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Chapter 4

Chapter 4. Return and Risk. Return and Risks. Learning Goals Review the concept of return, its components, the forces that affect the investor’s level of return, and historical returns. Discuss the role of time value of money in measuring return and defining a satisfactory investment.

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Chapter 4

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  1. Chapter 4 Return and Risk

  2. Return and Risks Learning Goals Review the concept of return, its components, the forces that affect the investor’s level of return, and historical returns. Discuss the role of time value of money in measuring return and defining a satisfactory investment. Describe real, risk-free, and required returns and the calculation and application of holding period return.

  3. Return and Risks Learning Goals (cont’d) Explain the concept and calculation of yield and how to find growth rates. Discuss the key sources of risk that might affect potential investment vehicles. Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

  4. The concept of Return • People are motivated to invest in a given asset by its expected return. • The return is the level of profit from an investment • Some investments guarantee a return, but most don’t. The return on a bank deposit insured by the federal government is virtually certain • The return earned on a loan to your business associate might be less certain. • The size and the certainty of expected of the expected return are important factors in choosing a suitable investment

  5. Components of return • The return on investment may come from more than one source.. • The most common source is periodic payments such as dividends or interest. • The other source of return is the change in the investment’s price. • We call these two sources of return current income and capital gains or losses.

  6. Income • Income may take the form of dividends from stocks or mutual funds, or interest received on bonds. • To be considered income, it must be in the form of cash or be readily convertible into cash. • For our purposes, an investment’s income is usually cash that investors periodically receive as a result of owning an investment

  7. Capital gains or losses • The second dimension of return focuses on the change in an investment’s market value. • The amount by which the proceeds from the sale of an investment exceed its original purchase price is a capital gain • If an investment sells for less than its original purchase price , a capital loss results.

  8. Capital gains or losses • Combining the capital gain or loss with the income gives the total return. • Its generally preferable to use percentage returns rather than dollar returns. • Percentages allow direct comparisons of different sizes and types of investments.

  9. Why return is important • An asset’s return is a key variable in the investment decision because it indicates how rapidly an investor can build wealth. • Most people prefer to have more wealth rather than less, they prefer investments that offer high returns rather than low returns if all else is equal. • Returns on most investments are uncertain

  10. Historical performance • Most people recognize the future performance is not guaranteed by past performance, but past data often provide a meaningful basis for future expectations. • A common practice in the investment world is to look closely at the historical record when formulating the expectations about the future. • Interest rates and other measures of financial return are most often cited on an annual basis. Evaluation of past investment return is typically done on the same basis

  11. Historical performance • Two aspects of these data are important. • First , we can determine the average level of return generated by this investment over the past 10 years. • Observe that there was considerable variation in return from one year to the next.

  12. Expected Return • Expected return: is a vital measure of performance . Its what you think the investment will earn in the future that determines what you should be willing to pay for it.

  13. Level of return • The level of return achieved or expected from an investment will depend on a variety of factors. • The key factors are internal characteristics and external forces.

  14. Internal characteristics • Certain characteristics of an investment affect its return. • For investments issued by companies, the characteristics that are important include things such as the type of investments ( E.g. stocks or bonds) • The quality of the firm’s management and whether the firm finances its operations with debt or equity.

  15. External forces • External forces such as Federal reserve actions , shortages, war, price controls and political events may also affect an investment’s return. • None of these are under the control of the issuer of the investment vehicles, and investment react differently to these forces. • Another external force is the general level of price changes, either up ( inflation ) or down (deflation). • Inflation tends to have a positive impact on real estate and a negative impact on stocks and fixed income securities.

  16. Historical returns • Returns vary both over time and between different types of investments. • By averaging historical returns over a long period of time, its possible to observe the differences in returns earned by various types of investments

  17. Table 4.4 Historical Returns for Popular Security Investments (1926-2005)

  18. Why Return is Important Allows comparison of actual or expected gains with the levels of gain needed Allows us to “keep score” on how our investments are doing compared to our expectations Historical Performance Provides a basis for future expectations Does not guarantee future performance Expected Return Return an investor thinks an investment will earn in the future Determines what an investor is willing to pay for an investment or if they are willing to make an investment

  19. Key Factors in Return Internal Characteristics Type or risk of investment Issuer’s management Issuer’s financing External Forces Political environment Business environment Economic environment Inflation Deflation

  20. The Time Value of Money and Returns The sooner you receive a return on a given investment, the better A dollar received today is worth more than a dollar received in the future The sooner your money can begin earning interest, the faster it will grow

  21. Determining a Satisfactory Investment Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs If the present value of the benefits just equals the cost, you would earn a rate of return equal to the discount rate. If the present value of the benefits exceeds the cost, you would earn a rate of return greater than the discount rate If the present value of the benefits is less than the cost, you would earn a rate of return less than the discount rate

  22. Determining a Satisfactory Investment • You would prefer only those investments for which the present value of the benefits equals or exceeds its cost. • In 1 and 2 , the rate of return would be equal to or greater than the discount rate.

