Wiley CPAexcel Exam Review 2014 Focus Notes: Business Environment and Concepts

Focus on: Financial Risk Management and Capital Budgeting—Module 43

FINANCIAL RISK MANAGEMENT

Expected Returns

The total return of an investment includes cash distributions (interest, dividends, rents) and the change in the value of the asset. For example, an investment of $100 that pays a dividend of $3 and then grows in value to $107 at the end of the year has a total return of 10%.

Gordon equation: Total return = Current dividend rate + Annual rate of dividend increase

Expresses total return only in terms of future cash distributions by assuming increased value will allow future distributions. For example, 3% current dividend rate + 7% expected rate of dividend increase = 10%. The effect is identical to adding dividend and value growth.

A group of investments in similar types of assets is known as a portfolio. The expected return on a portfolio is a weighted average of the expected return of the individual investments.

For example, if a portfolio is invested 60% in Asset A, which is expected to return 10%, and 40% in Asset B, which is expected to return 5%, the expected portfolio return is 8%, as follows:

60% × 10% + 40% × 5% = 6% + 2% = 8%

Average Returns

When measuring average returns, there are two different measures:

1. Arithmetic average returns—The result of adding different returns and dividing by the number of periods

2. Geometric average returns—The consistent return that would grow to the same final result as the actual returns of several different periods

For example, ...