Return

The concept of return

• Size
• Certainty
Components of return
• Current income
• Capital gain
A B

purchase price at beginning of the year 1000 1000

Cash received

ist quarter 10 0

2nd quarter 20 0

3rd quarter 20 0

4th quarter 30 120

total income 80 120

Sale price 1100 960

Components of return

• Total return income 80 120

capital
gain/loss 100 -40
total return 180 80

• Percentage return= earnings/initial investment

• 180/1000=18%
• 80/1000=8%
Why return is important
• Key variable
• People prefer more wealth
• How do people decide on the basis of return?
• Historical performance
• Expected return
• Stable vs unstable period
Level of return
• Internal characteristics
• Type of investment
• Quality of firm’s management
• Capital structure
• External forces
• Recessions
• Wars
• General level of price change
• Response to unexpected changes
• Influenced by investor’s beieve
TVM and return
• It is better to receive cash sooner than later
• Consider two investments
• Investment A pays you $100 next year and $100 the year after that.
• Investment B pays you $200 in two years.
• Assume that neither investment has any risk
• Which one will you prefer?
Determining satisfactory investment
• Use TVM techniques to determine whether an investment is satisfactory or
not. Ignoring risk at this point
• A satisfactory investment would be one for which the present value of benefits
equals or exceeds its cost. The three possible cost-benefit relationships and
their interpretations follows:
• If the PV of the benefits equals cost, you would earn a rate of return equal to discount
rate.
• If the PV of the benefits exceeds cost, you would earn a rate of return greater than the
discount rate.
• If the PV of the benefits equals cost, you would earn a rate of return less than the
discount rate.
• If you invest 1000, 8% 3 years.fv=5000, PV=FV/(1+r)^n,
5000/(1+0.08)^3=5000/1.26=3968
TVM techniques
• Simple interest
• Interest paid only on the initial investment for each period of time it is
invested.
• For example you made a $100 initial deposit in an account paying 6 % simple
interest. you would earn $6 an interest in each year that you left the money
on deposit.
• After one year your account balance would grow to $106, after two years it
would grow to $112 and so on. The account value goes up $6 each year
because you earn interest only on the initial deposit.
TVM techniques
• Compound interest
• Interest is paid not only on initial deposit but also on any interest
accumulated from one period to the next.
• When interest compounds, the rate of return on an investment increases, and
it increases more when interest compounds more frequently
• For example: you invest $100 in an account paying 6 % that compounds
interest once in a year. After one year , your account balance is $106, just as
was the case in the simple interest. However, in the second year you would
earn 6.36 in interest(0.06X106), and the account balance grows to $112.36. as
long as all of the money is left on deposit, interest payments increases year
after year.
TVM techniques
• Compounding frequency-annual compounding
• Suppose on jan 1 2016, you place $1000 into an account that earns
5% interest and interest compounds each year. You plan to withdraw
$300 at the beginning of year 2017, but you will invest another $1000
at the beginning of year 2018. what will be the account balance at the
end of 2018?
Saving account balance (5% interest compounded annually)
Date Deposit/ Beginning Interest for Ending account
withdrawal balance year balance
1/1/2016 $1000 $1000 $50 $1050
1/1/2017 $(300) $750 $37.50 $787.50
1/1/2018 $1000 $1787.50 $89.38 $1876.88
TVM techniques
• Compounding frequency-semiannual compounding
Saving account balance (5% interest compounded semiannually)
Date Deposit/ Beginning Interest for Ending account
withdrawal balance year balance
1/1/2016 $1000 $1000 $25 $1025
7/1/2016 $1025 $25.63 $1050.63
1/1/2017 $(300) $750.63 $18.77 $769.40
7/1/2017 $769.40 $19.24 $788.64
1/1/2018 $1000 $1788.64 $44.72 $1833.36
7/1/2018 $1833.36 $45.83 $1879.19
TVM techniques
• Stated rate vs true rate
• True rate if interest is the rate at which money grows over time after
accounting for the effects of compounding.
• Stated rate of interest is simply the rate used to calculate earnings in
each period.
• Continuous compounding calculates interest by compounding over
the smallest possible interval of time. It maximizes the true rate of
interest.
TVM techniques
• Future value: an extension of compounding
• Future value is the amount to which a current deposit till grow over time when it is
placed in an account paying compound interest.

• Consider a deposit of $1000 that is earning 8%(0.08 in decimal form) compounded

annually. We can calculate the future value of the deposit
•
FV1=$1080

FV2=1000 X1.166
FV2=1166.40
TVM techniques
• Future Value of annuity: a stream of equal cash flows that occur at
equal intervals over time.
• Ordinary annuity
• Annuity due
TVM techniques: Finding the Future value of
an ordinary annuity :Example
• Fran Abrams wishes to determine how much money she will have at
the end of 5 years if she chooses annuity A, the ordinary annuity. She
will deposit $1,000 annually, at the end of each of the next 5 years,
into a savings account paying 7% annual interest. This situation is
depicted on the following time line:
Finding the Future value of an ordinary
annuity : Example
• FV1= 1000 x (1.07)4 = 1310.80
• FV2= 1000 x (1.07)3 = 1225.40
• FV3= 1000 x (1.07)2 = 1144.90
• FV4= 1000 x (1.07)1 = 1070.00
• FV5= 1000 x (1.07)0 = 1000

=5750.74

OR
Finding the Future value of mixed stream :
Example
• FV1= 1000 x (1.07)4 = 1310.80
• FV2= 2000 x (1.07)3 = 2000X1.22=2450.06
• FV3= 1500 x (1.07)2 = 1500X1.14=1717
• FV4= 4000 x (1.07)1 = 4000X1.07=4280
• FV5= 3000 x (1.07)0 = 3000X1=3000

=12757
TVM techniques
• Present value: an extension of future value-determine the value today
of cashflows that an investment may provide in the future.
• Calculating the PV of lump sum is equivalent to answering the
question if an investor wants to accumulate a specific lump sum, n
years in the future, how much money must the investor set aside
today, assuming that investment earns r% interest

= =925.93
TVM techniques-Present Value of stream of returns

Present value of a mixed stream

End of year Income PV calculation at 8% PV at 8%
1 90 83.33

2 100 85.73

3 110 87.32

4 120 88.20

5 100 68.06

6 100 63.06

7 1200 700.19

TOTAL PV 1175.85
TVM techniques-Present Value of stream of
returns
• Present value of an annuity

199.375
TVM techniques- P4-19 Page #199
• Nabil Stafnanous purchased a truck for his construction company. The cost of
truck was $25000. he borrowed 80% of the cost, to be repaid in equal quarterly
instalments over three years at an annual interest of 8%. Calculate Nabil’s
quarterly payment to the bank.

• PV=25000*80%=20000
• Annual installment=20000*0.08/(1-(1/(1.08)3))=20000*0.08/(1-
(1/1.260))=20000*0.08/(1-0.793)=1600/0.207=7729
• Quarterly installment=7729/4=1933

• = (20000*0.02)/(1-(1/1.268))= (20000*0.02)/(0.211)
=400/0.211=1896
 TVM techniques-template loan amortization
• It is used to find how much amount one has paid against loan and how much is remaining. In
addition, it also gives information about how much amount is paid in the form of interest.