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Lecture Finance - Topic 5: Measuring risk and return

In this chapter we will focus our discussion on risk and return for common stock for an individual investor. The results, however, can be extended to other assets and classes of investors. In fact, in later chapters we will take a close look at the firm as an investor in assets when we take up the topic of capital budgeting. | Risk and Return 8/5/2015 Professor James Kuhle 1 Topic 5 I. Measuring Risk and Return 8/5/2015 Professor James Kuhle 2 A. Return 1. Return can be seen as the reward for investing. 2. Components of Return 3. Importance of Return 4. Calculating Return a. Historical Performance b. Expected Return 8/5/2015 Professor James Kuhle 3 A. Return (continued) Given the following information, calculate the expected return: Return Probability -30% .03 -20% .06 -10% .08 0% .15 Return Probability 10% .18 20% .20 30% .13 40% .12 50% .05 8/5/2015 Professor James Kuhle 4 A. Return (continued) EV = S RiPi n i=1 EV = (-30)(.03) + (-20)(.06) + (-10)(.08) + (0)(.15) + (10)(.18) + (20)(.20) + (30)(.13) + (40)(.12) + (50)(.05) EV = 14.1% 8/5/2015 Professor James Kuhle 5 A. Return (continued) 5. Measuring Return a. Net Present Value Example: Suppose we are considering investing in an asset that yields $1000 in year one, $1100 in year two, $1500 in year three and $3200 in year four. If your required rate of . | Risk and Return 8/5/2015 Professor James Kuhle 1 Topic 5 I. Measuring Risk and Return 8/5/2015 Professor James Kuhle 2 A. Return 1. Return can be seen as the reward for investing. 2. Components of Return 3. Importance of Return 4. Calculating Return a. Historical Performance b. Expected Return 8/5/2015 Professor James Kuhle 3 A. Return (continued) Given the following information, calculate the expected return: Return Probability -30% .03 -20% .06 -10% .08 0% .15 Return Probability 10% .18 20% .20 30% .13 40% .12 50% .05 8/5/2015 Professor James Kuhle 4 A. Return (continued) EV = S RiPi n i=1 EV = (-30)(.03) + (-20)(.06) + (-10)(.08) + (0)(.15) + (10)(.18) + (20)(.20) + (30)(.13) + (40)(.12) + (50)(.05) EV = 14.1% 8/5/2015 Professor James Kuhle 5 A. Return (continued) 5. Measuring Return a. Net Present Value Example: Suppose we are considering investing in an asset that yields $1000 in year one, $1100 in year two, $1500 in year three and $3200 in year four. If your required rate of return is 12%, and the asset costs $5000, determine the net present value. NPV = $1000/(1.12)1 + $1100/(1.12)2 + $1500/(1.12)3 + $3200/(1.12)4 - $5000 NPV = -$128.90 8/5/2015 Professor James Kuhle 6 A. Return (continued) c. Internal Rate of Return d. Modified Internal Rate of Return Example: MIRR $5000(1 + MIRR)4 = $1000(1.06)3 + $1100(1.06)2 + $1500(1.06)1 + $3200 $5000(1 + MIRR)4 = $1191 + $1236 + $1590 + $3200 $5000(1 + MIRR)4 = $7217 [(1 + MIRR)4]1/4 = [1.4434]1/4 1 + MIRR = 1.0961 MIRR = 9.61% 8/5/2015 Professor James Kuhle 7 8/5/2015 Professor James Kuhle 8 A. Return (continued) 6. Six Functions of a Dollar Future Value of a Single Sum Future Value of a Series of Payments Sinking Fund Factor Present Value of a Single Sum Present Value of a Series of Payments Amortization Factor 8/5/2015 Professor James Kuhle 9 1. Future Value of Single Sum $ ? PV i N COMP FV 8/5/2015 Professor James Kuhle 10 $ $ ? $ PMT 2. Future Value of an Annuity i N COMP FV 8/5/2015 Professor James Kuhle .