Chapter 4 Return and Risk Copyright 2011 Pearson

Chapter 4 Return and Risk Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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 of an investment and its original purchase price • Total Return: the sum of the income and the capital gain (or loss) earned on an investment over a specified period of time Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -2

Why Return is Important • Allows comparison of actual or expected gains with the levels of gain needed • Allows us to “keep score” on how our investments are doing compared 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -3

Key Factors in Return • Internal Characteristics – Type or risk of investment – Issuer’s management – Issuer’s financing • External Forces – – – Political environment Business environment Economic environment Inflation Deflation Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -4

Table 4. 4 Historical Returns for Popular Security Investments (1926 -2005) 1/1/1979 to 8/11/2011 (32. 5 years) S&P 500 Composite Total Return 11. 13% Russel 3000 Index Wilshire 5000 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 12. 42% 11. 19% 4 -5

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 a dollar received in the future • The sooner your money can begin earning interest, the faster it will grow Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -6

Determining a Satisfactory Investment • Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs • If Value >= Market Value, BUY • If IRR >= Required Return, BUY Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -7

Measuring Return • Required Return – The rate of return an investor must earn on an investment to be fully compensated for its risk Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -8

Measuring Return (cont’d) • 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 • Risk-free Rate – The rate of return that can be earned on a risk-free investment – The most common “risk-free” investment is considered to be the 3 -month U. S. Treasury Bill Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -9

Measuring Return (cont’d) • Risk Premium – Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics – Issue characteristics are the type, maturity and features – Issuer characteristics are industry and company factors • Required Return – The rate of return an investor must earn on an investment to be fully compensated for its risk Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -10

Holding Period Return (HPR) • Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle • Realized Return: current return actually received by an investor during the given return period • Paper Return: return that has been achieved but not yet realized (no sale has taken place) Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -11

Table 4. 6 Key Financial Variables for Four Investment Vehicles Copyright © 2011 Pearson Prentice Hall. All rights reserved. Holding Period Return 4 -12

Future values – N = years – I/Y = annual interest – PV = current value (-CF) • invest 1000 at 10% for 4 years Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -13

Compounding more frequently • Compounding periods = P/Y = m =periods per years • Invest 1000 for 6 years at 12% compounded semi-annually Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -14

Nominal and effective rates • Nominal - stated or contractual int rate, annual interest rate (I/Y) • Effective – EAR -true rate (APR) m=1 m=2 m=4 m = 12 i = 12% ieff = 12. 00% i = 12. 36 i = 12. 55 i = 12. 68 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -15

Present value (Discounting) What is the present value of $1000 3 years from now if can invest at 13% Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -16

Annuities • Equal cash flow for a certain period of time – ordinary CF starts at end of yr – annuity due starts with CF today Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -17

Future Value of an Annuity » FVA = pmt * (FVIFA) Start at age 20 invest $5000 per year in an IRA until age 60 @ 12% FVA = 5000( 767. 080) = 3, 835, 457 What if you made monthly payments ($416. 67)? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4, 901, 988 time value of money 4 -18

You have determined that you will need 1, 250, 000 in 30 years to retire and can earn 10%. What is the monthly payment to get the future amount ? Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -19

• You have now accumulated that $1, 250, 000 in an investment account. You want to withdraw an equal amount each year for 20 years and can invest at 10%. How much can you withdraw annually? Monthly? Monthly $12, 062 Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -20

Growing annuity • You would like to retire with a 100, 000 per year income. If you were to live for 35 years in retirement and could earn 8%. How much would you need to acquire in your retirement accounts? • You are concerned about inflation. If you desired for your income to keep pace with a 4% inflation rate, how much would you need? Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -21

Perpetuities PVperp = Pmt / I If you wanted to start an annual endowment that would provide your favorite professor (ME) with 20, 000 per year, and the college could earn 10% per year, how much would you have to donate? PV = 20, 000 /. 10 = 200, 000 • What if you wanted the payment to grow with inflation of 4% Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -22

