TABLE OF CONTENTS. SCHEME OF WORK Learning Outcomes Course Synopsis Teaching Methodology Assessment Teaching Schedule References

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This course provides students an exposure to the investment theories, investment securities available in the Malaysian capital market and ways to evaluate investment opportunities based on risks and returns. Students will also have the opportunity to carry out a task based on the principles and theories they have learned.

TEACHING METHODOLOGY

Lecture, group discussion and classroom exercise.

ASSESSMENT

Continous Assesment 60%

Final examination 40%

Total 100%

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TEACHING SCHEDULE

WEEK TOPIC REFERENCE

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CHAPTER 1: INTRODUCTION TO FUNDAMENTALS OF INVESTMENT

1.1 Definition of Investment 1.2 Benefits of Investment 1.3 Objectives of Investment 1.4 Required Rate of Return 1.5 Types of Investment

1.6 Conclusion

CHAPTER 2: RISKS AND RETURNS

2.1 Sources of Returns on Investment 2.2 Calculating Returns

2.3 Calculating Expected Returns 2.4 Reinvestment

2.5 Risks of Investment 2.6 Measuring Risks

2.7 Coefficient of Variation 2.8 Conclusion

Reference Book, Slide, Lecture Notes.

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CHAPTER 3: TIME VALUE OF MONEY

3.1 Concept of Time Value of Money

3.2 Time Value of Money for a Single Amount 3.3 Time Value of Money for Annuity

3.4 Time Value of Money for Perpetuity

3.5 Time Value of Money with Adjusted Rate of Return 3.6 Time Value of Money with Real Rate of Return 3.7 Conclusion

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CHAPTER 4: PORTFOLIO THEORY AND ASSET VALUATION MODEL

4.1 Introduction to the Diversification Concept and Portfolio

4.2 Diversification and Modern Portfolio Theory 4.3 Efficient Portfolio and Efficient Frontier 4.4 Conclusion

CHAPTER 5: PORTFOLIO MANAGEMENT AND ASSET MANAGEMENT STRATEGIES

5.1 Investment Strategies

5.2 Investment Strategies according to Modern Portfolio Theory

5.3 Conclusion

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SAEMBUDAYAAN USAHAWAN

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CHAPTER 6: COMPANY’S FINANCIAL STATEMENT ANALYSIS

6.1 Introduction to Financial Statement 6.2 Types of Financial Statements

6.3 Financial Statement Analysis 6.4 Limitations of Financial Analysis 6.5 Conclusion

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CHAPTER 7: STOCK VALUATION

7.1 Introduction to Stocks and Stock Investment 7.2 Stock Valuation

7.3 Estimating a Stock Price 7.4 Calculating Rate of Return 7.5 Relative Valuation

7.6 Conclusion

ASAS PEMBU

USAH

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CHAPTER 8: BOND VALUATION 8.1 Introduction to Bonds

8.2 Bond Value and Results 8.3 Yield to Maturity (YTM) 8.4 Bond Rating

8.5 Government Bonds 8.6 Conclusion

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CHAPTER 9: INVESTMENT PERFORMANCE EVALUATION

9.1 Introduction to the Concept of Investment Performance Evaluation

9.2 Criteria for Portfolio Evaluation 9.3 Rebalancing Investment Portfolios 9.4 Trade-off in the Decision to Rebalance 9.5 Conclusion

Reference Book, Internet, LCD

powerpoint

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REFERENCES

1. Avadhani, V.A.. “Securities Analysis and Portfolio Management”, Global Media, Mumbai, India, 2009

2. Kamarulzaman Bakri, “Analisis, Proses Dan Strategi Portfolio Pelaburan Berteraskan Syariah, Universiti Utara Malaysia, Mei 1999

3. Reilly & Brown, “The Investment Setting”, Investment Analysis and Portfolio Management, Thomson South Western, 8^th Edition, 2006

4. Ross, Westerfield and Jordan, “Fundamentals of Corporate Finance”, McGraw Hill, 6^th Edition, 2003

5. Yesim Tokat, “Portfolio Rebalancing in Theory and Practice”, Vanguard® Investment Counseling & Research

6. http://www.investopedia.com/articles/basics/03/080103.asp#ixzz1QZGrlYKk

7. http://www. towering skills.com

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CHAPTER 1 INTRODUCTION TO BASIC OF INVESTMENT

Learning Objectives

At the end of this chapter, students should be able to:

1. Explain the definition of investment 2. Understand the benefits of investment 3. Explain the objectives of investment 4. Identify the required rate of return 5. Differentiate the types of investment

1.1 Definition of Investment

Investment is defined as today’s financial commitment for a period of time with the purpose of obtaining returns in the future.

Investors may consist of individuals, governments, pension funds or corporates. This definition covers all types of investment, whether corporate investment in machinery and equipment, or individual investment in listed stocks, bonds and commodities. In all cases, investors convert a present amount of money in which the total is known with an amount of cash flow that is expected to be higher in the future in comparison to the initial investment.

This answers the question of why individuals invest and what they want from their investment. Individuals invest their money in order to reap the rewards for their time commitment, expected inflation and uncertainties of returns. The rewards are known as returns, whereas the uncertainties are called risks.

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Investment is an instrument to generate and accumulate wealth. In the financial management process, investment is a significant instrument in order to ensure that the individual’s financial goal is achieved. Imagine if Mr. A wishes to perform hajj in five years, but he does not invest his money and instead only keeps his money at home.

Although he diligently saves every month, will he be able to achieve his goal? The answer, maybe yes and maybe no.

1.2 Benefits of Investment

a. Investment Restricts Negative Effect Of Inflation On Value of Money

He may be able to perform hajj in five years if the amount he saves increases every year.

This is because the cost of performing hajj, as well as the cost of other goods and services, increases each year due to inflation. If the amount he saves is the same every year, he may be forced to postpone his journey to Mecca as he has to wait to attain sufficient savings. It is also provided that the government subsidises the cost of hajj in order to ensure that it does not increase. However, what about other costs that are always increasing?

