How do Investors decide how much is enough

1
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 cant even buy one
  Blizzard - Now I am PISS_ _
• All investors need enough money to keep up with
  inflation.

2
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)

3
The Woops Factor

• If you dont take your money now - how do you
  really know Im 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?

4
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

5
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

6
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 Wendys 30
• and .1 one upmanship premium

7
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

8
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

9
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
  dont 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)

10
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