MGMT 377

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MGMT 377

• Day One

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What is investing?
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What is Investing?

• Consumption Income
• Consumption gt Income (Borrow)
• Consumption lt Income
• Increase consumption or,
• Put the excess in a jar, or
• Invest the excess --- But why?

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Why Study Investing?
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Why Study Investments?

• If you have not already, you will be making
  investment decisionsYou really have no choice!

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Day 1 After Graduation

• You are 22 years oldYour employer has a 401(k)
  plan. If you invest 5 of your income with the
  plan sponsor, your employer will match it.
• The contributions can be invested in
• a risk free bond fund (earning on average 5
  annually) or
• in a more aggressive common equity fund (earning
  on average 9.75)
• Any combination of the above two choices.

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Invest in what?
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Types of Risky Assets

• Tangible Assets are on only one balance sheet.
• Reproducible Building/Machinery
• Non-Reproducible/Art, Land
• Intangible Assets are legal claims to some future
  benefits.
• Financial assets are Intangible Assets.
• They show up as either debt or equity on another
  entitys balance sheet.

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Value of Assets

• Tangible Assets
• Particular physical properties determine value.
• Intangible Assets
• Value unrelated to the form of the asset. Value
  depends on the legal claims to future events.

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Intangible Assets

• Debt (Fixed Income Securities)
• Equity
• Derivative Securities

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Basic Difference Between Debt and Equity

• To understand the basic difference, we first must
  establish what investors are buying.
• That is, what future benefits are promised by the
  intangible assets

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Debt

• Cash Flows are more clearly specifiedmore
  certain as to both
• Amount
• Timing
• In the event of default, creditors receive assets
  before equity holdersagain less risk.

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Equity

• Ownership Interest in the company.
• Two basic types
• Preferred
• Common

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Return and Risk

• Underlying investment decisions the tradeoff
  between expected return and risk
• Expected return is not usually the same as
  realized return

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Risk

• The chance that actual results will be different
  from expected.
• Obviously, investments in equity securities are
  more risky than investments in debt securities.
• Why will an investor take on more risk?

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The TradeoffBetween ER and Risk

• Investors manage risk at a cost - lower expected
  returns (ER)
• Any level of expected return and risk can be
  attained

Stocks
ER
Bonds
Risk-free Rate
Risk
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Risk and Return
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Determinants of Required Rates of Return

• Pure Time value of money
• Expected rate of inflation
• Risk involved

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Pure Time Value of Money

• The real risk-free rate (RRFR)
• Assumes no inflation.
• Assumes no uncertainty about future cash flows.
• Is the price charged for exchanging current goods
  and future goods.

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Nominal Risk-Free Rate

• Dependent upon
• Expected rate of inflation
• Monetary environment
• Supply and Demand for Money

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Adjusting For Inflation

• NRFR
• (1RRFR) x (1Expected Rate of Inflation) - 1

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Risk Premiumand Fundamental Risk

• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk

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Business Risk

• Uncertainty of income flows caused by the nature
  of a firms business affect income flows to an
  investor.
• Investors demand a risk premium based on the
  uncertainty caused by the basic business of the
  firm.

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Financial Risk

• Uncertainty is introduced by the method by which
  the firm finances its investments.
• Borrowing requires fixed payments which must be
  paid ahead of payments to stockholders.
• The use of debt increases uncertainty of
  stockholder income and causes an increase in the
  stocks risk premium.

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Liquidity Risk

• Uncertainty is introduced by the secondary market
  for an investment.
• How long will it take to convert an investment
  into cash?
• How certain is the price that will be received?
• Investors increase their required rate of return
  to compensate for liquidity risk.

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Exchange Rate Risk

• Uncertainty of return is introduced by acquiring
  securities denominated in a currency different
  from your own.
• Changes in exchange rates affect the investors
  return when converting an investment back into
  the home currency.

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Country Risk

• Political risk is the uncertainty of returns
  caused by the possibility of a major change in
  the political or economic environment in a
  country.
• Individuals who invest in countries that have
  unstable political-economic systems must include
  a country risk-premium when determining their
  required rate of return

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Total Risk

• Risk Premium is a function of
• Business Risk,
• Financial Risk
• Liquidity Risk
• Exchange Rate Risk
• Country Risk

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Trade off between return and riskNow, we need
to look at some measures of return and risk!