The simulation below shows the effect of inflation on the cost of hajj. The cost of hajj below is the actual cost imposed on pilgrims in years 2006-2010 after Tabung Haji provided subsidy of more than RM2,000 every year to each pilgrim. If Mr. A sets to save an amount of RM2,000 each year in order to attain a total of RM10,000 in five years, will his wish be fulfilled if the cost of hajj increases further in the next year?

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Diagram 1.1: Fixed Savings of Hajj in comparison to the Cost of Hajj

Investment is able to restrict the negative effect of inflation on the purchasing power of money because by investing, we have the potential to generate returns on the investment.

For example, if Mr. A deposits his money into Tabung Haji, the money will be accumulated to be invested in plantation, real estate, trade and other activities. The product of these investments enable Tabung Haji to pay dividend to its depositors. The dividend given by Tabung Haji is able to reduce the collapse of the individual’s purchasing power of money as a result of inflation.

The simulation in Table 1.1 displays the total savings of Mr. A, assuming that Tabung Haji provides a 5% dividend each year. The total savings of Mr. A will increase to RM11,604 at the end of year 5. If the cost of hajj is fixed at RM9,980, the remaining savings allow Mr. A to use it for other necessities.

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Table 1.1: Simulation of Total Savings with a 5% Yearly Dividend

Year 1 2 3 4 5

Beginning

balance 0.00 2,100.00 4,305.00 6,620.25 9,051.26 Savings 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 Balance 2,000.00 4,100.00 6,305.00 8,620.25 11,051.26

Dividend 100.00 205.00 315.25 431.01 552.56

Ending balance 2,100.00 4,305.00 6,620.25 9,051.26 11,603.83

b. Investment Helps Prepare For Future Financial Needs

Investment helps prepare for future financial needs. As in the previous example, investment helps Mr. A to attain his goal of performing hajj and at the same time provide extra money for other uses. The life of a human has a cycle – from childhood to adulthood which include career, marriage and retirement. Each stage of life requires different needs. At the time of retirement for example, life necessities increase in terms of medical needs, comfortable home and healthy food. Imagine if we only have an EPF savings of less than RM50,000 by the time we retire. This amount is indeed not sufficient to sustain life in retirement. If we assume that only RM1,000 is needed each month, the savings will be used up in 4 years and 2 months only! This did not take into account the effect of inflation on our expenses. If we have to maintain the amount of payment for fixed costs such as groceries and utility bills, with inflation, our savings will be exhausted within a shorter period.

Therefore, we must take immediate steps in preparing an investment plan to ensure that future needs are met.

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1.3 Objectives of Investment

Investment, in general, involves commitment of funds to the assets which will be held for a long period of time. Investors (as opposed to speculators) usually have a time limit which exceeds six months or a year. In making a decision to invest money for a long period of time, investors hope to acquire a reasonable return of investment. This return must provide compensation for investors for:-

a. The length of time the money is invested b. Expected inflation

c. Uncertainty of future returns

a. The length of time the money is invested

Investors would certainly want returns as compensation for their commitment. In making a decision to choose an investment product, investors indeed face several options such as whether to invest in unit trusts, listed stocks or even real estate investment trusts. Or perhaps, the easiest and lowest in risk is to deposit at Tabung Haji which can provide at least a 5%

yearly return. Therefore, if investors opt for unit trust for example, investors would surely expect to acquire a return that is at least equal to the return which may have been acquired from depositing at Tabung Haji. This is known as opportunity cost. Opportunity cost is one of the determining factors of the expected rate of return that investors want.

b. Expected inflation

Inflation is the rate of price increase. It is measured by comparing present price with previous price. Inflation causes the value of money to decrease. In other words, inflation causes the purchasing power of money to fall. Imagine if 30 years ago, with 20 cents, we were able to buy food and drinks for lunch at the school canteen. However, with 20 cents now, we can only buy 2 pieces of candy. 20 cents will not able to buy us a plate of noodles, even a piece of cake, today. Such are the effects of inflation.

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The official inflation rate recorded by Bank Negara Malaysia (BNM) is 4% per annum. With this rate, in 16 years, the value of money will decrease by 50%. This means, RM1,000 that we own today, will only be worth RM500 16 years from now. In 32 years, it will only have a value similar to RM250 today.

Inflation is said to be the main enemy of money, besides taxes. Taxes, which come in many forms such as income tax, road tax and sales tax, is especially understood to be the erosive factor of money. Nevertheless income tax for example, affects us only if we have an income which exceeds a certain level. This is also the case with road tax, which impacts only those possessing vehicles. Sales tax can also be avoided by not buying goods which impose tax.

However, it is different with inflation whereby it affects all, regardless of the level of income or lifestyle. It is important to mention that the higher the lifestyle, the higher the personal inflation rate. This is because luxury goods have a higher inflation rate in comparison to normal goods. For that reason, it is smarter to choose goods based on its usability and quality, rather than brand.

Another reason why inflation is the main enemy of money is due to its snow ball effect.

Compounded inflation rate causes the value of money to further decrease. As mentioned above, in 16 years, the value of money will decrease by 50% and in 32 years, the value of money will fall by 75%!

The understanding on inflation and its impact on the value of money is very important to ensure that the purchasing power of money is not affected. An easy way is to ensure that our return on investment is higher than the inflation rate. In order to achieve this goal, we must understand the types of investment, risks of the investment and methods to manage it.

c. Uncertainty of future returns

Investment is often associated with risk. Risk means that the investment may provide returns which differ from what we expect. In certain cases, we can lose all our investment money.

For that reason, investors always hope to acquire returns which correspond to the risk taken.

The higher the risk, the higher the expected rate of return.

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This explains the concept of risk and return trade-off. Investors are usually risk avoiders. If they are forced to face a high risk in their investment, they would also expect a high return.

Therefore, product suppliers or operators should also provide high returns for a high-risk product with the purpose of attracting many people to invest in the product.

Another way to explain the concept of risk and return trade-off is to view investment products which depend on the supply and demand factor such as the listed shares on Bursa Malaysia.

Some listed shares or stocks have a high volatility. This means that the potential to gain a high return on capital from this share is great. However, keep in mind, share price which has the potential to rise higher has also the same potential to fall badly. Therefore, the higher the return, the bigger the risk!

