 million 108 1/4

Coupon rate of 7% Closing

Current yield Market price

$70/108.25 $1,082.50
= 6.47%
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 Chapter #4 Example Problems

Park
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 Assignment #2
• Due Tuesday 19Sept22
• Problems:
• 3.5, 3.13, 3.15, 3.27, 3.42, 3.52, 3.72
• 4.3, 4.18, 4.30, 4.68, 4.73, 4.77

• For all problems draw cash flow diagrams prior to attempting the
problem.
• Hint: Cash flow diagrams help to express patterns accurately.