CHAPTER
4
Components of Return
:
Current Income:
usually cash or nearcash 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, RiskFree, & 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.
RiskFree Rate:
the rate of return that can be earned on a riskfree 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 longterm
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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 Spring '09
 Upton
 Time Value Of Money, Net Present Value, Dividend, Dividend yield

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