The Return on an Investment - Business Finance - ثاني ثانوي

Link to digitat lesson 6.2 The Return on an Investment www.ten.edu.sa Rem What earned on an investiment: the stim of income and capital gama generated by an investment Dividends A period payment to stock shareholder in cash or other shares of stock Capre yo The increase in the value of the asset, based on the asset's ongmal price Key Terms Return Dividends Capital gain Expected return Required return All investments are made in anticipation of a return. This applies to individuals and to financial managers of firms. The Sources of Return An investment may offer a return from two sources: • The first source of return is the flow of income. In many countries, an investment yields a flow of interest income. This could be from an investing account, a bond, or some other type of debt obligation, such as a loan. Interest is typically specified contractually for these investments. Income from stocks will come in the form of dividends. A dividend is a periodic payment to a stock shareholder in cash or other shares of stock. Businesses are not required to pay dividends, but many investors consider dividends as part of the expected return from owning a stock. ⚫ The second source of return is capital appreciation. -If an investor buys stock and their price increases, the investor earns a capital gain. A capital gain is the increase in the value of an asset based on the original price of the asset. A discounted bond, where the maturity price is SAR 10,000, may be purchased for a discounted rate. The difference between the discounted rate and the maturity rate is the capital gain. All investments offer potential income and/or capital appreciation. Investments, such as an investment in land, may offer only capital appreciation. Some investments may require 232 Business Finance 1921-1889

expenditures, such as taxes, on the part of the investor. The Expected Return and The Required Return Investors and financial managers make investments because they anticipate a return. It is important to differentiate between the expected return and the realized return. The expected return is the financial or other incentive for accepting risk by investing. This must be compared with the required return, which is the amount that investors need to get back in order for them to be induced to make an investment. Typically, the higher the risk involved in an investment, the higher the expected return. The expected return depends on individual expected outcomes and the probability of their occurrence. The inancial or other incentive for accepting risky investing The amount that investurs need to get back in order for them to be induced to make an investment وزارة الصليد CHAPTER Risk and Its Measurements 233

234Business Finance 2821-1889 EXAMPLE Assume Abdullah works for a mutual fund company. He is a professional investor who must consider all of the factors that can influence the return on an investment given possible risks. The company Abdullah works for has multiple mutual funds with different goals. These funds could be to have low, moderate, or higher risk growth opportunities. Abdullah's mutual fund company can't promise expected returns for investors, but he must structure the mutual funds to allow investors to reach their investment goals. ⚫ Abdullah will evaluate potential company stocks to include in the mutual funds and may determine that under normal economic conditions, which occur 60% of the time, the expected return on this stock is 10% through capital gains and dividends. After reviewing the potential company's management, competition, and market conditions, Abdullah determines there is a 20% chance the economy will grow more rapidly, in which case the investment will return 15% Abdullah also determines there is a 20% chance the economy will enter a recession and the company will do poorly, in which case it will earn only a 5% return. Given the possible outcomes and their probabilities, Abdullah needs to determine the expected return on this investment. Abdullah answers this question by looking at the outcomes and the probability of their occurring (in other words, the probability of the economy growing more rapidly, growing at a normal rate, or entering into a recession). Since Abdullah believes these probabilities are 20%, 60%, and 20%, respectively, the expected return on the investment is determined by a weighted average, see Equation 6.1: Expected Return - Weighted Average Weighted Average = (probability of event 1 x return on event 1) + (probability of event 2 x return on event 2) + ... In this case, the weighted average would be calculated as: Weighted Average (0.2 x 15%) + (0.6 x 10%) + (0.2 x 5%) Weighted Average = 10%. Note: The sum of the probabilities should be 100%. Notice that the expected return is a weighted average of the individual expected outcomes and the probability of occurrence. If the individual expected outcomes had been different, the expected return would differ.

You Try It Assume you are analyzing an expected return on stocks. The expected retums of these stocks under different economic conditions are shown in the table below: Normal outlook Positive outlook Negative outlook Probability Returns 60% 9% 15% 12% 25% 39 Determine the weighted average return on the investment. Will you buy this stock? Why or why not? Now analyze an expected return on a second stock: Normal outlook Positive outlook Negative outlook Probability 50% Returns 8% 20% 30% 15% 1% What is the weighted average of the second investment? Which stock would you prefer to invest in? Exercises Choose the correct answer. 1. The expected return on an investment includes both the expected income plus expected price appreciation. True/False 2. The difference between the discounted rate and the maturity rate is the capital gain. True/False وزارة التعليم CHAPTER & Risk and Its Measurements 235