978-0134083308 Chapter 4 Solution Manual Part 1

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Chapter 2 Securities Markets and Transactions 15

Chapter 4

Return and Risk

 Outline

Learning Goals

I. The Concept of Return

A. Components of Return

1. Income

2. Capital Gains (or Losses)

B. Why Return Is Important

1. Historical Performance

2. Expected Return

C. Level of Return

1. Internal Characteristics

2. External Forces

D. Historical Returns

E. The Time Value of Money and Returns

1. Computational Aids for Use in Time Value of Money Calculations

2. Determining a Satisfactory Investment

Concepts in Review

II. Measuring Return

A. Real, Risk-Free, and Required Returns

1. Inflation and Returns

2. Risk and Returns

B. Holding Period Return

1. Understanding Return Components

2. Computing the Holding Period Return

3. Using the HPR in Investment Decisions

C. The Internal Rate of Return

1. IRR for a Single Cash Flow

a. Calculator Use

b. Spreadsheet Use

2. IRR for a Stream of Income

a. Calculator Use

16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

b. Spreadsheet Use

3. Interest-on-Interest: The Critical Assumption

D. Finding Growth Rates

1. Calculator Use

2. Spreadsheet Use

Concepts in Review

III. Risk: The Other Side of the Coin

A. Sources of Risk

1. Business Risk

2. Financial Risk

3. Purchasing Power Risk

4. Interest Rate Risk

5. Liquidity Risk

6. Tax Risk

7. Event Risk

8. Market Risk

B. Risk of a Single Asset

1. Standard Deviation: An Absolute Measure of Risk

2. Historical Returns and Risk

C. Assessing Risk

1. Risk-Return Characteristics of Alternative Investments

2. An Acceptable Level of Risk

D. Steps in the Decision Process: Combining Return and Risk

Concepts in Review

Summary

Key Terms

Discussion Questions

Problems

Case Problems

4.1 Coates’ Decision

4.2 The Risk-Return Tradeoff: Molly O’Rourke’s Stock Purchase Decision

Excel@Investing

Chapter-Opening Problem

 Key Concepts

1. The concept of return, its component parts, and the forces that affect the level of return realized by

an investor; historical returns reviewed

2. Interest income and the concept of the time value of money, its underlying future and present

value computations, and its use in the investment decision-making process. (Covered in detail in

Appendix 4A.)

Chapter 2 Securities Markets and Transactions 17

3. Usage of financial calculators, computers, and spreadsheets in measuring risk and return

4. Real, risk-free, and required returns on investments

5. The computation and use of the holding period return and the internal rate of return, and the role

they can play in the investment decision

6. The sources and basic types of risk, the concept of risk, its positive relationship to return, and its

role in investment decision making

7. The basic steps involved in evaluating the risk-return characteristics of an investment

 Overview

The concepts of return and risk are developed in this chapter. This chapter is conceptually more

demanding than the preceding one, so the instructor should plan to spend more class time on it.

1. Returns are rewards for investing. The components of total return are income and capital gains (or

losses). Income is cash received for holding an investment, whereas capital gains refers to income

that is attributed to an increase—realized or unrealized—in the value of the investment.

2. Expected return motivates a person to invest in a particular security. Expectations of returns are

based on the past returns of that investment. Measuring the historical return of a particular investment

reveals its average return as well as the trend of its returns.

3. The level of returns for a particular investment depends on internal characteristics, such

as type of investment and issuer characteristics, and external forces, such as war, political events,

and the level of price changes (inflation or deflation).

4. A satisfactory investment is one in which the present value (PV) of benefits (discounted at the

appropriate rate) equals or exceeds the PV of costs. The instructor may indicate that NPV (PV of

benefits minus PV of costs) measures the same thing.

5. The required return of an investment is the rate that compensates the investor for its risk. It is

composed of the real rate of return—the return earned in a perfect world with no risk—plus the

expected inflation premium, which is called the risk-free rate, plus the risk premium for the

investment.

6. The holding period return (HPR), defined next, is useful in making investment decisions. The

instructor may show the class how HPR is computed, stressing that the HPR from identical periods

should be used when comparing two investments.

7. The internal rate of return (IRR), represents the annual rate of return earned on a long-term

investment. A satisfactory investment is one that has an IRR equal to or greater than the appropriate

discount rate. Some instructors may want to spend time discussing the critical assumption that

intermediate cash flows are reinvested at the internal rate of return.. Others may choose to skip this

technical, but important, discussion. Those who cover the reinvestment rate issue should find Figure

4.1 helpful in explaining it. At this point, the instructor should have made it clear to the class that the

returns from an investment may be measured either in dollar or percentage terms although

percentages are more useful if the investments are of unequal size.

