FINANC 3000 1st Edition Lecture 14 Outline of Last Lecture I. Dividend Discount ModelII. Estimating Growth RateIII. Preferred StockIV. Variable Growth TechniqueV. P.E. ModelOutline of Current Lecture I. Rate of ReturnII. RiskIII. Risk vs. ReturnCurrent LectureWhat is Return?- Return is the compensation for taking on risk- Investors in stocks and bonds get returns in two forms:o Dividends and interest paymentso Capital gains or losses (Sales price – purchase price)- If stock is sold – realized gains, continue to hold – unrealized gains- Ex. o Consider an investor who bought a share of stock for $65 at the start of the year. At the end of the year, it is worth $76 and has paid a dividend of $1.10. His pre-tax percentage return is given by:These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. Percentage return=capital gain +dividendinitial share pricePercentage return=( $ 76−65)+$ 1. 10$65=18.62%Rate of Returns- Average rate of return – the arithmetic average return provides an estimate for how the investment has performed over long periods of time.o- Geometric mean return – the mean return computed by finding equivalent return that iscompounded for N periods.o To find geometric mean return use TVM formula- Ex.o What was your average and geometric mean return if you invested $100, earned 50% in year 1($50) and then lost 50%($75) in year 2. Average = (50% +-50%)= 0 Geometric mean return(N=2, PV=$100, FV=-75, CPT I=-13.4%)Risk- Risk is how much uncertainty about future returns you can expectWhat is the risk/return relationship?- If you take on more risk, you expect to be compensated for it with a higher return.- All financial instruments and activities are priced from this relative risk. Price is the compensation.How do you measure risk?- Look at historical data to determine variability in returns, can use it to project into the future- Standard deviationo A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. Standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility. Provide a way to measure security’s total risk Gives a way to compare riskiness of different securitiesRisk vs. Return- Higher risk investments offer higher return- Short term volatility in risky investments can be substantial- Investor may experience negative returns (lose money) once in a while- Many investors intellectually understand stock market is risky, but can’t take the pain of losses when they occur- To get more return you have to assume more risk – trade off between risk and return- How much extra return can you expect for taking on risk?- Coefficient of variation – is a measure of risk return relationship (standard deviation/average return)o- Investor wants to receive high return with low risk -> smaller CoV indicates are better risk-return