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60 Cards in this Set
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Return

 The level of profit from an investment, or
 The reward for investing 
Components of Return

 Income: cash or nearcash that is received as a result of owning an investment
 Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price 
Total Return

the sum of the income and the capital gain (or loss) earned on an investment over a specified period of time

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  Expected Return 
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 
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 
Satisfactory Investment:

one for which the present value of benefits equals or exceeds the present value of its costs

Required Return

The rate of return an investor must earn on an investment to be fully compensated for its risk

Required Return formula

RR on Investment = Real rate of Return+Expected inflation premium+Risk premium or investment

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

Riskfree Rate

 The rate of return that can be earned on a riskfree investment
 The most common “riskfree” investment is considered to be the 3month U.S. Treasury Bill 
Riskfree Rate Formula

Risk Free Rate = Real Rate of Return+Expected Inflation Premium

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 
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)

Holding Period Return

The total return earned from holding an investment for a specified holding period (usually 1 year or less)

Holding Period Return formula

= current income during period + Capital gain (Loss) during period / Beg investment vaule

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 
Internal Rate of Return:

determines the compound annual rate of return earned on an investment held for longer than one year

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 5year holding period?

Advantages of IRR

 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

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.

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 
RiskReturn Tradeoff

is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa

Risk

is the chance that the actual return from an investment may differ from what is expected

Currency Exchange Risk

is the risk caused by the varying exchange rates between the currencies of two countries.

Currency Exchange Risk: Types of Investments Affected

 International stocks or ADRs
 International bonds 
Currency Exchange Risk: Examples of Currency Exchange Risk

U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment

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.

Business Risk: Types of Investments Affected

 Common stocks
 Preferred stocks 
Business Risk: Examples of Business Risk

 Decline in company profits or market share
 Bad management decisions 
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.

Financial Risk: Types of Investments Affected

Common stocks
 Corporate bonds 
Financial Risk: Examples of Financial Risk

 Company can’t get additional loans for growth or to fund operations
 Company defaults on bonds 
Purchasing Power Risk

is the chance that changing price levels (inflation or deflation) will adversely affect investment returns.

Purchasing Power Risk: Types of Investments Affected

 Bonds (fixed income)
 Certificates of deposit 
Purchasing Power Risk: Examples of Purchasing Power Risk

Movie that was $8.00 last year is $9.00 this year

Interest Rate Risk

is the chance that changes in interest rates will adversely affect a security’s value.

Interest Rate Risk: Types of Investments Affected

 Bonds (fixed income)
 Preferred stocks 
Interest Rate Risk: Examples of Interest Rate Risk

 Market values of existing bonds decrease as market interest rates increase
 Income from an investment is reinvested at a lower interest rate than the original rate 
Liquidity Risk

is the risk of not being able to liquidate an investment conveniently and at a reasonable price.

Liquidity Risk: Types of Investments Affected

Some small company stocks
Real estate 
Liquidity Risk: Examples of Liquidity Risk

The price of a house has to be lowered for a quick sale

Tax Risk

is the chance that Congress will make unfavorable changes in tax laws, driving down the aftertax returns and market values of certain investments.

Tax Risk: Types of Investments Affected

 Municipal bonds
 Real estate 
Tax Risk: Examples of Tax Risk

 Lower tax rates reduce the tax benefit of municipal bond interest
 Limits on deductions from real estate losses 
Market Risk

is the risk of decline in investment returns because of market factors independent of the given investment.

Market Risk: Types of Investments Affected

All types of investments

Market Risk: Examples of Market Risk

 Stock market decline on bad news
 Political upheaval  Changes in economic conditions 
Event Risk

comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.

Event Risk: Types of Investments Affected

All types of investments

Event Risk: Examples of Event Risk

 Decrease in value of insurance company stock after a major hurricane
 Decrease in value of real estate after a major earthquake 
Measures of Risk: Single Asset

 Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return
 Coefficient of variation is a statistic used to measure the relative dispersion of an asset’s returns; it is useful in comparing the risk of assets with differing average or expected returns  Higher values for both indicate higher risk 
Acceptable Levels of Risk Depend Upon the Individual Investor

 Riskindifferent describes an investor who does not require a change in return as compensation for greater risk
 Riskaverse describes an investor who requires greater return in exchange for greater risk  Riskseeking describes an investor who will accept a lower return in exchange for greater risk 
Steps in the Decision Process:Combining Return and Risk

 Estimate the expected return using present value methods and historical/projected return rates
 Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns  Evaluate the riskreturn of each investment alternative to make sure the return is reasonable given the level of risk  Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept 