EYK2_1 - E x t e n d Yo u r K n o w l e d g e 2 - 1 :...

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Extend Your Knowledge 2-1: Return on Investment and Return on Equity Supplement Return and Risk Proft is oFten reFerred to as return . The term return derives From the idea oF get- ting something back From an investment. Return also derives From the concept oF return on investment . Return on investment is oFten stated in ratio Form as proft divided by amount invested . ±or example, banks or trust companies oFten report our return From a savings account in the Form oF an interest rate oF return on investment. We can invest our money in many ways. IF we invest it in a bank savings account or in Canada Savings Bonds, it will probably give us a return oF around 3% to 6%. We could also invest in a company’s shares, or even start our own busi- ness. How do we decide among these investment options? Our answer rests on the trade-oFF between return and risk. Risk is the amount oF uncertainty about the return we expect to earn. All business decisions involve risk. But some decisions involve more risk than others. The lower the risk oF an investment, the lower the expected return. The reason why savings accounts pay a low return is the small degree oF risk oF the Funds not being repaid with interest. Indeed the government guarantees most savings accounts against deFault. Similarly, the reason that Canada Savings Bonds pay a low return is the low risk oF deFault by the Canadian government. However, iF we buy a share oF Canadian Tire, there is no guarantee oF return. There is even a risk oF loss. Bonds are written promises by organizations to repay amounts borrowed plus interest. Canadian treasury bonds provide us a low expected return, but they also oFFer low risk since they are backed by the Canadian government. High-risk corporate bonds oFFer a much larger expected return but with much greater risk. But expected return is not actual return. The diFFerence between expected and actual return is the primary source oF risk. The trade-oFF between return and risk is a normal part oF business. Higher expected return oFFsets higher risk. We must remember that actual return usually diFFers From expected return. Higher risk implies higher, but more risky expected returns. To help us make better business decisions, we use accounting inForma-
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EYK2_1 - E x t e n d Yo u r K n o w l e d g e 2 - 1 :...

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