1.4 Required Rate of Return

The definition of investment means that investors require a minimum rate of return on their investment, and investments will only be made if investors are confident in acquiring returns that exceed this rate. In the field of investment, this rate is termed

“required rate of return”.

Investors “need” to acquire minimum returns as compensation for their sacrifice: (1) separating from their money, (2) facing decline of value of money (inflation), and (3) bearing the risk of uncertain returns which will be acquired later.

Therefore, in theory the required rate of return comprises the following three elements:

• Real rate of return, r

• Inflation rate, i

• Rate for the risks faced (risk premium, rp)

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Element 1: Real rate of return

Real rate of return is compensation for the sacrifice of assets; i.e. the duration in which the investors part from their money. It is also a reward for postponing the use of the money until the future.

The real rate of return is also considered as the rate of return for all investments in the absence of inflation and risk.

Element 2: Inflation protection

As discussed earlier in this chapter, inflation is the increase of general price level of goods. When inflation occurs, purchasing power of money will decline. If the value of money declines in the future due to inflation, we require a compensation to protect ourselves from this loss. This is called inflation protection.

What is the relationship between the real rate of return and inflation rate? In investment, the real rate of return can be interpreted as real interest rate. Interest rate is the rate of return on risk-free assets, such as bond.

Market interest rate is called nominal rate, nr, and it covers (1) real interest rate, and (2) expected inflation rate.

Its simple formula: nr = r + i

Whereby:

nr = nominal rate r = real rate i = inflation rate.

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Element 3: Compensation for bearing risk

Risk in investment is the uncertainty of returns to be acquired. Investors in general are risk avoiders. Nevertheless, risks cannot be evaded in investment. Therefore, investors must be given compensation that is appropriate with the risks they bear.

For investments with no risks, a reasonable return is similar to “risk-free nominal interest rate”.

If the investment is risky, investors require returns which exceed the risk-free rate as a premium for risk.

In conclusion, the rate of return required by investors is a mixture of (1) real rate of return, (2) inflation and (3) risk premium. The risk premium vary according to how low or high the risk of an investment is. The higher the risk, the higher the risk premium that is required.

As a formula, the required rate of return can be written as follows:

k = r + i + rp

(r + i) is also stated as rate of return without risk or risk-free rate, krf.

Hence, the rate of return can be rewritten as follows:

k = krf + rp

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1.5 Types of Investment

There are several types of investment in the market. They consist of physical assets, financial assets, derivative assets and alternative assets.

1.5.1 Physical assets

Physical assets are when investors invest their money in physical assets such as lands, houses, office buildings, factory buildings, machinery and equipment as well as stocks. What are the risk factors which should be considered in physical investments?

– Long term capital returns

– Fairly fixed but uncertain cash flow – Repair costs

– Low liquidity

1.5.2 Financial assets

Financial assets are when investors invest their money in financial instruments which can be used as claims on the value which they have invested. Examples of financial assets are shares, bonds and trust units.

a. Shares

Investment in the shares of a company is a direct investment in which investors invest their money by buying the company’s shares. The money invested by investors will be used by the company to finance its business operations. As a reward, investors may acquire returns resulting from the company’s profits. Two forms of returns from share investment are:

i. Cash flow from distribution of profit which is known as dividend

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Investors of share investment are also entitled to attend the company’s Annual General Meeting and to cast their votes in the meeting. In other words, by owning the shares of the company, investors actually have the right to make decisions in the company.

Share investment, however, has its own risks. Among the risks of share investment are:

i. Price which may fluctuate drastically due to changes in the economy, politics and natural disasters

ii. Companies which may suffer losses and were delisted

iii. Mismanagement which may cause companies to be suspended from the list

iv. Low liquidity due to low demand

b. Bonds

Bonds are debt instruments issued by governments or companies to acquire money to finance the operations of major projects. Bond investors are creditors of bond issuers whereby every six months or every year bond issuers will pay interest to bond holders. Bond investment is only open to major investors as each bond unit costs more than RM1 million.

Bond investment provides fixed returns to investors. The risk of bond investment depends on the types of bond. Company bonds are considered a higher risk in comparison to government bonds. The risk of bond investment lies in the failure of the bond issuers to pay the pledged interest at each term and in more severe cases, the failure to reimburse the principal sum of the investment.

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c. Unit trust

Unit trust is a fund which accumulates the money of many investors with similar goals to be invested in financial markets such as stock market, bond market and short term money market such as Negotiable Certificate of Deposit, Treasury Bill, Banker’s Acceptance, etc.

Unit trust investment enables investors to reap dividend returns and capital gains from proceeds of reselling of all units which may increase in price.

Advantages of investing in unit trusts are:

i. Funds are managed by professional managers

ii. Higher level of liquidity compared to direct investment in shares

iii. Provides diversification benefits, i.e. lower risk compared to direct investment

iv. Provides an opportunity for small investors to gain exposure to assets which are not individually affordable, such as bonds and sukuk.

Conversely, disadvantages of investing in unit trusts are:

i. Investors do not have the right to make decisions

ii. Sales and management costs which are relatively higher if compared to direct investment in stock markets

iii. Diversification lowers risks and at the same time reduces returns

1.5.3 Derivative assets

Derivative assets are assets in which its value is acquired from its underlying assets.

The most common form of derivative assets are futures contracts and options contracts. An example of derivative asset in Malaysia is Future Crude Palm Oil. For this asset, its value depends on the price of crude palm oil in the market.

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Derivative assets pose a higher risk in comparison to other financial assets. This is because the asset trade is done in advance based on a price which is expected in the future. The risk is higher when the asset purchase is made using money loans.

1.5.4 Alternative assets

Alternative assets are gold, silver, paintings, antiques, etc. These assets are usually personal collections and are only when the need arises.

1.6 Conclusion

Investment is a very significant activity in financial management. Its goal is to acquire returns as a reward for the sacrifice of investors in postponing its use, expected inflation and uncertainty of obtaining the returns. The skill of choosing a suitable asset is highly important to ensure investors gain the desired benefits from the investment.

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CHAPTER 2 RISKS AND RETURNS

2.1 Sources of Returns on Investment

As discussed previously, returns on an investment consist of two parts:

a. Return on revenue

These returns are cash inflows from the investment to investors. It is the distribution of profit which is known as dividend, profit and bonus or may also be service charge such as rent and fees.

