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02-Compounding (2)

# 02-Compounding (2) - Returns Review Key Ideas Calculating...

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Returns: Review Key Ideas Calculating Returns Present Value and Future Value Returns and Compounding Returns to a portfolio

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Measuring Performance: Price, Payoff, and Return 1 Share of Cisco Stock You buy it now for \$100 In three months you sell it for \$110 1 Share of Apache Stock You buy it now for \$200 In three months you sell it for \$215 What is the correct “measuring stick?” Payoff: what you get at the end of the investment Profit: payoff minus price Return:gross returns and net returns
Gross Returns Gross returns measure payoff as a percentage of the initial investment. Gross returns are simply payoff/price Gross return from buying Cisco: 110/100 = 110% By investing in Cisco, you get back 110% of what you initially invested . Gross returns above 100% are good Gross returns below 100% are bad

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Net Returns Net returns measure profit as a percentage of the initial investment. Net returns are simply payoff/price - 1 Net return from buying Cisco: 110/100 - 1 = 10% Or 10/100 = 10% Your investment grows by 10%. Net returns above 0 are good Net returns below 0 are bad Net returns are the growth rate of your investment
Returns and Divideds Some stocks pay dividends. If dividend is not reinvested, or is paid just before the end of the investment holding period, net return is 0 at time price 1 at time paid divided 1 at time price 1 at time observed return 1 0 1 1 1 0 1 1 1 = = = = - + = P D P r P D P r

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Returns and Future Value Example: Investment with effective net return of 5% per year. Initial Investment: \$100 After first year, what is the value of investment? After second year, what is the value of investment? After third year, what is the value of investment? What is the 3-year return? 115.76/100-1=15.76% 105 05 . 1 100 = × 25 . 110 05 . 1 100 05 . 1 105 2 = × = × 76 . 115 05 . 1 100 05 . 1 25 . 110 3 = × = ×
Future Value In general: FV=P 0 (1+r) n P 0 = initial principal invested r = effective net return on investment n = number of time periods Financial Calculator n =number of time periods PV = -initial principal (remember “-” sign) r = net return on investment pmt =coupons paid before end of each period (0)

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02-Compounding (2) - Returns Review Key Ideas Calculating...

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