Investment Decisions and Analyses Dr. John Saymansky Research Assistant Professor

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Investment Decisions and AnalysesDr. John
SaymanskyResearch Assistant Professor

• Personal
• Corporate
• Public

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Questions

• Personal
• How do you decide on what to do with your
  discretionary income?
• Corporate
• What do you do with profits?

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4 Key Concepts

• Time Value of Money
• Implications of Taxes
• Relationship Between Risk and Returns
• Inflation

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Primary Difference in Evaluation of Personal and
Corporate Investments

• Tax Code

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Time Value of Money (TVM)

• Based on the premise that one dollar today is not
  worth the same amount as a dollar one year from
  today.
• WHY?

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Reasons TVM Exists

• Inflation
• General rise in prices
• Results in decrease in purchasing power
• Interest
• Reward for postponing consumption
• Money is a valuable asset ..business and people
  are willing to pay for its use
• Amount of Compensation investor receives is
  affected by Income Taxes and Inflation

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Interest

• Nominal Interest Rate or Annual Percentage Rate
• Used by financial institutions in quoting
  interest rates on transactions
• Does not explain the effect of any compounding
  during the year
• Effective Interest Rate
• Represents the actual interest earned or charged
  for a specific time period.
• 12 compounded quarterly or 3 per quarter
• Effective annual interest rate is 12.55
• 12 compounded monthly
• Effective annual interest rate is 12.68

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Who wants to be a millionaire?

• How much would you need to invest every month to
  have 1,000,000 when you retire?
• Assumptions
• Term 40 years
• Interest Rate 8 ( very conservative)
• 286.45/month or 9.55/day
• Interest Rate 10
• 158.13/month or 5.27/day
• Interest Rate 12 (rate often used by brokers)
• 85/month or 2.83/day

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Financial Investments
Rates of Return

• Savings Accounts
• CDs
• U.S. Treasury Bills, Notes and Bonds
• Money Market Accounts
• Money Market Mutual Funds
• Bonds
• Mutual Funds
• Stocks

Low
High
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Capital Investments

• Investments in Physical Assets
• Plants
• Equipment
• Machinery

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Financial Statements

• Source of Information for Evaluation of
  Investments
• Need to Be Able to Read and Interpret
• Financial Statements to Evaluate Investments

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Financial Statements

• Profit and Loss most frequently, but it is also
  frequently called the Income Statement in
  accounting.
• Revenue Cost Earnings
• The Balance Sheet is a picture of a business
  assets, liabilities, and equity -- its overall
  financial picture -- on a given date, at a given
  time.
• Cash Flow - logic is based on a direct cash flow,
  listing cash received, then cash spent, and then
  summing at the bottom to calculate Net Cash Flow.
  
• Conceptually the Cash Flow reconciles the Profit
  and Loss with the Balance Sheet

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Financial Statement Relationship
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Risk

• The Possibility of Suffering Loss

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What is risk tolerance and why is it so important?

• Risk tolerance basically is the amount of
  psychological pain youre willing to suffer from
  your investments.

Risk Tolerance Quiz http//moneycentral.msn.com/in
vestor/calcs/n_riskq/main.asp
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General Classes of Risk

• Systematic (Market Risk)
• Unsystematic (Company risk)
• Total Risk
• Includes both systematic risk and unsystematic
  risk.

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Systematic (Market Risk)

• Is risk inherent in the market
• Cannot be diversified because it is systemic to
  the market.
• Includes recession, high inflation, and a bear
  market.
• Measured by beta, which reflects the stocks
  correlation to the market, such as the SP 500
  Index.

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Risk Measures

• Beta Examples
• Market 1
• Microsoft 1.3
• Pfizer 0.4
• Yahoo 3.1
• Price Earnings Ratio
• Reflects the risk future potential earning of
  the firm
• Higher multiples mean higher earnings potential
  but also higher risk.
• Growth Price Range 20 Times Earnings
• Nortel 31 P/E
• Growth and Income 7-12 Times Earnings
• Bank of America 12.8 P/E

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Risk Measures Bonds
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Unsystematic Risk

• Unique risk associated with a company
• Such as management, sector (industry)
  characteristics, labor strikes, etc.
• Good diversification can reduce or eliminate
  unsystematic risk by combining stocks and other
  investments that tend to move in opposite
  directions in response to changes in the economic
  environment. This combination of investment is
  often referred to as a portfolio
• Example
• If oil prices rise sharply, the stocks of
  companies in the oil industry tend to rise, while
  major fuel-consuming industries, such as airlines
  and utilities, tend to fall.

