Lecture-3-Risk+and+Return

Theaboveequationisusedtodeterminetherateofreturn

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Unformatted text preview: d t Ct =cash (flow) received from the asset investment in the time period t ­1 to t Pt=price (value) of asset at time t Pt­1=price (value) of asset at time t­1 The return, kt, reflects the combined effect of cash flow, Ct, and changes in value, Pt ­Pt1, over period t. The above Equation is used to determine the rate of return over a time period as short as 1 day or as long as 10 years or more. However, in most cases, t is 1 year, and k therefore represents an annual rate of return. 8 Return Return Robin’s Gameroom, a high­traffic video arcade, wishes to determine the return on two of its video machines, Conqueror and Demolition. Conqueror was purchased 1 year ago for $20,000 and currently has a market value of $21,500. During the year, it generated $800 of after­tax cash receipts. Demolition was purchased 4 years ago; its value in the year just completed declined from $12,000 to $11,800. During the year, it generated $1,700 of after­tax cash receipts. Substituting into the above Equation , we can calculate the annual rate of return, k, for each video machine. Conqueror (C): 9 Return Return Although the market value of Demolition declined during the year, its cash flow caused it to earn a higher rate of return than Conqueror earned during the same period. Clearly, the combined impact of cash flow and changes in value, measured by the rate of return, is important. 10 Return Example Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year? $1.00 + ($9.50 – $10.00 ) $1.00 = 5% 5% R= $10.00 Risk Preferences Risk Preferences Feelings about risk differ among managers (and firms). Thus it is important to specify a generally acceptable level of risk. The three basic risk preference behaviors—risk­ averse, risk­indifferent, and risk­seeking. For the risk­indifferent manager, the required return does not change as risk goes from x1 to x2. I...
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