How do Investors decide how much is enough? • One thing is inflation. • If I put off buying my Dairy Queen Blizzard and you give me extra money but the price of a Dairy Queen Blizzard goes up - I can still only gratify myself with one Dairy Queen Blizzard. • If the price of the Blizzard goes up more than the extra money I got - now I can’t even buy one Blizzard - Now I am PISS_ _ • All investors need enough money to keep up with inflation.
What Else Does it Take • If all I get is to keep up with inflation then in the end all I get is a Blizzard now or a Blizzard later • I need extra buying power • This is called the “safe rate” • Free market economies have been paying people about the same amount extra for delayed gratification for hundreds of years (except the 90s)
The Woops Factor • If you don’t take your money now - how do you really know I’m going to come up with the cash when you graduate? • Delaying gratification means taking a risk that someone might not come through for you • What if you bought stock in a company that sells florescent carrots over the internet and then they were found to be radio-active?
How Risky? • The riskier the investment, the more likely the company or government is to fail (anyone for Russian Treasury bonds?), the more likely the bank is to close the bigger the • “Risk Premium”
The One Upmanship Factor • Ever noticed how a gas station puts gas a penny cheaper than the station next door or the bank sets the interest rate a little higher than the next bank, or offers a cooler alarm clock if you deposit at their bank • Many times investments are a dime a dozen • projects will often try to do a one upmanship to be just a little bit cooler than the next opportunity
Putting Together a Rate of Return • Four components to a Rate of Return • Lets say inflation is 3.5% • The “safe rate” is 2% • This investment is real risky because their building a factory to make beef flavored sawdust patties for a new line of low calorie hamburgers at Wendy’s 30% • and .1% one upmanship premium
What is my Required Rate of Return or Cost of Capital? • Lets see • 3.5 + 2 + 30 + .1 = 35.6% • Right! • Wrong - Sucker • (1.035)*(1.02)*(1.30)*(1.001) = 1.3737 • 37.37% • Why? • The 3.5% was needed just to keep the same buying power
Compounding • I want a return on my delayed gratification - because I will need a $1.03 (and a half) next year to buy the same as a dollar now I want my delayed gratification payment on the same buying power • It compounds • Because sawdust hamburger paddies sound pretty risky I might loose my money my keep up with inflation and my delayed gratification payment • I want a risk premium on everything I might loose
An aside about Rate of Return • When we are trying to project the cash flow that we will get back from an investment sometimes we don’t know what the rate of inflation will be in 5 years • (If you do, Alan Greenspan has a job for you) • We write down the cash flows as if there were no inflation • (ok we do that a lot in engineering economic analysis)
Unscrewing the Rate of Return • Now I have a rate of return that tells how much I need for inflation and a cash flow with no inflation • I fix the problem by dropping out the inflation factor from by ROR • Thus we have two kinds of RORs • Real rate of return means both the cash flow and the ROR ignored inflation (even though its fake we call it real because it measures real buying power) • Nominal rate of return considers inflation in both the cash flow and the ROR • If inflation is included in one and not the other - you screwed up