Lecture Topic 3a - Return and Risks

Chapter 4
Return and Risks

Return and Risks
• Learning Goals
1. Review the concept of return, its components, the
forces that affect the investor’s level of return, and
historical returns.
2. Discuss the time value of money and the calculations
involved in finding future values.
3. Explain the concept of present value, the procedures
for calculating present values, and the use of present
value in determining whether an investment
is satisfactory.
4-2
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
Return and Risks
• Learning Goals (cont’d)

4. Describe real, risk-free, and required returns and the
computation and application of holding period return,
yield (internal rate of return), and growth rates.
5. Discuss the key sources of risk and how they might
affect potential investment vehicles.
6. Understand the risk of a single asset, risk assessment,
and the steps that combine return and risk.
4-3
The Concept of Return
• Return
– The level of profit from an investment, or
– The reward for investing
• Components of Return
– Current income: cash or near-cash 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 current income and the capital
gain (or loss) earned on an investment over a specified
period of time
4-4
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
4-5
Key Factors in Return
• Internal Forces
– Type of investment
– Risks of investment
• External Forces
– Political environment
– Business environment
– Economic environment
– Inflation
– Deflation
4-6
Table 4.4 Historical Returns
4-7
The Time Value of Money
• Time Value of Money: as long as an opportunity

exists to earn interest, the value of money is
affected by the point in time when the money
is received
– A dollar received today is worth more than a dollar
received in the future.
– The sooner you receive money from an investment,
the better.
– The sooner your money can begin earning interest,
faster it will grow.
4-8
Interest: The Basic Return to Savers
• Interest: the “rent” paid by a borrower for use of the

lender’s money
• Simple Interest
– Interest is paid only on the initial deposit
• Compound Interest
– Interest is paid on the initial deposit and any interest
accumulated from prior periods
– Interest is earned on interest
– More frequent compounding periods provide higher true rate
of interest
– Compounding periods range from annually to continuously
4-9
Figure 4.1 Calculating Time Value:
Financial Tables
4-10
Figure 4.2 Calculating Time Value:
Financial Calculators
4-11
Calculating Time Value:
Computers and Spreadsheets
• Built-in routines similar to financial calculators
– Values for variables are entered in individual cells
on spreadsheet
– Cells are linked by equations programmed to
calculate time values
– Changes in variable values automatically update
time values
• Provides flexibility to investors
4-12
Future Value:
An Extension of Compounding
• Future Value: the amount a current
deposit will grow to over a period of
time when it is placed in an account
paying compound interest
• Future Value Example:
How much will $1,000 deposited
into an account earning 8%
compounded annually be worth in
two years?
4-13
Future Value:
Using an Excel Spreadsheet
4-14
Future Value of an Annuity
• Annuity: a stream of equal cash
flows that occur at equal intervals
over time
• Ordinary Annuity: an annuity
where cash flows occur at the end
of each period
• Future Value of an Annuity
Example: What is the future value
of $1,000 deposited at the end of
each year for 8 years in an account
earning 6% compounded annually?
4-15
Future Value of an Annuity:
4-16
Present Value:
An Extension of Future Value
• Present Value: the value today
of a sum to be received at some
future date
• Present Value Example: How
much would need to be deposited
today into an accounting earning
6% compounded annually to grow
to $500 in 7 years?
4-17
Present Value:
4-18
Present Value
of a Mixed Stream of Returns
• Mixed Stream of Returns: series of returns that have no
special pattern
• Present Value of an Annuity Example: What is the present
value of the following stream of returns discounted at 9%?
4-19
Table 4.9 Present Value
of a Mixed Stream of Returns
4-20
Present Value of a Mixed Stream of
Returns: Using an Excel Spreadsheet
4-21
Present Value of an Annuity
• Annuity: a stream of equal cash
flows that occur at equal intervals
over time
• Present Value of an Annuity
Example: What is the present
value of $50 deposited at the end
of each year for 5 years in an
account earning 9% compounded
annually?
4-22
Present Value of an Annuity:
4-23
Determining
a Satisfactory Investment
• Satisfactory Investment: one for which the
present value of benefits equals or exceeds
the present value of its costs
4-24
Measuring Return
• Real Rate of Return

– The rate of return that could be earned in a perfect
world where all outcomes are know and certain—where
there was no risk
– Historically, this amount has remained relatively stable
at 1% to 2%
• Expected Inflation Premium
– The average rate of inflation expected in the future
– Inflation has average 3.1% per year since 1925
4-25
Measuring Return (cont’d)
• Risk-free Rate
– The rate of return that can be earned on a
risk-free investment
– The sum of the real rate of return and the expected
inflation premium
– The most common “risk-free” investment is considered
to be the 3-month U.S. Treasury Bill
Real rate Expected inflation
Risk-free rate = +
of return premium
RF = r * + IP
4-26
• Risk Premium
– Additional return an investor requires on an
investment to compensate for higher risks based
upon issue and issuer characteristics
– Issue characteristics are the type, maturity
and features
– Issuer characteristics are industry and
company factors
4-27
• Required Return
– The rate of return an investor must earn on an
investment to be fully compensated for its risk
Required return Risk-free Risk premium

= +
on investment j rate for investment j
Required return Real rate Expected inflation Risk premium

= + +
on investment j of return premium for investment j
4-28
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)
4-29
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)
Current income Capital gain (or loss)
+
during period during period
Holding period return =
Beginning investment value
Capital gain (or loss) Ending Beginning