Examples of return on revenue

i. Ahmad purchases a TNB share with the price of RM10.00 per share. In a year, TNB pays a 30 cents dividend for each share. Return on revenue = 0.30/10.00 = 0.03 = 3.0%

ii. Hamid buys a house with the price of RM200,000 to be rented. The net annual rent income is RM10,000. Return on revenue = 10,000/200,000 = 0.05 = 5% per Learning Objectives:

At the end of this chapter, you are able to:

1. Identify the sources of returns on investment 2. Understand the method of calculating returns 3. Understand how to calculate expected returns 4. Appreciate the importance of reinvestment 5. Explain the meaning of “risk” in investment 6. Identify risk measurement methods

7. Understand the use of coefficient of variation in investment decision making

he meaning of asset, liability and owner’s equity

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b. Return on capital

Return on capital is the return on proceeds of reselling the investment. It is obtained through the changes in price of the asset. If the price of investment increases compared to the purchase price, investors will make a profit. If the price decreases, investors will incur a loss.

Examples of calculation for return on capital

i. Ahmad purchases a TNB share with the price of RM10.00 per share. In a year, the TNB share price increases to RM11.20. Capital gain = (11.20-10.00)/10.00 = 0.12 = 12%

ii. Hamid buys a house with price of RM200,000 to be rented. After five years, the house is sold with the price of 260,000. Capital gain=(260,000-200,000)/200,000

= 0.30 = 30% for five years.

2.2 Calculating Returns

2.2.1 Return on Money (Ringgit)

– The amount of money earned from investment for a specific period – Return on Ringgit = Income + Price Difference

– Depends on the size of investment and the holding period (investment)

2.2.2 Holding Period Return (%)

– Calculated as percentage of Return on Money (RM) compared to total investment

– Can be used to compare the performance of investments provided that the holding period and risk are the same

– Rate of Return = Income + (Selling Price-Purchase Price) Purchase Price

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2.2.3 Return per Year (or Annual)

– In most cases pertaining to return on investment, we usually call it in the form of “rate of return per year” or “annual rate of return”

– By calculating the annual return on investment, we can compare the performance of any investments which are calculated using the same method.

– A simple method (or approximate) of converting the Holding Period Return (PTP) to Annual rate of Return (PT):

PT = PTP x number of period per year (n)

– Examples:

 Holding period return of 6 months is 8%. Therefore, return per year is:

8% x 2 = 16%

 Holding period return of 3 months is 2.5%. Return per year is: 2.5% x 4 = 10%

 Holding period return of three years is 36%. Return per year is: 36% x 1/3 = 12%

– The exact method:

PT = (1+PTP)^1/n– 1

2.3 Calculating Expected Returns

Expected returns can be calculated by measuring the average rate of return for real returns over several past periods. The average return is usually used to anticipate the rate of return which is the most likely to be achieved by an investment in the future. It is the easiest method to acquire the expected rate of return for an investment.

Let’s look at the table below, if our investment produces the following annual returns.

What is our average rate of return?

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Year Rate of Return

1 10.00%

2 30.00%

3 -20.00%

4 0.00%

5 20.00%

There are two methods of calculating the average return:

– Arithmetic Mean – Geometric Mean

2.3.1 Arithmetic Mean Return

Arithmetic mean return is the simple average return for a given series of returns. We only total all returns and divide by the number of years:

Pa = (PTP)/t

From the above example:

Pa = 40/5 = 8%

The average rate of return is 8%. Is the calculation accurate? Actually, it is not. If we acquire this rate of return annually, the amount of money earned is not the same as the actual total.

Table 2.3 (a) below shows the initial investment total of RM1,0000 increasing to become RM1,372 when given returns such as the previous example.

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Table 2.3 (a): Total investment with real rate of return Year Beginning

Balance (RM)

Rate of Return

Return (RM)

Ending Balance (RM)

1 1,000.00 10.00% 100.00 1,100.00

2 1,100.00 30.00% 330.00 1,430.00

3 1,430.00 -20.00% -286.00 1,144.00

4 1,144.00 0.00% 0.00 1,144.00

5 1,144.00 20.00% 228.80 1,372.80

If we use an average rate of 8%, the amount of money earned in year 5 is not the same as the real amount. Table 2.3 (b) displays the total investment after 5 years at the average rate of 8%.

Table 2.3 (b): Total investment with average rate of return of 8%

Year Beginning Balance (RM)

Return (RM)

1 1,000.00 8.00% 80.00 1,080.00

2 1,080.00 8.00% 86.40 1,166.40

3 1,166.40 8.00% 93.31 1,259.71

4 1,259.71 8.00% 100.78 1,360.49

5 1,360.49 8.00% 108.84 1,469.33

An accurate method is to calculate the Geometric Mean Return.

2.3.1 Geometric Mean Return

Geometric mean return will provide a total return which is exact to the value of money earned from the investment:

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It is calculated according to the following formula:

Pg = [Л(1+PTP)]^1/n– 1

= [(1.10)(1.30)(.80)(1.00)(1.20)]^1/5– 1 = .0654 or 6.54%

Now let’s look at the total investment after 5 years using the geometric mean return.

Notice that the total investment in the fifth year is equal to the total investment based on the annual real rate of return.

Table 2.3 (c): Total investment with average rate of return of 6.54%

Year Beginning Balance (RM)

Return (RM)

1 1,000.00 6.54% 65.42 1,065.42

2 1,065.42 6.54% 69.70 1,135.12

3 1,135.12 6.54% 74.26 1,209.38

4 1,209.38 6.54% 79.12 1,288.50

5 1,288.50 6.54% 84.30 1,372.80

2.4 Reinvestment

Notice that in the previous examples, calculation is made by assuming investors reinvest the returns earned from the investment. This method is called compounded method whereby returns in the first year will be reinvested to be the principal value or the principal for the second year increases with the total returns earned in the first year. In other words, we do not remove it from our investment system.

With reinvestment practices, the value of investment increases faster.

