Finance Investments Chapter 4 PPT

8/13/2019 Finance Investments Chapter 4 PPT

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Copyright 2011 Pearson Prentice Hall. All rights reserved.

Chapter 4

Return

and Risk


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Return and Risks

Learning Goals

1. Review the concept of return, its components,the forces that affect the investors level of

return, and historical returns.2. Discuss the role of time value of money in

measuring return and defining a satisfactoryinvestment.

3. Describe real, risk-free, and required returns andthe calculation and application of holding periodreturn.


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Return and Risks

Learning Goals (contd)

4. Explain the concept and calculation of yield andhow to find growth rates.

5. Discuss the key sources of risk that might affectpotential investment vehicles.

6. Understand the risk of a single asset, risk

assessment, and the steps that combine returnand risk.


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The Concept of Return

Return The level of profit from an investment, or

The reward for investing

Components of Return Income: cash or near-cash that is received as a result of owning an investment

Capital gains (or losses): the difference between the proceeds from the sale ofan investment and its original purchase price

Total Return:the sum of the income and the capital gain (or loss) earnedon an investment over a specified period of time


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Why Return is Important

Allows comparison of actual or expected gains with the levelsof gain needed

Allows us to keep score on how our investments are doingcompared to our expectations

Historical Performance Provides a basis for future expectations

Does not guarantee future performance

Expected Return

Return an investor thinks an investment will earn in the future Determines what an investor is willing to pay for an investment or if

they are willing to make an investment


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Key Factors in Return

Internal Characteristics Type or risk of investment

Issuers management

Issuers financing External Forces

Political environment

Business environment

Economic environment Inflation

Deflation


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Table 4.4 Historical Returns for Popular Security

Investments (1926-2005)


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The Time Value of Money and Returns

The sooner you receive a return on a given

investment, the better

A dollar received today is worth more than adollar received in the future

The sooner your money can begin earning

interest, the faster it will grow


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Determining a Satisfactory Investment

Satisfactory Investment: one for which thepresent value of benefits equals or exceedsthe present value of its costs


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Measuring Return

Required Return

The rate of return an investor must earn on an

investment to be fully compensated for its risk

Required returnon investmentj

Real rateof return

Expected inflation

premium

Risk premiumfor investmentj

Required return

on investmentj

Risk-free

rate

Risk premium

for investmentj


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Measuring Return (contd)

Real Rate of Return

Equals the nominal rate of return minus the inflation rate

Measures the change in purchasing power provided by an investment

Expected Inflation Premium The average rate of inflation expected in the future


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Risk-free Rate

The rate of return that can be earned on arisk-free investment

The most common risk-free investment is considered to be the 3-month U.S. Treasury Bill

Risk-free rate Real rateof return

Expected inflationpremium

RF r* IP


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Risk Premium

Additional return an investor requires on a risky investment tocompensate for risks based upon issue and issuer characteristics

Issue characteristics are the type, maturity and features

Issuer characteristics are industry and company factors


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Holding Period Return (HPR)

Holding Period: the period of time over which an investorwishes to measure the return on an investment vehicle

Realized Return: current return actually received by aninvestor during the given return period

Paper Return: return that has been achieved but not yetrealized (no sale has taken place)


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Holding Period Return (HPR)

Holding Period Return

The total return earned from holding an investment for a specifiedholding period (usually 1 year or less)

Holding period return

Current income

during period

Capital gain (or loss)

during period

Beginning investment value

Capital gain (or loss)during period

Endinginvestment value

Beginninginvestment value


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Table 4.6 Key Financial Variables for Four Investment

Vehicles


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Using HPR in Investment Decisions

Advantages of Holding Period Return

Easy to calculate

Easy to understand

Considers income and growth

Disadvantages of Holding Period Return

Does not consider time value of money Rate may be inaccurate if time period is longer

than one year


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Yield: Internal Rate of Return (IRR)

Internal Rate of Return: determines thecompound annual rate of return earnedon an investment held for longer thanone year

Yield (IRR) Example: What isthe yield (IRR) on an investment costing$1,000 today that you expect will beworth $1,400 at the end of a 5-yearholding period?


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Calculating an Investments Yield Using an Excel

Spreadsheet


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Using IRR in Investment Decisions (contd)

Advantages of Internal Rate of Return

Uses the time value of money

Allows investments of different investment

periods to be compared with each other

If the yield is equal to or greater than the required

return, the investment is acceptable

Disadvantages of Internal Rate of Return

Calculation is complex


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Yield (IRR) for a Stream of Income

Some investments, such as bonds, provide uneven streams ofincome over the investment period

Calculate yield (IRR) by finding the discount rate that equatesthe PV of the investments income stream to its market price

Table 4.7 Present Value Applied to an Investment


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Internal Rate of Return (IRR):

Using an Excel Spreadsheet


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Interest on Interest:

The Critical Assumption

Using yield (IRR) to measure return assumes

that all income earned over the investment

horizon is reinvestedat the same rate as the

original investment.

Reinvestment Rateis the rate of return earned on interest or

other income received from an investment over its

investment horizon.

Fully compounded rate of returnis the rate of return thatincludes interest earned on interest.


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Figure 4.1 Earning Interest on

Interest


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Finding Growth Rates

Rate of Growth

The compound annual rate of change in the valueof a stream of income

Used to see how quickly a stream of income, suchas dividends, is growing


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Growth Rate Example: Calculate the rate of growth on the

dividend stream in Table 4.3.

