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Test 2 Review - -C HAPTER 4-Components of Retu rn Cu r rent...

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------------------------------------------------------------------CHAPTER 4------------------------------------------------------------------------------- Components of Return : Current Income: usually cash or near-cash that is periodically received as a result of owning an investment. Capital Gains (Losses): the change, if any, in the market value of an investment. Real, Risk-Free, & Required Returns : Required Return: rate of return an investor must earn to compensate for the risk taken. -Required Return = Real Rate + Expected Inflation Premium + Risk Premium - r j = r * + IP + RP j Real Rate: rate of return that could be earned in a perfect world where all outcomes are known and certain (where there is no risk. Expected Inflation Premium: the average inflation rate expected in the future. Risk-Free Rate: the rate of return that can be earned on a risk-free investment. -Risk Free Rate = Real Return + Expected Inflation Premium - R f = r * + IP Risk Premium: return premium that reflects the issue and issuer characteristics within a given investment vehicle. Holding Period Return : total return earned from holding an investment for a specified period of time. ( HPR fails to consider the time value of money). -HPR = (Current Income during period + Capital Gains (losses) during period) / Beginning Investment Value -HPT = (C + CG) / V 0 -where Capital Gains (losses) = Ending Investment value – Beginning Investment Value -CG = V n – V 0 Realized Return: current income actually received by an investor. Paper Return: a return that has been achieved but not yet realized by an investor. Yield: The Internal Rate of Return : the compound annual rate of return earned by a long-term investment; the discount rate the produces a present value of the investment’s benefits that just equals its cost. Yield for a Single Cash Flow: Some investments (savings bonds, stocks w/t dividends, futures contracts, etc.), are purchased for a fixed amount up front, and pays no periodic income, only a single future cash flow at maturity – for those investments we can use the IRR yield. - On Calculator: treat the earliest value as the PV, the latest value as the FV, and the number of periods holding the investment – input the values into the TVM calculator and calculate I /Y. Yield for a Stream of Income: Most investments provide streams of income, not a lump sum upon maturity – for those investments we can use the IRR yield. -On Calculator: cost of investment, cash outflow – PV; income expected each period – FV; CPT – I /Y. Finding Growth Rates : compound annual rate of change in the value of a stream of income. - On Calculator: earliest value – PV; latest value – FV; periods – N; CPT – I /Y Types of Risk :
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Business Risk: degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors. Financial Risk: degree of uncertainty of payment attributable to the mix of debt and equity used to finance a business; the larger the proportion of debt financing the greater this risk.
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