Try to compare the total investment accumulated after 5 years with reinvestment (Table 2.4 (a)) and without reinvestment (Table 2.4(b)). Assume that the initial investment is RM50,000 and the average rate of return is 8%.

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Notice that with reinvestment, the total investment increases to RM73,466. Whereas assuming that the investor withdraws all of the earned returns, the total investment remains RM50,000 after 5 years.

Table2.4 (a): Total investment with reinvestment of returns Year Beginning Balance

(RM)

Return (RM)

1 50,000.00 8.00% 4,000.00 54,000.00

2 54,000.00 8.00% 4,320.00 58,320.00

3 58,320.00 8.00% 4,665.60 62,985.60

4 62,985.60 8.00% 5,038.85 68,024.45

5 68,024.45 8.00% 5,441.96 73,466.40

Table 2.4 (b): Total investment without reinvestment of returns Year Beginning

Balance (RM)

Return (RM)

Withdrawal (RM)

1 50,000.00 8.00% 4,000.00 4,000.00 50,000.00

2 50,000.00 8.00% 4,000.00 4,000.00 50,000.00

3 50,000.00 8.00% 4,000.00 4,000.00 50,000.00

4 50,000.00 8.00% 4,000.00 4,000.00 50,000.00

5 50,000.00 8.00% 4,000.00 4,000.00 50,000.00

2.5 Risks of Investment

Risks are the uncertainties pertaining to the return on investment. When investing, we have an expectation on the return. This expectation may be accurate; it may also not be (usually not accurate). These uncertainties in acquiring the expected return is called risks in investment.

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In investment, uncertainties occur in three situations:

– Uncertainty in return on revenue – Uncertainty in investment price change – Uncertainty in rate of reinvestment

Risks can be divided into two types: (1) systematic risk and (2) unsystematic risk. Both risks stem from different factors.

Systematic risks are risks which are caused by factors of economy, politics and natural disasters, whereby its occurrence gives an impact to the overall market. For example:

changes in interest rate, inflation, national production, political crisis, tsunami, etc.

Unsystematic risks are risks which are limited to specific companies, types of product or industries. Examples of unsystematic risks are the fluctuation in product demand, management misconduct, changes in policy pertaining to a product, etc.

2.6 Measuring Risks

As explained earlier in this chapter, the risk of investment is the possibility that the earned returns are not the same as the expected returns. We have also learned how the expected return is calculated based on the real returns which were recorded over several years. As investments are made in order to earn future returns, it is reasonable that probable returns are also considered in order to obtain the expected return.

For expected returns which are made based on past records of real returns, the distance between the real returns and the average returns can reveal the rate of investment risk.

Compare the assets of investment A and B shown in Table 2.6. At random, what can you say about both of these assets?

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Table 2.6: Real return of Asset A and Asset B

Year Asset A Asset B

1 8.00% 20.00%

2 9.00% 30.00%

3 7.00% -5.00%

4 8.00% 15.00%

5 10.00% 40.00%

Based on the average return formula discussed previously, the average return or expected return for Asset A and Asset B are as follows:

Pg Asset A = [Л(1+PTP)]^1/n– 1

= [(1.08)(1.09)(1.07)(1.08)(1.10)]^1/5– 1 = 0.084 or 8.40%

Pg Asset B = [Л(1+PTP)]^1/n– 1

= [(1.20)(1.30)(0.95)(1.15)(1.40)]^1/5– 1 = 0.190 or 19.00%

Investment risks are calculated by considering the distance between the real returns and the expected returns of the investment. The distances are then squared and totalled in order to obtain the total distance or variance. The standard measure for risk is standard deviation which is the square root of the variance. In other words, standard deviation is the average distance between the distribution of real returns and expected returns of the investment.

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The formula for variance is:

2= [Σ(Ri-E(R))²]/(n-1) whereby:

– Rⁱ= probable value, – E(R) = expected value,

– n = number of probable value

Therefore, the variance and standard deviation for Asset A E(R) = 8.40%

2 = [(8.00-8.40)²+(9.00-8.40)²+(7.00-8.40)²+(8.00-8.40)²+(10.00-8.40)²]/(5-1) = [0.0016% + 0.0037% + 0.0195% + 0.0016% + 0.0258%]/(5-1)

= 0.0130%

= 1.14%

The variance and standard deviation for Asset B E(R) = 19.00%

2 = [(20.00-19.00)²+(30.00–19.00)²+(-5.00-19.00)²+(15.00-19.00)²+(40.00-19.00)²]/(5- 1)

= [0.0101% + 1.2107% + 5.7584% + 0.1597% + 4.4114%]/(5-1) = 2.8876%

= 16.99%

Notice that asset B has a higher expected return than A, and also pose a higher risk than A. It is clear that the law of risk and return trade-off is proven – the higher the return, the higher the risk.

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Therefore, how do investors choose between these two assets? If investors choose a high return, obviously they should opt for B. However, B has a very high risk compared to A.

If investors prefer low risk, they should then choose A. However, A provides a very low return. What is the solution?

2.7 Coefficient of Variation

Coefficient of variation measures risks for each unit of return. This means that for each 1% of return, what is the risk of the asset. This measurement enables investors to choose their investments, such as the example above, between Asset A and Asset B.

The formula for coefficient of variation is:

CV = / E(R)

Therefore, the Coefficient of Variation for asset A and B are as follows:

CV Asset A = 1.14%/8.40% = 13.58%

CV Asset B = 16.99%/19.00% = 89.45%

Notice that Asset A has a risk of 13.58% for every 1% of its return, whereas Asset B has a risk of 89.45% for every 1% of its return. Investors who are rationally risk avoiders will definitely choose Asset A as it has a lower risk than Asset B.

Risks and returns are the most important concepts which investors need to understand.

Investors must be skilled in the method of calculating returns to ensure the goal of investment is achieved. The risk-return relationship requires investors to understand how to balance between risk and return to ensure the investments made produce optimum returns.

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Activity 1:

Calculate the return on revenue based on the information given:

1. Ali buys 10,000 ASN units with the price of RM0.70 per unit. At the end of the year, ASN gives a dividend of 5.6 cents per unit.

