Lecture No.14
Chapter 4
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
A. Investment Basics
 The three basic investment objects are: growth,
income, and liquidity.
 Liquidity – How accessible is your money?
 Risk – What is the safety 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.
Contemporary Engineering Economics, 5th edition, © 2010
Basic Concept - How to Determine Your
Expected Return
Real Return
U.S. Treasury Bills
Risk-free
real return
Inflation
Very safe
Risk
premium
Very risky
An internet stock
2%
Inflation
4%
Risk premium
0%
Total expected
return
6%
Real Return
2%
Inflation
4%
Risk premium
20%
Total expected
return
26%
Contemporary Engineering Economics, 5th edition, © 2010
Figuring Average Versus Compound Return
Period
Year 1
Year 2
Year 3
Return
5%
10%
12%
Average rate of return
5%  10%  12%
i
3
 9%
5%
0
12%
10%
1
2
3
Compound Rate of Return
F  (1  0.05)(1  0.10)(1  0.12)
 1.2936
(1  i)3  1.2936
i  8.96%
Contemporary Engineering Economics, 5th edition, © 2010
Annual Investment Yield (Base investment of $1,000)
Investment
Case 1
Case 2
Case 3
Case 4
Case 5
Case 6
Year 1
9%
5%
0%
0%
-1%
-5%
Year 2
9%
10%
7%
0%
-1%
-8%
Year 3
9%
12%
20%
27%
29%
40%
Compound Versus Average Rate of Return
Investment
Case 1
Case 2
Case 3
Case 4
Case 5
Case 6
Average return
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
Balance at the
end of year 3
$1,295
$1,294
$1,284
$1,270
$1,264
$1,224
Compound return
9.00%
8.96%
8.69%
8.29%
8.13%
6.96%
Contemporary Engineering Economics, 5th edition, © 2010
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.
Contemporary Engineering Economics, 5th edition, © 2010
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
 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 increase 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
Contemporary Engineering Economics, 5th edition, © 2010
Broader Diversification Increases Return
Amount
Investment
$2,000
Buying lottery
tickets
$2,000
Under the mattress
0%
$2,000
Term deposit (CD)
5%
$2,000
Corporate bond
10%
$2,000
Mutual fund (stocks)
15%
Contemporary Engineering Economics, 5th edition, © 2010
Expected Return
-100% (?)
Expected Value in 25 Years
 Option 1: Invest $10,000 in one asset category (say, bond with 7% interest )
 Option 2: Invest $10,000 in five different classes of assets.
Option
Amount
1
$10,000
Bond
$2,000
Lottery tickets
$2,000
Mattress
0%
$2,000
$2,000
Term deposit (CD)
5%
$6,773
$2,000
Corporate bond
10%
$21.669
$2,000
Mutual fund
(stocks)
15%
$65,838
2
Investment
Expected
Return
7%
-100%
Value in 25
years
$54,274
$0
$96,280
Contemporary Engineering Economics, 5th edition, © 2010
C. Investing in Stocks
 Investing in stocks and bonds is one of the most
common investment activities among investors.
 Stocks: Ownership in a corporation
 Ownership: If a company issues 1M shares, and you buy
10,000 shares, you own a 10% of the company.
 Valuation: (1) cash dividend and (2) share appreciation at
the time of sale
Contemporary Engineering Economics, 5th edition, © 2010
Conceptual Stock Valuation
 Valuation:
Given:
Stock price as of May 1 ,
2010: $72/share
Earnings growth for
next 5 years: 8%
Expected cash dividend
in 2010: $2.00/share
Expected stock price in
3 years: $95/share
Required return on your
investment: 10%
Find: Current value of stock
$2
$2(1  0.08) $2(1  0.08)2  $95
P


(1  0.10) (1  0.10)2
(1  0.10)3
 $76.73  $72, underpriced
$95
$2(1+0.08)
$2(1+0.08)2
$2
0
1
Contemporary Engineering Economics, 5th edition, © 2010
2
3
D. Investing in Bond
 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
Contemporary Engineering Economics, 5th edition, © 2010
Types of Bonds
and How They
are Issued in the
Financial Market
Contemporary Engineering Economics, 5th edition, © 2010
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
Contemporary Engineering Economics, 5th edition, © 2010
Bond Quotes
Maturity (2020)
AT&T 7s20
Trading volume
6.5% 5 million 108 1/4
Coupon rate of 7%
Current yield
$70/1082.5
= 6.47%
Contemporary Engineering Economics, 5th edition, © 2010
Closing
Market price
$1,082.50
Example 4.20 Yield to Maturity and Current Yield
 Given: Initial purchase price =
$996.25, coupon rate = 9.625%
per year paid semi-annually, and
10-year maturity with a par
value of $1,000
 Find: (a) Yield to maturity and
(b) current yield
 Solution:
(a) Yield to maturity
 Cash Flow Transaction Associated with Investing
in Delta Corporate Bond
i = 4.8422% per semi-annual
(b) Current yield
Contemporary Engineering Economics, 5th edition, © 2010
Bond Value Over Time
Mr. Gonzalez wishes to
sell a bond that has a
face value of $1,000. The
bond bears an interest
rate of 8% with bond
interests payable
semiannually.
Four years ago, $920
was paid for the bond. At
least a 9% return (yield)
in investment is desired.
What must be the
minimum selling price?
 Solution:
 Semiannual interest payment = $40
 Required semiannual return = 4.5%
 Desired selling price of the bond (F):
920 = $40(P / A,4.5%,8)  F (P / F ,4.5%,8)
F  $933.13
Contemporary Engineering Economics, 5th edition, © 2010