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Investing. I.N. Vestor is the top plastic surgeon in Tennessee. He has $10,000 to invest at this time. He is considering investing in Frizzle Inc. What factors will influence his investment on Frizzle, Inc.?. He wants to make money ( generate a return ) on his investment .
I.N. Vestor is the top plastic surgeon in Tennessee. He has $10,000 to invest at this time. He is considering investing in Frizzle Inc. What factors will influence his investment on Frizzle, Inc.?
is the percentage either gained or lost on the original investment.
In order to make an educated investment decision, I.N. Vestor can research the return that the investment has generated in the past. (also known as historical return)
The time frame starting when the initial investment in the stock/bond begins and ending on the day the stock/bond is sold.
Realized Return = Dividend + (P1 – P0)
Example: I.N. Vestor purchased Stock ABC one year ago for $33. The stock paid a dividend of $1.75 and now has a price of $37.25. What realized (historical) return did he earn over the one-year period?
Solution: If I.N. Vestor sells the stock now for $37.25 then he will collect
$37.25 plus the $1.75 dividend that was paid during the year
Realized return =
Dividend + (price @ end of period - price @ beginning of period)
Price @ beginning of the period
On his initial investment of $33, the realized (historical) return is
1.75 + (37.258 - 33) / 33 = 18.2%
The Realized Return is 18.2% in one year per share of ABC.
Questions to Consider:
Dividends: A portion of a company’s earnings distributed to their stockholders.
Capital gain: Profit that is realized when the security is sold and the selling price of the security is greater than the purchase price. If the price of the stock drops during the period, a capital loss is realized.
Capital Gain (Loss) = P1 –P0
Capital gain: Profit that is obtained when the security is sold and the price of a security is greater than the purchase price. If the price of the stock drops during the period, a capital loss is realized.
Capital Gain (Loss) = P1 –P0
Coupon: Periodic payment of interest that the issuer is required to pay at set intervals, (typically semiannually) until maturity.
Capital gain: If the bond is held to maturity, the investor receives the full principal value.
The idea that a dollar received today is worth more than a dollar received in the future. A dollar received today can be either used for consumption purposes or be reinvested, earning additional income from return or interest.
Time Value of Money is the principle that drives the expected return model.
Present Value Formula:The Present Value Formula determines how much a sum of money received in the future would be worth today. The Future value of money is discounted using the interest rate. The Future value of money is discounted using the interest rate.
PV = Present Value of the $
FV = Future Value of the $
i = interest rate
n = number of interest periods
Discounting:Finding the present value of an investment by taking the future value of that investment and discounting it by the interest rate.
B. The choice is clear: most people will choose to take the money today.
2) Now, what if the options are:
Here, the choice is less clear.
The option you would choose is based on how much interest you think you can earn on $20,000 today.
Situation 2: Now assume the interest rate is 4%, compounded annually. After three years, you will have $22,497.28 so you would rather take the $23,000 in the future.
FV = PV*(1+i) n
FV= 20,000(1+.04)3= $22,497.28
So taking the $23,000 in three years would be the best option.
The formula for simple interest is:
Interest = Principal*Interest Rate*Time
In the compound interest calculation, the coupons and dividend payments are assumed to be reinvested. So, the coupons and dividends generate additional interest after they are paid to the investor because the investor reinvests the payments. Compound interest causes your money to grow at a faster rate
The formula for compound interest is:
M = P(1+i)n
M = The amount generated (including the initial principal)
P = Principal, the initial investment
i= Interest rate
n= Number of interest periods
Example: I.N. Vestor wants to know how much he will make in 3 years if he puts $10,000 into his savings account today. The savings account interest rate is 4% compounded annually. How much will I.N. Vestor have after 3 years?
i = 4%
M= 10,000 (1+.04) 3= $11,248.64
I.N. Vestor will have $11,248.64 after 3 years.
Expected/Required Return: Return an investor requires or expects for assuming a certain amount of risk with the investment. The expected return is based on future expected cash flows for a set period of time.
Components of Stocks’ Expected Return
Unlike bonds, stocks have no maturity date. To recover principal, an investor must sell stock in the stock market.
P0 = + + + … +
P0 = price of the stock today
i = expected rate of return
D1 = dividend year1
D2 = dividend year2
D3 = dividend year3
= price of the stock in future
Example: I.N. Vestor buys 1 share of stock XYZ at $1,000 per share. It pays a 2% annual dividend ($20 per year). The price of the stock after 1 year is $1,200. What is the expected rate of return?
Solution: 1,000 = _20_+ 1200
1000 (1+i) = 1220
1000i = 220
i = 0.22 = 22%
The expected rate of return is 22%
Components of Bonds’ Expected Return
A company that issues a bond must pay the coupons or coupon payments to the bondholder.
Long-term bonds have higher coupon rates than short-term bonds. This is because of risk. Bonds with longer maturities have higher coupon rates because the longer time frame makes them riskier to an investor because there is a greater change of default.
Yield to Maturity:In the bond market, this is the rate of return that an investor would earn if he bought the bond at its current market price and held it until maturity.
Solution using Formula:
i = 3% = 1.5% (because of semi-annual coupons)
n = number of periods = 4 (2 years*2 payments/year)
C = 25M = par value = 1,000
P = 25/(1+.015)1+ 25/(1+.015)2+ 25/(1+.015)3+ 25/(1+.015)4+ 1000/(1+.015)4
P = 24.63054187 + 24.2665437 + 23.9079248+23.55460576+942.1842303
P = $1,038.54
YTM = Yield To Maturity
YTM= C+ (F-P)/n
YTM = 50+ (1050-1000)/5
The yield to maturity is 5.85%