2. Ah Peng buys a Public Bank share with the price of RM12.50 per share. The annual dividend is 25 cents per share.

3. Muthu buys a land lot with the price of RM80,000. He expects to sell it in three years with the price of RM120,000. The land now is turned into a car park and generates an average income of RM400 per month.

Activity 2:

Calculate the return on capital for the following investments

1. Ali buys 10,000 ASN units with the price of RM0.70 per unit. At the end of the year, the price of ASN has increased to RM0.74 per unit.

2. Ah Peng buys a Public Bank share with the price of RM12.50 per share.

After a year, the price share is RM10.00 per share.

3. Muthu buys a land lot with the price of RM80,000. After three years, he sells it with the price of RM110,000.

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CHAPTER 3 TIME VALUE OF MONEY

3.1 The Concept of Time Value of Money

Time value of money is the most basic principle of financial and investment knowledge.

Time value of money states that the value of an amount of money today is higher than the same amount of money to be acquired in the future. This is due to its ability to generate income if used for investment.

If it is not used for investment, and instead used for purchases, the satisfaction it gives today is higher than the satisfaction gained if the same amount of money is spent in the future. One of the reasons is the factor of inflation which causes the amount of goods obtained in the future to not be as much as the amount obtained today. This causes today’s value of money to be higher than the value of the same amount of money in the future.

The principle of time value of money makes a rational individual to not accept the same amount of money in the future, unless he is rewarded with an appropriate compensation.

Learning Objectives:

1. Explain the concept of time value of money

2. Calculate the time value of money for a single amount

3. Calculate the time value of money for a cash flow or annuity

4. Calculate the time value of money for an infinity or perpetuity cash flow

5. Calculate the time value of money for adjusted rate of return

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As discussed in the previous chapter, an appropriate compensation means returns which can equal:

 Opportunity cost: profit which can be earned if the money is invested

 Inflation: the occurring increase in the price of goods

 Credit risk: the possibility the money is not paid

3.2 Time Value of Money for a Single Amount

If we invest RM10,000 in an investment instrument which can give us a 7% return per year, what is the future time value of money after 10 years?

Or, if we would like to obtain a total of RM100,000 in five years, what is the amount that we need to invest today if the investment can provide a 6% return?

Both of these questions are concerned with time value of money for a single amount. A single amount means an amount that we need to invest today without increasing our investment. Or an amount which we will obtain only once in the future, such as EPF savings which we will withdraw at the age of 55.

Time value of money is divided into two: future value and present value. Future value is acquired using compounding method whereas present value uses discounting method. To understand the meaning of compounding and discounting methods, we need to look at Diagram 3.2:

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Diagram 3.2: Compounding and Discounting

Diagram 3.2 shows that in order to obtain future value in year 3 for an RM1,000 that is invested today, the RM1,000 needs to be compounded at a certain profit rate for a specific duration.

3.2.1 Future Value for a Single Amount

As explained previously, the future value for a single amount is the value of an amount of money which we invest today at a certain profit rate for a specific duration. Let’s look at this example: What is the accumulated value if we invest RM10,000 today for a period of 10 years, assuming that the investment can provide a 7% return.

Its basic formula is:

FV = PV x (1 + r)

n Discounting and Compounding

Compounding

Future value

-RM1000 RM1500 RM2000 RM2500

0 1 2 3

Present value

Discounting

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Whereby:

FV = future value

PV = present value

r = profit rate

n = period in number of years

Therefore, when RM10,000 is invested at the rate of 7% for a period of 10 years, the future value is:

FV = 10,000 x (1+0.07)¹⁰

= 10,000 x 1.9672

= 19,672

If we want a higher future amount, what can we do with the same amount of money today? In other words, if we feel that RM19,672 is not sufficient, what are the ways so that the RM10,000 that we own today will increase to a higher amount?

The answer, with the same present value, the future value can be increased by:

 Acquiring a higher profit rate

 Obtaining an investment instrument which makes profit distribution more frequent (More frequent compounding)

 Investing for a longer period

 Acquire a higher profit rate

Example: r = 12%

In comparison to the previous example in which the profit earned is 7%, we can increase the future value by obtaining a higher return, which is 12%.

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r 7% 12%

FV = 10,000 x (1+0.07)¹⁰ = 10,000 x (1+0.12)¹⁰

= 10,000 x 1.9672 = 10,000 x 3.1058

= 19,672 = 31,058

 Obtain an investment instrument which has more frequent profit distribution (More frequent compounding)

Example: twice a year, hence n = 10 x 2 = 20 r = 7 %/2 = 3.5%

When profit is distributed more frequently, specifically twice a year, the future value becomes higher, i.e. RM19, 898, compared to RM19, 672 which was obtained previously.

Frequency Once a year Twice a year

FV = 10,000 x (1+0.07)¹⁰ = 10,000 x (1+0.035)²⁰

= 10,000 x 1.9672 = 10,000 x 1.9898

= 19,672 = 19,898

 Invest for a longer period Example: n = 15

In comparison to an earlier example, when the period of investment is extended to 15 years, the future value increases to RM27,590.

n 10 15

FV = 10,000 x (1+0.07)¹⁰ = 10,000 x (1+0.07)¹⁵

= 10,000 x 1.9672 = 10,000 x 2.7590

= 19,672 = 27,590

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3.2.2 Present Value for a Single Amount

The present value is today’s value for an amount to be received or paid in the future. As in the second example above, we want to know the present value for an amount of money, i.e. RM100,000 which we expect to receive after five years if the investment we choose can provide a 6% return.

Its basic formula is:

PV = FV (1 + r)

n

Whereby:

FV = future value

PV = present value

r = profit rate

Therefore, to acquire RM100,000 in five years, assuming that the rate of return is 6%, the amount which we need to invest today is:

PV = 100,000 / (1+0.06)⁵

= 100,000 / 1.3382

= 74,727

We may think that RM74,727 is still too high for us to invest today in order to earn RM100,000 five years from now. What is a way so that we do not need to invest a lot of money, but is still able to earn RM100,000?

Similar to future value, we can also determine the amount that we need to invest today without changing the amount we expect in the future. However, if for future value we expect a higher amount, for present value, a rational investor usually expects a lower amount.