Example • You currently earn 50, 000 per year and have been able to save $15, 000 in a retirement account. You will retire in 35 years at age 60 and inflation is 4%. What will your income need to be in year 1 of retirement to maintain your current lifestyle? PV = 50 K $197, 304 FV = ? N=35 I/Y=4% m=1 PMT = 0 • If you live to 90, how much do you need in your pension fund at age 60 with 8% return. PVA = ? FV = 0 N=30 I/Y=8% m=1 PMT = 197304 $2, 221, 205 • If you wanted your retirement income to keep up with an expected inflation rate of 4. 5%, how much would you need? PVA = ? FV = 0 N=30 I/Y=8% m=1 PMT = 197304 Growth of annuity = 4. 5% $3, 539, 071 • How much must you invest each month in your retirement plans to get your desired growing retirement income if you can earn a 12% return? PV = -15000 FV = 3539071 N=35 I/Y=12% m=12 PMT for FVA = ? Copyright © 2011 Pearson Prentice Hall. All rights reserved. Monthly 397. 99 4 -23

You currently have $5, 000 in your 401 k. You are 35 years old and plan to retire in 25 years. You also have estimated that you will need 2 million dollars in your retirement account. You are currently investing $250 per month and your company matches that amount. What rate of return must your retirement account earn to meet your goal? Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -24

Using IRR in Investment Decisions • Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one year • 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -25

Solve for Returns • Bought an asset 5 yrs ago for $50, now worth $75. What return? Copyright © 2011 Pearson Prentice Hall. All rights reserved. time value of money 4 -26

Yield (IRR) for a Stream of Income • Some investments, such as bonds, provide uneven streams of income over the investment period • Calculate yield (IRR) by finding the discount rate that equates the PV of the investment’s income stream to its market price Copyright © 2011 Pearson Prentice Hall. All rights reserved. TV Mixed Cash Flows 4 -27

Interest on Interest: The Critical Assumption • Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment. • Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon. • Fully compounded rate of return is the rate of return that includes interest earned on interest. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -28

Sources of Risk • Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa • Risk is the chance that the actual return from an investment may differ from what is expected Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -29

Sources of Risk (cont’d) • Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -30

Sources of Risk (cont’d) • Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -31

Sources of Risk (cont’d) • Financial Risk is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk. • Types of Investments Affected – Common stocks – Corporate bonds • Examples of Financial Risk – Company can’t get additional loans for growth or to fund operations – Company defaults on bonds Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -32

Sources of Risk (cont’d) • Purchasing Power Risk is the chance that changing 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -33

Sources of Risk (cont’d) • Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -34

Sources of Risk (cont’d) • Liquidity Risk is the risk of not being able to liquidate an investment 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -35

Sources of Risk (cont’d) • Tax Risk is 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -36

Sources of Risk (cont’d) • Market Risk is the risk of decline in investment returns because of market factors independent 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -37

Sources of Risk (cont’d) • Event Risk comes 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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -38

Measures of Risk: Single Asset • Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return • Coefficient of variation is a statistic used to measure the relative dispersion of an asset’s returns; it is useful in comparing the risk of assets with differing average or expected returns • Higher values for both indicate higher risk Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -39

Risk Measurement • The expected value of a return, k-bar, is the most likely return of an asset (average, mean). • The most common statistical indicator of an asset’s risk is the standard deviation, σk, which measures the dispersion around the expected value. • Coefficient of variation – For making risk comparisons Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -40

stand alone risk Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -41

Table 4. 10 Historical Returns and Standard Deviations for Select Asset Classes (1900– 2008) Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -42

Figure 4. 2 Risk-Return Tradeoffs for Various Investment Vehicles Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -43

Acceptable Levels of Risk Depend Upon the Individual Investor • Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk • Risk-averse describes an investor who requires greater return in exchange for greater risk • Risk-seeking describes an investor who will accept a lower return in exchange for greater risk Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -44

Real data risk and return • Uses sample statistics • Start with monthly prices of a set of assets BUA 350 Project 1 Data • Calculate the monthly returns and the statistics of those assets BUA 350 Project 2 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -45

Historical Data Returns Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -46

Steps in the Decision Process: Combining Return and Risk • Estimate the expected return using present value methods and historical/projected return rates • Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns • Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk • Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -47

Chapter 4 Additional Chapter Art Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Table 4. 1 Profiles of Two Investments Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -49

Table 4. 2 Total Returns of Two Investments Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -50

Table 4. 3 Historical Investment Data for Exxon. Mobil Corp. (XOM) Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -51

Table 4. 8 Historical Returns for Exxon. Mobil and Panera Bread Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -52

Table 4. 9 Calculation of Standard Deviations of Returns for Exxon. Mobil and Panera Bread Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -53

Investment Profile Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4 -54