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Chapter 6 FIN - Chapter 6 Expected Return Defined and...

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Chapter 6 Expected Return Defined and Measured Holding period return (historical or realized rate of return): the rate of return earned on an investment, which equals the dollar gain divided by the amount invested. Holding period dollar gain= price at end of period + cash distribution – Price at beginning of period Rate of return = (dollar gain/Pbeginning of period) = (p end of period +dividend – p beginning of period) / p beginning of period Expected rate of return: the arithmetic mean or average of all possible outcomes where those outcomes are weighted by the probability that each will occur. Expected cash flow = (CF1 x Pb1) + (CF2 x Pb2) + (CF3 x Pb3) Expected rate of return = (r1 x Pb1) + (r2 x Pb2) + (r3 x Pb3) Risk Defined and Measured Risk: potential variability in future cash flows. The wider the range of possible events that can occur, the greater the risk. Standard Deviation: a statistical measure of the spread of a probability distribution calculated by squaring the difference between each outcome and its expected value, weighting each value by its probability, summing over all possible outcomes, and taking the square root of this sum. *For the publishing company’s common stock, we calculate the standard deviation using the following five-step procedure: 1. Calculate the expected rate of return of the investment 2. Subtract the expected rate of return from each of the possible rates of return and square the difference 3. Multiply the squared differences calculated in step 2 by the probability that those outcomes will occur 4. Sum all the values calculated in step 3 together. The sum is the variance of the distribution of possible rates of return. Note that the variance is actually the
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