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Of course, if given the choice, we would like a lower present value of investment to earn a similar future value. The way is similar to the method of obtaining a high future value.

In order to acquire a low present value, we need to:

 Acquire a higher profit rate

 Obtain an instrument which makes profit distribution more frequent (More frequent compounding)

 Invest for a longer period – we may have to postpone the desire to earn the amount in five years

 Acquire a higher profit rate Example: r = 11%

r 6% 11%

PV = 100,000 / (1+0.06)⁵ = 100,000 / (1+0.11)⁵

= 100,000 / 1.3382 = 100,000 / 1.6851

= 74,727 = 59,344

 Obtain an instrument which has a more frequent profit distribution (More frequent compounding)

Example: twelve times a year, hence n = 5 x 12 = 60 r = 6 %/12 = 0.5%

Frequency Once a year Twelve times a year

FV = 100,000 / (1+0.06)⁵ = 100,000 / (1+0.0005)⁶⁰

= 100,000 / 1.3382 = 100,000 / 1.3488

= 74,727 = 74,139

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 Invest for a longer period Example: n = 10

n 5 10

FV = 100,000 / (1+0.06)⁵ = 100,000 / (1+0.06)¹⁰

= 100,000 / 1.3382 = 100,000 / 1.7908

= 74,727 = 55,841

3.3 Time Value of Money for Annuity

If earlier we have learned the method of calculating the time value of money for a single amount, now we will learn the time value of money for a repeated value. The same value of money which is repeated or received /paid regularly is called annuity. In other words, annuity involves more than a single amount.

For example, how much is to be invested today in order to earn RM1,000 each year for the next five years if the investment asset provides a 6% annual return?

Or, what is the amount to be accumulated in another 15 years if RM1,000 is invested each month in a trust fund which provides an average return of 12% per year?

The same amount (RM1,000) which will be received or invested for each period is known as annuity, which is a similar and regular cash flow.

3.3.1 Present Value of Annuity

The present value for an annuity (PVA) of RM1,000 which is to be received at the end of the first until the fifth year, can be determined through discounting the amounts separately, at a given rate of return:

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PVA = [RM1,000 / (1.06)¹ ] + [ RM1,000 / (1.06)²]+

[RM1,000 / (1.06)³ ] + [ RM1,000 / (1.06)⁴]+

[RM1,000 / (1.06)⁵ ]

= RM943.40 + RM890.00 + RM839.62 + RM792.09 + RM747.26

= RM4,212.37

For a clearer picture, Diagram 3.3 shows the process of discounting cash flows separately as explained above.

Diagram 3.3: Process of discounting cash flows separately

The basic formula for annuity is as follow:

PVA = PMT [ 1 ]

r (1 + r)ⁿ NOW Year 1 Year 2 Year 3 Year 4 Year 5

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Whereby:

PVA = present value of annuity

PMT = annuity

r = profit rate

As it would be a rather complicated calculation for us to use the mathematical approach, it is more practical to calculate annuity using a financial calculator. Here, the calculator used is Casio FC100V.

SET END

n = 5

r = 6

PV = SOLVE 4212.37

PMT = -1000

3.3.2 Future Value of Annuity

The future value of annuity is the opposite of the concept of present value of annuity. The future value of an annuity (FVA) can be determined by compounding payments separately. For example, the future value for an annual investment of RM6,000 made at the end of the year for four years in an investment fund which provides an average return of 10% can be illustrated as follows:

FVA = [RM6,000 x (1.10)³ ] + [ RM6,000 x (1.10)²]+ [RM6,000 x (1.10)¹ ] + [RM6,000 x (1.10)⁰]

= RM7,986.00 + RM7,260.00 + RM6,600.00 + RM6,000 = RM27,846.00

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Using a financial calculator:

SET END

n = 4

r = 10

PMV = -6000

PMT = SOLVE 27846

3.4 Time Value of Money for Perpetuity

If previously we have learned how to calculate time value of annuity, now we will learn what is perpetuity and the method of calculation. Like annuity, perpetuity is also a similar and regular cash flow. What differentiates it from annuity is that annuity has a specific period, whereas perpetuity is an infinity or eternal cash flow.

NOW Year 1 Year 2 Year 3

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Why do we need infinity cash flow? In financial planning, the needs of human beings differ. Some individuals have their own reasons on why they require an infinity cash flow. Among them are:

 Has a dependent which require continued financial provision, such as a special child.

 Intends to establish a fund for welfare needs on an ongoing basis

In Islamic financial planning, the practice of waqf is highly encouraged especially for those who possess extra money. To establish waqf, especially a private waqf, a person has to know the amount of present value which he needs to establish as the principal amount in order to gain a continuous cash flow or dividend.

Its basic formula:

PV = PMT/ r

Whereby:

PV = present value

PMT = annuity

r = profit rate

Example:

If Mr. Amin wants the income he receives after retirement to continue (as he is worried that his remaining life will exceed 20 years) and wants his son to continue to receive the income after his demise, Mr. Amin needs to use the present value of perpetuity method to calculate the capital needed at the time of retirement.

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Required income = RM48,000 Expected rate of return = 5%

Present value of Perpetuity = PMT r = RM48,000 0.05 = RM960,000

This means that, in order to obtain a continuous cash flow of RM48,000 per year, Mr.

Amin needs to have RM960,000 at the time of his retirement and place that money in an investment instrument which can provide him with an annual return of 5%.

3.5 Time Value of Money with Adjusted Rate of Return

The method of calculating the time value of money with adjusted rate of return is used to calculate the future value of investment which increases at a certain rate.

Its basic formula:

FV = A((1+r)

n

-(1+g)

n

/(r-g))

Whereby:

FV = future value

A = annuity or total contribution/investment on regular basis

r = profit rate

n g

=

period in number of years growth rate

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Example:

Mr. Suhaimi is 37 years old. The ending balance of Mr. Suhaimi’s EPF account is RM100,000. At this time, Mr. Suhaimi’s total contribution is RM13,800 per year. What is the expected amount of money in his EPF at the time of retirement if Mr. Suhaimi’s income increases at the rate of 7% and the rate of return is 5%?

