FIN CH 8 study guide - Return On Investment(ROI After the fact actual investment returns can be measured by calculating the Return on Investment or ROI

FIN CH 8 study guide - Return On Investment(ROI After the...

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Return On Investment (ROI) After the fact, actual investment returns can be measured by calculating the Return on Investment , or ROI , an annual measure . The ROI includes: Income à Cash received. Capital Gain/Loss à The change in the value of the asset. It can be expressed in dollars or percentages. Dollar Profits & Percentage Returns Dollar Profit or Loss = Ending value + Distributions – Original Cost Rate of Return = Dollar Profit or Loss Original Cost Example: You took a $3,700 position in a stock. (100 shares @ $37/share) The stock paid a $1.85/share dividend during the year and is worth $40.33 one year later. What is your ROI? Income: $1.85 × 100 shares = $185 Capital Gain: ($40.33-$37.00) × 100 = $333 Total Dollar ROI: $185 + $333 = $518 Percentage ROI - Stock To compare investments, percentages are used. Percentages allow you to compare relative returns. Dividend Yield = D t +1 / P t Capital Gain/Loss Yield = (P t +1 - P t ) / P t Total ROI = [ (P t +1 - P t ) + D t +1 ] / P t Where: P t = Stock price at beginning of year D t +1 = Dividend paid during year Example: You took a $3,700 position in a stock. 100 shares @ $37.00/share; $1.85/share dividend; $40.33/share one year later Dividend Yield = D t +1 / P t = $1.85/$37.00 = .05 = 5% Capital Gain/Loss Yield = (P t +1 - P t ) / P t = ($40.33-$37.00)/$37.00 = 9% Total ROI = [ (P t +1 - P t ) + D t +1 ] / P t = [($40.33-$37.00) + $1.85] / $37.00 = 14% Or, = 5% + 9% = 14% Or, = ($4,218 - $3,700) / $3,700 = 14%
Risk We know that the higher the risk, the higher the return expected by investors. This is called the risk-return tradeoff . Investors wish to maximize their expected return for a given level of risk…or, minimize their risk for a given expected return. Risk can be defined as a measure of the uncertainty in a set of potential outcomes for an event in which there is a chance of some loss. Risk can be quantified by measuring the deviations of the actual returns from the average. We can statistically quantify risk by calculating the variance and its square root, the standard deviation ( σ ). The σ is the average deviation from the mean. It measures how much the returns can vary ( uncertainty ).

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