= −
during period investment value investment value
4-30
Table 4.11 Holding Period Return
4-31
Using HPR
in Investment Decisions
• Advantages of Holding Period Return
– Easy to calculate
– Easy to understand
– Considers current income and growth
• Disadvantages of Holding Period Return
– Does not consider time value of money
– Rate may be inaccurate if time period if longer
than one year
4-32
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 (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?
4-33
Internal Rate of Return (IRR):
4-34
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
4-35
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 calculating the PV of the
different income amounts and adding together
4-36
Internal Rate of Return (IRR):
4-37
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.
4-38
Figure 4.3
Earning Interest on Interest
$2,600 = $1,000 + ($80 x 20 years)
4-39
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
4-40
Finding Growth Rates
• Growth Rate Example: Calculate the rate of

growth on the dividend stream in Table 4.13.
4-41
Finding Growth Rates:
4-42
Risk
• Risk-Return 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
4-43
Sources of Risk
• Business Risk is the degree of uncertainty

associated with an investment’s earnings and
the investment’s ability to pay the returns
owed investors.
• Types of Investments Affected
– Common stocks
– Preferred stocks
• Examples of Business Risk
– Decline in company profits or market share
– Bad management decisions
4-44
Sources of Risk (cont’d)
• Currency Exchange Risk is the risk caused by

the varying exchange rates between the currencies
of two countries.
– International stocks or ADRs
– International bonds
• Examples of Currency Exchange Risk
– U.S. dollar gets “stronger” against foreign currency,
reducing value of foreign investment
4-45
• Financial Risk is the degree of uncertainty

attributable to the mix of debt and equity used to
finance a business; the larger the proportion of
debt financing, the greater this risk.
– Common stocks
– Corporate bonds
• Examples of Financial Risk
– Company can’t get additional loans for growth or to
fund operations
– Company defaults on bonds
4-46
• Purchasing Power Risk is the chance that

changing price levels (inflation or deflation) will
adversely affect investment returns.
– Bonds (fixed income)
– Certificates of deposit
• Examples of Purchasing Power Risk

– Movie that was $8.00 last year is $9.00 this year
4-47
• Interest Rate Risk is the chance that changes

in interest rates will adversely affect a
security’s value.
– Bonds (fixed income)
– Preferred stocks
• 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
4-48
• Liquidity Risk is the risk of not being able to

liquidate an investment conveniently and at a
reasonable price.
– Some small company stocks
– Real estate
• Examples of Liquidity Risk

– The price of a house has to be lowered for a quick sale
4-49
• Tax Risk is the chance that Congress will make

unfavorable changes in tax laws, driving down
the after-tax returns and market values of
certain investments.
– Municipal bonds
– Real estate
• Examples of Tax Risk
– Lower tax rates reduce the tax benefit of municipal
bond interest
– Limits on deductions from real estate losses
4-50
• Market Risk is the risk of decline in investment

returns because of market factors independent of
the given investment.
– All types of investments
• Examples of Market Risk

– Stock market decline on bad news
– Political upheaval
– Changes in economic conditions
4-51
• Event Risk comes from an unexpected event that

has a significant and unusually immediate effect
on the underlying value of an investment.
– All types of investments
• 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
4-52
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
4-53
Historical Returns and Risk
4-54
Figure 4.4 Risk-Return Tradeoffs
for Various Investment Vehicles
4-55
Acceptable Levels of Risk Depend
Upon the Individual Investor
• Risk-indifferent describes an investor who does
not require a change in return as compensation for
greater risk.
• Risk-averse describes an investor who requires

greater return in exchange for greater risk.
• Risk-seeking describes an investor who will

accept a lower return in exchange for greater risk.
4-56
Figure 4.5 Risk Preferences
4-57
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 risk-return 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.
4-58
Chapter 4 Review
• Learning Goals
1. Review the concept of return, its components, the
forces that affect the investor’s level of return, and
historical returns.
2. Discuss the time value of money and the calculations
involved in finding future values.
3. Explain the concept of present value, the procedures
for calculating present values, and the use of
present value in determining whether an investment
is satisfactory.
4-59
Chapter 4 Review (cont’d)
• Learning Goals (cont’d)

4. Describe real, risk-free, and required returns and the
computation and application of holding period return,
yield (internal rate of return), and growth rates.
5. Discuss the key sources of risk and how they might
affect potential investment vehicles.
6. Understand the risk of a single asset, risk assessment,
and the steps that combine return and risk.
4-60

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Chapter 4

Return and Risks

• Learning Goals (cont’d)

• Allows comparison of actual or expected gains with the

• Time Value of Money: as long as an opportunity

• Interest: the “rent” paid by a borrower for use of the

• Real Rate of Return

Required return Risk-free Risk premium

Required return Real rate Expected inflation Risk premium

• Holding Period: the period of time over which an

• Realized Return: current return actually received

• Paper Return: return that has been achieved but

• Holding Period Return

Capital gain (or loss) Ending Beginning

• Internal Rate of Return:

• Some investments, such as bonds, provide uneven

• Growth Rate Example: Calculate the rate of

• Risk-Return Tradeoff is the relationship

• Business Risk is the degree of uncertainty

• Currency Exchange Risk is the risk caused by

• Financial Risk is the degree of uncertainty

• Purchasing Power Risk is the chance that

• Examples of Purchasing Power Risk

• Interest Rate Risk is the chance that changes

• Liquidity Risk is the risk of not being able to

• Examples of Liquidity Risk

• Tax Risk is the chance that Congress will make

• Market Risk is the risk of decline in investment

• Examples of Market Risk

• Event Risk comes from an unexpected event that

• Standard deviation is a statistic used to measure

• Risk-averse describes an investor who requires

• Risk-seeking describes an investor who will

• Learning Goals (cont’d)

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