Basketball TVM

Former NBA star Allen Iverson signed an endorsement contract with Reebok back in 2001. One of the terms of the contract was that Iverson would receive $800,000 per year for the rest of his life, plus a trust fund of $32 million on his 55th birthday on June 7, 2030. As an article about the agreement explains, Iverson may have received the worst of the deal, but we do have several problems with the analysis in the article. First, it is unlikely that Reebok would have offered Iverson $32 million in 2001 or $32 million on 2030. Reebok funded the trust with less than $32 million in 2001 with the intent that it would be worth $32 million in 2030. The second issue is a time value of money issue. The article notes that if Iverson had invested $32 million in 2001 at 5 percent, it would be worth $87 million in 2030. Check this for yourself and see if you don't agree that the future value of $32 million for 29 years at 5 percent is about $131.7 million

The Power Of Compounding

We hope you have learned about the power of compounding by now. If not, consider your future retirement. How much of your salary do you need to save in order to replace your pre-retirement income? Somewhere between 4 and 44 percent of your salary! If you start saving at 25 and retire at 70, you only need to save 4 percent of your salary, but if you wait to start saving until you are 45 and want to retire at 62, you will have to save 44 percent of your salary. That is quit a big difference and shows the power of compounding.

Dow 150,000!

With the DJIA at about 18,500, it may be hard to imagine the DJIA hitting 150,000, yet there is a good chance the Dow hitting or exceeding that mark in your lifetime. Even though the number may seem impossible, such is the power of compounding. As this article points out, for the Dow to hit 150,000 by 2046, the annualized return only needs to be about 7.25 percent. One important note on the Dow is that it is a price index, not a total return index, so it excludes dividends. Unfortunately, many people, including business writers, have little idea of the effect of compounding. In 1995, when mutual fund pioneer Bill Berger predicted that the Dow would hit 116,200 by 2040, the business writer audience laughed. However, based on the level of the Dow when he made the prediction, such a move only required an annual return of about 7.5 percent. While we hope you take many things from this textbook, time value of money and compounding is perhaps the most important. 

An Overconfident Donald

One of the biases often discussed in behavioral finance is overconfidence, that is the belief your abilities are better than they are. Further, many people actually have overconfidence in individuals who tell everyone how good they are. Take Donald Trump. Although his wealth is estimated by Forbes at $4.1 billion, he recently stated that he was worth $10 billion as a self-made man (who started with his father’s millions.) And while his companies have filed bankruptcy four times, The Donald will tell you how good of an investor he is. Unfortunately, a recent article disputes this statement. If The Donald had taken his stated wealth of $500 million in 1982 and invested in the S&P 500, he would now have $20 billion, twice his stated worth. We hope you note a couple of important points. First, as we discuss in the textbook, the power of compounding greatly increases the value of a portfolio over time. Second, don’t always believe the hype of self-styled investment gurus.

Middle Class Tax Break?

One thing that really bothers us is when popular press financial writers do not understand basic finance. For example, this article argues that the deductibility of 401k deposits decreases tax revenue by $163 billion. While we are sure that the author got the numbers used from another source, the fact that this number is used shows little understanding of finance. In fact, the deductibility of retirement account deposits actually increases tax receipts. Suppose you deposit $5,000 into a 401k. In the 30 percent tax bracket you would save $1,500 in taxes today. In 30 years at a 10 percent interest rate you would have $87,247. If you withdraw all of the money, you would pay $26,174 in taxes at the same 30 percent tax rate. Guess what the future value of $1,500 today for 30 years at 10 percent is? You got it --- $26,174! The tax deductibility of the deposit does not affect the tax receipts, only the timing of the tax receipts. At a 10 percent interest rate the NPV of the taxes is zero. Further, compared to a taxable account, the tax deductibility and tax deferral in a 401k actually increases tax receipts in the long run. The reason is that in a taxable account, all capital gains would be taxed at the capital gains tax rate, which is lower than the income tax rate for most people. In a 401k, the capital gains are taxed at the higher income tax rate, resulting in greater tax receipts.

Pay Your Debt

Berlin, Germany has close to €63 billion in debt, but that amount may grow if Mittenwalde, Germany has its way. An archivist recently found a certificate of debt that indicated Mittenwalde had loaned Berlin 400 guilders on May 28, 1562 at an interest rate of 6 percent per year. It was reported that the debt would now be at 11,200 guilders, or €112 million ($136.79 million). In fuzzy reporting, how this amount was calculated is not given. A quick time value of money calculation indicates that the actual amount owed by Berlin is about 97.66 trillion guilders, or about €976.6 quadrillion!

How Much Is That Degree?

The average cost for a year of college is $15,100 at a public university and $32,900 at a private university. Over the last 10 years, the cost of a year of education at a public university has increased 6.5 percent per year. As a result of the (unfortunate in this case) exponential effect of compounding, this means that in 2030 the average cost per year of a public college will be $44,047.