8. The chapter next covers the calculation of growth rates for streams of dividends or earnings, a

present value application that is an important part of common stock valuation.

18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

9. The concept of risk is introduced and defined. The possible sources of risk include business risk,

financial risk, purchasing power risk, interest rate risk, liquidity risk, tax risk, market risk, and event

risk. The concepts of diversifiable, nondiversifiable, and total risk are covered in the next chapter.

Next introduced is the risk of a single asset, the standard deviation as a measure of absolute risk. The

risk-return tradeoff is also discussed.

10. The text’s description of the four steps in the investment decision process is useful and should be

highlighted.

 Answers to Concepts in Review

4.1 Return on investment can come from either income or capital gains, or both. Income, most

commonly, is periodic payments, such as interest received on bonds, dividends on stock, or rent

The use of percentage returns is generally preferred to dollar returns to allow investors to directly

compare different sizes and types of investments.

4.2 Although future returns are not guaranteed by past performance, historical data often gives the

investor a meaningful basis on which to form future expectations. Past return data, such as average

The level of expected returns depends on many internal characteristics of the investment and the

external forces on the investment. Internal characteristics include the type of investment, the quality

History tells us that stock market returns have averaged well above the interest rates payable on

savings accounts at banks. In recent years, especially during the latter part of the 1990s, the returns

4.3 A satisfactory investment is one for which the present value of benefits discounted at the appropriate

Chapter 2 Securities Markets and Transactions 19

4.4 a. The real rate of return on an investment measures the increase in purchasing power the

investment provides. It is approximately equal to the nominal rate of return on a security less

b. The expected inflation premium represents the expected average future rate of inflation over an

c. The risk premium varies for different security issues and represents the additional return required

to compensate an investor for the risk characteristics of the issue and the issuer. It is the return on

The risk-free rate of return equals the real rate of return plus the expected inflation premium:

The required rate of return equals the real rate of return plus the expected inflation premium

(together, the risk-free rate) and the risk premium: ri  RF RPj. Alternatively, it equals the

risk-free rate of return plus the risk premium.

4.5 The holding period is simply the period of time over which the investor wishes to measure the return

on an investment. In comparing alternative investments, it is essential to use equal-length holding

The holding period return (HPR) is the total return earned from holding an investment for a

4.6 The IRR is the annual rate of return earned by a long-term investment. It is also defined as the

discount rate that produces a present value of benefits received equal to the present value of

20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

4.7 The critical assumption underlying the use of internal rate of return is an ability to earn a return equal

to the calculated rate of return on all income received from the investment during the holding period.

If you earn 10% on all income received from an investment during the holding period, your yield on

the investment will be 10%. On the other hand, if you earn 0% on the income received, your rate of

4.8 If the present value of returns from an investment is greater than the initial cost of the investment, it

In the example given, Investment A is clearly acceptable because its IRR (8%) is greater than the

4.9 Risk is the uncertainty surrounding the actual return that an investment will provide. The standard

deviation is a statistic that is often used to measure risk. The risk-return tradeoff is the relationship

4.10 a. Business risk is concerned with the degree of uncertainty associated with an investment’s

b. Financial risk is the risk associated with the mix of debt and equity (capital structure) used to

c. Purchasing power risk arises because of uncertain inflation rates and price-level changes in the

d. Interest rate risk is risk associated with changes in the prices of fixed-income securities resulting

from changing market interest rates. As the market interest rates change, the prices of these

e. Liquidity risk is the risk of not being able to sell an investment quickly and at a reasonable price.

f. Tax risk is the risk that tax laws enacted by Congress will adversely affect certain types of

investments and decrease their after–tax returns.

Chapter 2 Securities Markets and Transactions 21

g. Event risk is the risk that comes from a largely or totally unexpected event that has a significant

and usually immediate effect on the underlying value of an investment. The effect of this risk

seems to be isolated in most cases, affecting only certain companies and properties.

4.11 Standard deviation is a common, but somewhat flawed measure of an asset’s risk. It measures the

4.12 Investors’ attitudes toward risk or their risk-return tradeoffs may be classified as one of the following:

In general, most investors are risk averse. They require increased returns from an investment as its

risk increases. The risk preference of an investor is an important determinant of his or her investment

4.13 The investment decision process can be summarized in four steps:

(1) Estimate the expected return over a given holding period using historical data or projected return

data, or both. The time value of these returns must be considered for long-term investments.