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Rates of Return

• The market, theoretically, does not reward an
  investor for risk that can be diversified.
• Therefore, the only relevant risk in portfolio
  management is systematic risk (Market Risk).
• Generally speaking the higher the systematic risk
  the higher the Required Rate of Return
• Investors require a premium for incurring risk

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Financial Investments

• Savings Accounts
• CDs
• U.S. Treasury Bills, Notes and Bonds
• Money Market Accounts
• Money Market Mutual Funds
• Bonds
• Mutual Funds
• Stocks

Less Risk
More Risk
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Stock Classifications
Less Risk

• Large-Cap
• Mid-Cap
• stocks generally are subject to greater
  volatility than other kinds of stocks and because
  mid-sized companies may not always have the
  financial strength and stability of large firms.
• Small-Cap
• Small-cap stocks have limited marketability and
  may be subject to more abrupt or erratic market
  movements than large-cap stocks. The Russell
  2000 the average market capitalization was
  approximately 530 million the median market
  capitalization was approximately 410 million.
  Largest company in the index had market
  capitalization of 1.4 Billion

More Risk
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Investment Classifications
Less Risk

• Income
• Growth and Income
• Growth

More Risk
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What is an Optimal Portfolio?
An optimal portfolio is one that -- at least is
most suitable to you. An optimal portfolio fits
your range of risk parameters and can be placed
onto a utility or risk curve. Problems
Arise When investors want a higher return
without understanding or accepting higher risk
levels, or when their ability to handle risk
changes. If you want to increase your investment
returns, be prepared to take on more risk -- but
never accept more than you and your personal
financial situation can handle.
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Risk Measurement

• Total risk is statistically measured by the
  standard deviation.
• It is part of Harry Markowitzs Modern Portfolio
  Theory," which won him a Nobel Prize in economics
  in 1990.
• The standard deviation measure of risk
  (variability) predicts a portfolios future
  fluctuation.
• The higher the standard deviation, the higher the
  variability of returns around the mean return and
  the less certain an investor is of receiving a
  desired return.

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Importance of Diversification

• Lack of diversification costs are huge
• A study of 401(k) plans released last month found
  that 62 failed to offer enough plan choices for
  workers to build adequately diversified
  portfolios.
• Workers who had enough choices, and who used them
  properly, averaged annual returns of 10.7 over a
  20-year period, according to the. That compares
  to the 7.5 averaged by the workers with
  inadequate plans.
• Over 30 years, the worker with higher returns who
  contributed 10,000 a year would build a nest egg
  of nearly 1.9 million. The worker with lower
  returns would amass just over 1 million -- an
  845,000 difference.
• Source 401(k) adequacy study Martin Gruber and
  Edwin Elton of New York University's Leonard N.
  Stern School of
• Business, and Christopher Blake of Fordham
  University's Graduate School of Business

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Good 401(k) Would Offer the Following 8 Options

• Large-company growth stocks
• Large-company value stocks
• Small- and medium-company growth stocks
• Small- and medium-company value stocks
• International stocks
• High-quality domestic bonds
• High-yield domestic bonds
• International bonds

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7 Most Common 401(k) Blunders

• Not Signing Up
• Missing out on the full company match
• Typically large company plans match 50 of your
  contributions up to 6 of your salary
• Taking too little risk
• Taking too much risk overloading on stocks
• Good starting point is 60 Stocks, 30 Bonds, 10
  Cash
• Drinking the company Kool-Aid
• Investing too much in your companys stock
• Taking out loans
• May lose your job and not be able to payback the
  loan
• Borrowing from your retirement may be a sign that
  you are spending too much
• Cashing out when you leave a job

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Taxes

• Investments held less than 12 months, dividends
  and interest income are typically taxed at your
  marginal tax rate.
• Most types of investments held for 12 months are
  typically subject to capital gains taxes when
  sold.

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What are capital gains taxes?

