Chapter5 notes-1

Chapter5 notes-1 - Chapter 4 (Contd) Time Value of Money...

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Chapter 4 (Cont’d) Time Value of Money
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2 Spring 2010 Focusing Question You are a financial planner wishing to persuade a young client to reconsider her $50,000 invested in 3%-CDs. Your client believes that stock mutual funds will return about 12% for the foreseeable future, but she is averse to the volatility in returns. Her money will remain fully invested for the next 48 years. How to convince her to take the risk of investing in stock mutual funds?
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3 Spring 2010 Learning Objectives 1. Use the rule of 72 to solve for required rate of return or number of periods to double the investment. 2. Compute TVM questions in Excel.
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4 Spring 2010 Doubling: Rule of 72 0.72 n * i ± Interest factor to double the PV: ± Example: You are a financial planning wishing to persuade a young client to reconsider her $50,000 invested in 3%- CDs. Your client believes that stock mutual funds will return about 12% for the foreseeable future, but she is averse to the volatility in returns. Her money will remain fully invested for the next 48 years. How to convince her to take the risk of investing in stock mutual funds?
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5 Spring 2010 Doubling: Rule of 72 ± The first step requires the calculation of how long is required to obtain a single doubling ² CDs: 72/3 = 24 years to double ² Mutual fund: 72/12 = 6 years to double ± The second step requires the calculation of how many doublings will occur during the lives of the investments ² CDs: 48/24 = 2 doublings ² Mutual fund: 48/6 = 8 doublings ± The third step calculates the value of the investment in 48 years ² CDs: 2 doublings of $50,000 2 2 times = 4 times = 4 * $50,000 = $200,000 ² Mutual fund: 8 doublings of $50,000 2 8 = 256 !!! = 256 * $50,000 = $12,800,000
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6 Spring 2010 Growth of $50,000 (Log Scale) 48 Years Log scale 10000 100000 1000000 10000000 100000000 0 5 10 15 20 25 30 35 40 45 50 Holding Period in Years Value at end of Holding Period (Log Scale) CD Stock
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7 Spring 2010 Conclusion: Rule of 72 ± Using the accurate method, her respective wealth is $206,613 and $11,519,539 ± We shall discover that her risk is smaller than she imagines, but she will be about 64 times more wealthy if she accepts that risk ± The lesson is to start to invest early, and accept some risk ± It is a good practice to estimate values before computing them ± The rule of 72 is one tool that sometimes gives you “numerical feel” of a problem
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8 Spring 2010 Quick Quiz 1. Given an investment horizon of 8 years, what rate of return will enable you to double your investment? A. 8% B. 9% C. 10% D. 16%
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9 Spring 2010 Using EXCEL Spreadsheet ± Use the following formulas for TVM calculations ² FV(rate,nper,pmt,pv) ² PV(rate,nper,pmt,fv) ² RATE(nper,pmt,pv,fv) ² NPER(rate,pmt,pv,fv)
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10 Spring 2010 Using Excel Spreadsheet ± You can use the PV or FV functions in Excel to find the present value or future value of a set of cash flows ± Setting the data up is half the battle – if it is set up properly, then you can just copy the formulas ± Click on the Excel icon for an example
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Chapter5 notes-1 - Chapter 4 (Contd) Time Value of Money...

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