Finding Growth Rates

Table 4.3 Dividends Per Share


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Finding Growth Rates:

Using an Excel Spreadsheet


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Sources of Risk

Risk-Return Tradeoffis the relationshipbetween risk and return, in which investmentswith more risk should provide higher returns,

and vice versa

Riskis the chance that the actual return froman investment may differ from what

is expected


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Sources of Risk (contd)

Currency Exchange Riskis the risk caused bythe varying exchange rates between thecurrencies of two countries. (Discussed in

Chapter 2)

Types of Investments Affected International stocks or ADRs

International bonds

Examples of Currency Exchange Risk U.S. dollar gets stronger against foreign currency,

reducing value of foreign investment


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Business Riskis the degree of uncertainty associated with an

investments earnings and

the investments ability to pay the returns

owed to investors.

Types of Investments Affected

Common stocks

Preferred stocks

Examples of Business Risk Decline in company profits or market share

Bad management decisions


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Financial Riskis the degree of uncertainty ofpayment resulting from a firms mix of debt andequity; the larger the proportion of debt

financing, the greater this risk.

Types of Investments Affected Common stocks

Corporate bonds Examples of Financial Risk

Company cant get additional loans for growth or tofund operations

Company defaults on bonds


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Purchasing Power Riskis the chance thatchanging price levels (inflation or deflation)will adversely affect investment returns.

Types of Investments Affected Bonds (fixed income) Certificates of deposit

Examples of Purchasing Power Risk

Movie that was $8.00 last year is $9.00 this year


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Interest Rate Riskis the chance that changes

in interest rates will adversely affect a securitys value.

Types of Investments Affected

Bonds (fixed income) Preferred stocks

Examples of Interest Rate Risk Market values of existing bonds decrease as market interest rates

increase

Income from an investment is reinvested at a lower interest rate than the

original rate


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Liquidity Riskis the risk of not being able to liquidate aninvestment conveniently and at a reasonable price.

Types of Investments Affected Some small company stocks

Real estate

Examples of Liquidity Risk The price of a house has to be lowered for a quick sale


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Tax Riskis the chance that Congress will make unfavorable

changes in tax laws, driving down

the after-tax returns and market values of

certain investments. Types of Investments Affected

Municipal bonds

Real estate

Examples of Tax Risk Lower tax rates reduce the tax benefit of municipal bond interest

Limits on deductions from real estate losses


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Market Riskis the risk of decline ininvestment returns because of market factorsindependent of the given investment.

Types of Investments Affected All types of investments

Examples of Market Risk Stock market decline on bad news Political upheaval Changes in economic conditions


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Event Riskcomes from an unexpected event that has a

significant and unusually immediate effect on the underlying

value of an investment.

Types of Investments Affected All types of investments

Examples of Event Risk Decrease in value of insurance company stock after

a major hurricane

Decrease in value of real estate after a major earthquake


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Measures of Risk: Single Asset

Standard deviation is a statistic used to measure thedispersion (variation) of returns around an assets average orexpected return

Coefficient of variation is a statistic used to measure the

relative dispersion of an assets returns; it is useful incomparing the risk of assets with differing average orexpected returns

Higher values for both indicate higher risk


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Table 4.10 Historical Returns and Standard Deviations

for Select Asset Classes (19002008)


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Figure 4.2 Risk-Return Tradeoffs

for Various Investment Vehicles


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Acceptable Levels of Risk Depend Upon the Individual

Investor

Risk-indifferent describes an investor who does not require achange in return as compensation for greater risk

Risk-averse describes an investor who requires greater returnin exchange for greater risk

Risk-seeking describes an investor who will accept a lowerreturn in exchange for greater risk


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Figure 4.3 Risk Preferences


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Steps in the Decision Process:

Combining Return and Risk

Estimate the expected return using present value methods andhistorical/projected return rates

Assess the risk of the investment by looking at historical/projected returnsusing standard deviation or coefficient of variation of returns

Evaluate the risk-return of each investment alternative to make sure thereturn is reasonable given the level of risk

Select the investment vehicles that offer the highest expected returnsassociated with the level of risk you are willing to accept


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Chapter 4 Review

Learning Goals

1. Review the concept of return, its components,

the forces that affect the investors level of

return, and historical returns.

2. Discuss the role of time value of money in

measuring return and defining a satisfactory

investment.3. Describe real, risk-free, and required returns and

the calculation and application of holding period

return.


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Chapter 4 Review (contd)

Learning Goals (contd)

4. Explain the concept and calculation of yield and how to find growthrates.

5. Discuss the key sources of risk that might affect potential investment

vehicles.6. Understand the risk of a single asset, risk assessment, and the steps

that combine return and risk.


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Table 4.1 Profiles of Two Investments


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Table 4.2 Total Returns of Two Investments


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Table 4.3 Historical Investment Data for ExxonMobil

Corp. (XOM)


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Table 4.5 Present Value Applied to an Investment


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Table 4.7 Yield Calculation for an $1,100 Investment


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Table 4.8 Historical Returns for ExxonMobil and Panera

Bread


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Table 4.9 Calculation of Standard Deviations of Returns

for ExxonMobil and Panera Bread

Finance Investments Chapter 4 PPT

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