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

2. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-2 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

3. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-3 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

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

5. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-5 Table 4.4 Historical Returns for Popular Security Investments (1926-2005) 1/1/1979 to 8/11/2011 (32.5 years) S&P500 Composite Total Return 11.13% Russel 3000 Index 12.42% Wilshire 5000 11.19%

6. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-6 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

7. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-7 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

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

9. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-9 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

10. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-10 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

11. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-11 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)

12. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-12 Table 4.6 Key Financial Variables for Four Investment Vehicles Holding Period Return

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

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

15. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-15 Nominal and effective rates Nominal - stated or contractual int rate, annual interest rate (I/Y) Effective – EAR -true rate (APR) i = 12% m = 1 ieff = 12.00% m = 2 i = 12.36 m = 4 i = 12.55 m = 12 i = 12.68

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

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

18. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-18 Future Value of an Annuity What if you made monthly payments ($416.67)? 4,901,988 time value of money »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

19. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-19 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 ? time value of money

20. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-20 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 time value of money

21. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-21 time value of money 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?

22. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-22 Perpetuities PV perp = 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% time value of money

23. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-23 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? If you live to 90, how much do you need in your pension fund at age 60 with 8% return. If you wanted your retirement income to keep up with an expected inflation rate of 4.5%, how much would you need? 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? $197,304 $2,221,205 Monthly 397.99 $3,539,071 PV = 50K FV = ? N=35 I/Y=4% m=1 PMT = 0 PVA = ? FV = 0 N=30 I/Y=8% m=1 PMT = 197304 Growth of annuity = 4.5% PV = -15000 FV = 3539071 N=35 I/Y=12% m=12 PMT for FVA = ?

24. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-24 You currently have $5,000 in your 401k. 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? time value of money

25. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-25 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

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

27. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-27 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 TV Mixed Cash Flows

28. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-28 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.

29. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-29 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

30. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-30 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

31. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-31 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

32. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-32 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

33. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-33 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

34. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-34 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

35. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-35 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

36. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-36 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

37. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-37 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

38. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-38 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

39. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-39 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

40. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-40 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, σ k, which measures the dispersion around the expected value. Coefficient of variation –For making risk comparisons

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

42. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-42 Table 4.10 Historical Returns and Standard Deviations for Select Asset Classes (1900–2008)

43. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-43 Figure 4.2 Risk-Return Tradeoffs for Various Investment Vehicles

44. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-44 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

45. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-45 Real data risk and return Uses sample statistics Start with monthly prices of a set of assets Calculate the monthly returns and the statistics of those assets BUA350 Project 1 Data BUA350 Project 2

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

47. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-47 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

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

49. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-49 Table 4.1 Profiles of Two Investments

50. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-50 Table 4.2 Total Returns of Two Investments

51. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-51 Table 4.3 Historical Investment Data for ExxonMobil Corp. (XOM)

52. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-52 Table 4.8 Historical Returns for ExxonMobil and Panera Bread

53. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-53 Table 4.9 Calculation of Standard Deviations of Returns for ExxonMobil and Panera Bread

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