• Any time you sell an investment for a profit --
  be it stocks, bonds, real estate, -- you will
  owe taxes on any gains realized. These are called
  capital gains taxes.
• You dont have to pay capital gains taxes until
  the asset is actually sold.
• So, in effect, your taxes are being deferred
  while your personal wealth is growing.
• In an effort to encourage investment, Congress
  has reduced the tax rates on capital gains.

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Current Capital Gains Rates

• Sales of assets on or after May 6, 2003.
• The top tax rate of 15 applies to gains from the
  sale of assets held longer than 12 months for
  taxpayers in the 25 bracket or higher.
• Meanwhile, an even lower 5 rate applies to
  taxpayers in the 15 tax bracket or lower.
• Sales of assets before that date
• the rates are 20 for taxpayers in the 25
  bracket or higher
• 10 for taxpayers in the 15 bracket or lower.
• Rates of 18 and 8 that were to apply to assets
  held for five years or more are repealed.
• There is a separate 28 long-term capital gain
  tax rate for collectibles.

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Capital Gains Tax Rates

• There is also a 25 capital gains rate on
  long-term capital gains attributable to prior
  depreciation that had been claimed on real
  property.
• This type of depreciation is referred to as
  unrecaptured Section 1250 gain. This rate is
  unchanged.
• The Taxpayer Relief Act of 1997 also allows most
  couples who file a joint return to keep up to
  500,000 of the resale profit on their home
  tax-free and lets single filers keep up to
  250,000.
• An accountant, tax planner or other financial
  professional can help you design an investment
  program that will minimize taxes.

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Effects of Taxes and Inflation on Investment
Returns

• 10,000 in investment income would be reduced to
  6,900

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Effects of Taxes and Inflation on Investment
Returns
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Personal Tax Minimizing Options

• Make maximum allowable contributions to tax
  deferred retirement savings or pension Plans
• 401k Contribution
• Traditional Individual Retirement Account (IRA)
• Take advantage of lower capital gains taxes when
  selling securities
• Tax free bonds may be an option
• Consult Registered Financial Planner or Tax
  Accountant

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Corporate Tax Minimizing Options

• Debt Financing
• Capital Investment Expenditures
• Take Advantage of Lower Capital Gains Tax Rates
• Deferred Taxes and Depreciation
• Select Appropriate Form of Business Organization

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Conclusions

• To evaluate any type of investment you must
  understand the basic concepts of
• Time Value of Money
• Implications of Taxes
• Relationship Between Risk and Returns
• Inflation
• These concepts apply to personal business and
  public investments.

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Conclusions

• Do not accept more risk than you and your
  personal financial situation can handle.
• Remember the relationship between risk and return
• The higher the return the high the risk
• Practice sound financial management and budget.
• Payoff debt
• Interest compounding works the same way on debt
  as it does on investments. The problem is you are
  paying it and not receiving it.

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Conclusions

• Interested in learning more about
• Investment Analysis and Evaluation consider
• the following course
• ARE 543 - Project Analysis and Evaluation

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ARE 543Proposed Topics

• Introduction to Financial Decisions and Financial
  Statements
• Depreciation and Corporate Taxation
• Use of Effective and Marginal Income Tax Rates
• Financing Capital Structure Theory and
  Application
• Information Requirements
• Review of Time Value of Money Concepts
• Uncertainty and Risk
• Concept of Risk
• Role of Utility Theory
• Alternative Approaches to Decision Making
• Measures of Investment Worth Under Risk
• Methods of Comparing Risky Projects

• Evaluation Methods
• Discounted Cash Flow Analysis
• Probabilistic Analysis
• Simulations
• Sensitivity Analysis
• Decision Tree Analysis
• Certainty Equivalences and Expected Values
• Cost Benefit Analysis
• Value at Risk
• Multiattribute Analysis Techniques
• Real Options Valuations
• Registration Information
• Lecture ARE 543 CRN 11853 Project Analysis
  Evaluation Sec 01 Tu. Th. 1100 - 1215 Room 2061
  AGS - E Credits 3
• Lab ARE 691B CRN 11857 Sec 01 ADTP Computer
  Methods Time to Be Announced Room 2023 AGS - E
  Credits 1

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• THE END