Future value for savings balance

Set : End

N = 55-37 = 18 I% = 5

PV = -100000

FV = SOLVE 240,661.92

Future value of yearly contributions

A((1+r)ⁿ-(1+g)ⁿ)/(r-g)

= 13800((1+0.05)¹⁸-(1+0.07)¹⁸)/(0.05-0.07)

= 13800(2.4066 – 3.3799)/(-0.02)

= -13431.54/(-0.02)

= 671,577

Total EPF savings at the time of retirement = 240,661.92 + 671,577 = 912,238.92

Using FC100V to calculate the future value of yearly contributions

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First step: Find the present value of yearly contributions Set : Begin

N = 19

I% = (1.05/1.07)-1 = -0.018692 PMT = 13800

PV = SOLVE -262,641.00

Second step: Find the future value of contributions Set : Begin

N = 19 I% = 5 PMT = 0

PV = - 262641.00

FV = SOLVE 663,682.33

Total EPF savings at the time of retirement: = 240,661.92 + 663,682.33 = 904,344.25

3.6 Time Value of Money with Real Rate of Return

Real rate of return is the rate of return which is adjusted after considering the factor of inflation. Inflation, as we understand, has a negative impact on the time value of money.

Therefore, it should be considered in the calculation of time value of money.

Its basic formula:

R = 1+r - 1 1+g

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Whereby:

R = Real rate of return

r = Profit rate

g = Growth rate

Therefore, if the expected rate of return is 5% and the inflation rate is 4%, the real rate of return is 0.9615%

Real Rate of Return = 1+0.05 - 1 1+0.04

= 0.009615 @ 0.9615%

This real rate of return is to be used for all calculations involving rate of return that needs to be adjusted to the factor of inflation. For example, in calculating the required expenses for life after retirement, the factor of inflation must be considered to coordinate the rate of return in order to obtain the total pension fund that needs to be available at the age of 55.

Example:

Mrs. Rokiah, 40 years old, would like to maintain her current lifestyle after retiring. The total monthly expenses of Mrs. Rokiah and her family is RM4,000. Therefore, Mrs.

Rokiah would like a post-retirement income of RM48,000 per year.

Based on a 4% inflation rate, the income required when Mrs. Rokiah is at the age of 55 is:

Set : End N = 15.00 I% = 4.00 PV = -48000.00

FV = SOLVE86,445.29 per year

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The amount of RM86,445.29 is the future value for the income required by Mrs. Rokiah when she is at the age of 55, after considering the factor of inflation. This amount will continue to increase based on the inflation rate. Therefore, to obtain an amount which Mrs. Rokiah needs to accumulate in order to accommodate her life for 20 years after retirement, Mrs. Rokiah needs to find a present value for an amount which can produce income that increases in line with inflation. Assuming Mrs. Rokiah places the amount or fund in an investment instrument which provides a 5% return, the real rate of return for Mrs. Rokiah’s pension fund is 0.9615%, after considering the factor of inflation.

Hence, the present value of Mrs. Rokiah’s pension fund is:

Set : Begin N = 20 I% = 0.09615 PMT = -86445.29

PV = SOLVE RM1,727,327.57

This means that in order to acquire a post-retirement income which increases at a 4% rate for 20 years, the amount that Mrs. Rokiah needs to have at the age of 55 is RM1,727,327.57.

Time value of money is an important concept in investment. It is used to determine the investment value which should be done today in order to earn an amount of money in the future or to calculate the total revenue of future investment after being involved in today’s investment.

The time value of money concept is also the basis of determining the total profit for financing products in financial institutions. It is also the basis for calculation in order to determine the instalment payments by borrowers. Therefore, it is a necessity in the

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CHAPTER 4 PORTFOLIO THEORY AND ASSET VALUATION MODEL

4.1 Introduction to the Diversification Concept and Portfolio

Diversification is the act of diversifying investment assets for the purpose of minimising risks and maximising returns. Diversification means “expanding investments to several branches”, i.e. to not place money in one investment instrument only; instead to enter several investment instruments.

It is similar to not putting all eggs in one basket, because if the basket drops, odds are all eggs will be broken. Similarly, if we invest all our money in the stocks of one company, if the stock value plummets, we may lose the money we invested.

A diversified investment portfolio has several classes of investments, for example equities, fixed income instruments and derivatives. Each class of investment in turn may comprise several types of different assets. For example in a class of equities, the portfolio can be diversified by holding the shares of listed companies, unit trusts, real estate investment trusts and exchange-traded funds. The next step is to diversify the investment within an asset type. For instance, if buying shares from listed companies, buy from varying sectors, and within the sector, buy the shares of several diverse companies. Or if buying unit trusts, buy more than one type (i.e. income funds, growth funds, bond funds, etc.) An example of a diversified portfolio is shown in Table 4.1:

Learning Objectives:

1. Explain the diversification concept and portfolio

2. Apply the diversification concept in Modern Portfolio The ory 3. Understand the concept of efficient portfolio and efficient frontier

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Table 4.1: Example of Diversification in a Portfolio Class Percentag

e

Asset Type Sector Company

Equity 90% Listed stocks Oil and gas Alam Maritim Berhad Petronas Gas Berhad Plantation IOI Corporation

Berhad

KL Kepong Berhad Unit Trusts Growth Fund Public Ittikal

CIMB Dana Ihsan Balanced

Fund

Dana Imbang Islamik

Real Estate Investment Trusts

Services KPJ Al-Aqar REIT Plantation Al-Hadarah REIT

Fixed Income 10% Tabung Haji Savings

- -

A good strategy is to combine a high-risk investment with low-risk and to place the investment in each class of investment and asset type. This is necessary so that we have a better chance of succeeding in a specific asset class and within groups of an asset. This is important for a risk and return trade-off. Imagine how it would be if all our savings are tied up in the stock market when we are in a desperate situation and need cash quickly.

Of course we will face liquidity problems if at that time the stock market continues to plummet. This situation occurs as a result of not diversifying investments within an asset class. Or we may place all our money in oil and gas shares, and then found out that crude oil prices have plummeted which causes the price of many oil and gas companies to be affected. In this situation, it would be best if we diversify investments within companies that use oil and gas, such as plantation and trade, which of course are enjoying increased