  23. Measuring return • We need to incorporate the time value of money concepts that explicitly consider differences in the timing of investment income and capital gains. • We must be able to calculate the present value of the future benefits. • The nominal return on an investment is the actual return that the investment earns expressed in current dollars. • The real rate of return equals the nominal return minus the inflation rate, and it measures the increase in the purchasing power provided by an investment

  24. Measuring Return Required Return The rate of return an investor must earn on an investment to be fully compensated for its risk

  25. Measuring Return (cont’d) Real Rate of Return Equals the nominal rate of return minus the inflation rate Measures the change in purchasing power provided by an investment Expected Inflation Premium The average rate of inflation expected in the future

  26. Measuring Return (cont’d) Risk-free Rate The rate of return that can be earned on a risk-free investment The most common “risk-free” investment is considered to be the 3-month U.S. Treasury Bill

  27. Measuring Return (cont’d) Risk Premium Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics Issue characteristics are the type, maturity and features Issuer characteristics are industry and company factors such as the line of business and financial condition of the issuer. Together ,the issue and the issuers factors contribute to the overall risk of an investment and cause investors to require a risk premium above the risk free rate. Example is required !!

  28. Holding Period Return (HPR) Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle Realized Return: current return actually received by an investor during the given return period Paper Return: return that has been achieved but not yet realized (no sale has taken place)

  29. Holding Period Return (HPR) • Capital gains and losses, on the other hand, are realized only when the investors sells an asset at the end of the holding period. Until the sale occurs , the capital gain is merely a paper return. • Even if the capital gain isn’t realized , it must be included in the total return calculation • Income and capital gains components can have a negative value, occasionally , an investment may have negative income, that’s, you may be required to pay out cash to meet certain obligations

  30. Holding Period Return (HPR) Holding Period Return The total return earned from holding an investment for a specified holding period (usually 1 year or less)

  31. Table 4.6 Key Financial Variables for Four Investment Vehicles

  32. Using HPR in Investment Decisions Advantages of Holding Period Return Easy to calculate Easy to understand Considers income and growth Disadvantages of Holding Period Return Does not consider time value of money Rate may be inaccurate if time period is longer than one year

  33. Yield: Internal Rate of Return (IRR) Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one year Yield can also be defined as the discount rate that produces a present value of benefits just equal to its cost. Yield (IRR) Example: What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5-year holding period?

  34. Calculating an Investments Yield Using an Excel Spreadsheet

  35. Using IRR in Investment Decisions (cont’d) Advantages of Internal Rate of Return Uses the time value of money Allows investments of different investment periods to be compared with each other If the yield is equal to or greater than the required return, the investment is acceptable Disadvantages of Internal Rate of Return Calculation is complex

  36. Yield (IRR) for a Stream of Income Some investments, such as bonds, provide uneven streams of income over the investment period Calculate yield (IRR) by finding the discount rate that equates the PV of the investment’s income stream to its market price Table 4.7 Present Value Applied to an Investment

  37. Internal Rate of Return (IRR): Using an Excel Spreadsheet

  38. Interest on Interest: The Critical Assumption Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment. Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon. Fully compounded rate of return is the rate of return that includes interest earned on interest.

  39. Figure 4.1 Earning Interest on Interest

  40. Finding Growth Rates Rate of Growth The compound annual rate of change in the value of a stream of income Used to see how quickly a stream of income, such as dividends, is growing

  41. Growth Rate Example: Calculate the rate of growth on the dividend stream in Table 4.3. Finding Growth Rates Table 4.3 Dividends Per Share

  42. Finding Growth Rates: Using an Excel Spreadsheet

  43. Risk: the other side of the coin • Risk is the uncertainty surrounding the actual return that an investment will generate. • The risk associated with a given investment is directly related to its expected return • The greater the investment’s risk, the higher the expected return is/ • In general : investors attempt to minimize risk for a given level of return or to maximize return for a given level of risk. This relationship between risk and return is called the risk-return trade off

  44. Sources of risk • We can find the required return on an investment by adding its risk premium to the risk free rate. • This premium in abroad sense results from the sources of risk, which derive from characteristics of both the issue and the issuer

  45. Business risk • The degree of uncertainty associated with an investment’s earnings and investment’s ability to pay the returns ( interest, principal, dividends) owed investors. • The business risk associated with a given investment is tied to the firm’s industry • The business risk in a public utility common stock differs from the risk in the stock of a high fashion clothing manufacturer.

  46. Sources of Risk (cont’d) Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors. Types of Investments Affected Common stocks Preferred stocks Examples of Business Risk Decline in company profits or market share Bad management decisions

  47. Financial risk • Firms that borrow money sometimes experience financial difficulties because they cant generate enough cash to pay all their bills, including debt payments. • The uncertainty surrounding a firm’s ability to meet its financial obligations because it has borrowed money is financial risk • The more debt used to finance the firm, the greater the financial risk is.

  48. Financial risk • Debt financing obligates the firm to make interest and principal payments, thus increasing risk • Inability to meet debt obligations could result in business failure and in losses for bondholders and stockholders.

  49. Sources of Risk (cont’d) Financial Risk is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk. Types of Investments Affected Common stocks Corporate bonds Examples of Financial Risk Company can’t get additional loans for growth or to fund operations Company defaults on bonds

  50. Purchasing power risk • The changes which is happening in the price levels ( inflation or deflation) will affect the investment’s return is called the purchasing power risk • The risk is the chance that generally rising prices ( inflation) will reduce the purchasing power ( the goods and services that can be purchased with a dollar) • In general, investments whose values move with general price levels have low purchasing power risk and are profitable during periods of rising prices

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