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FIN 501 (31)
Chapter 1

Chapter 1.docx

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Department
Finance
Course
FIN 501
Professor
Edward Blinder
Semester
Summer

Description
Chapter 1: A Brief History of Risk and Return 1.1 Returns: Dollar Returns: - If you buy an asset of any type, your gain (or loss) from that investment is called the return on your investment - This return has 2 components: 1. You may receive some cash directly while you own the investment 2. The value of the asset you purchase may change (you have a capital gain or capital loss on your investment) - Ex: You purchased 100 shares of stock in Toronto Dominion Bank on Jan 1 . At that time, TD was selling for $69 per share, so your 100 shares cost you $6900. At the end of the year, you want to see how you did with your investment. o A company may pay cash dividends to its shareholders. As a shareholder in TD, you are a part owner of the company, and you are entitled to a portion of any money distributes. So if TD chooses to pay a dividend, you will receive some cash for every share you own. o In addition to the dividend, the other part of your return is the capital gain or loss on the stock: Case 1 Case 2 Ending Stock Price $74 $65 January 1 value $6900 $6900 December 31 value 7400 6500 Dividend income 150 150 Capital gain or loss 500 -400 o Over the year, Toronto Dominion pays dividend of $1.50 per share. Dividend income = $1.50 x 100 = $150 o Case 1: Capital Gain = ($74 - $69) x 100 = $500 o Case 2: Capital Loss = ($65 - $69) x 100 = -$400 o Notice that a capital loss is the same thing as a negative capital gain o The Total Dollar Return on your investment = the return on an investment measured in dollars that accounts for all cash flows and capital gains or losses o Total Dollar Return = Dividend income + Capital gain (or loss) o Total dollar return = $150 + $500 = $650 o Overall, between the dividends you received and the increase in the price of the stock, the value of your investment increased from $6900 to $6900 + $650 = $7550 o Suppose you hold on to your TD stock and dont sell it at the end of the year, you should still consider the capital gain as part of your return o The capital gain is every bit as much a part of your return as the dividend and you should certainly count it as part of your return. The fact that you decide to keep stock and dont sell (you dont realize the gain) is irrelevant because you could have converted it to cash if you had wanted to. o After all, if you insist on converting your gain to cash, you could always sell the stock and immediately reinvest by buying the stock back. There is no difference between doing this and just not selling (assuming that there are no transaction costs or tax consequences from selling the stock) o The point is that whether you actually cash out and buy pizzas or continue to hold the investment doesnt affect the return you actually earn Percentage Returns: - It is usually more convenient to summarize information about returns in percentage terms than in dollar terms, because that way your return doesnt depend on how much you actually invested- With percentage returns the question we want to answer is: How much do we get for each dollar we invested? - - Case 1 Case 2 Ending Stock Price $74 $65 January 1 value $69 $69 December 31 value 74 65 Dividend income 1.50 1.50 Capital gain or loss 5 -4 - Dividend Yield = the annual stock dividend as a percentage of the initial stock price Ex: Dividend Yield = $1.50 / $69 = 2.17% This says that for each dollar we invested we received 2.17 cents in dividends. - Capital Gain Yield = the change in stock price as percentage of the initial stock price Ex: Capital Gain Yield = (74 69) / 69 = 7.25% This 7.25 percent yield means that for each dollar invested we got 7.25 cents in capital gains. - Total Percent Return = the return on an investment measured as a percentage that accounts for all cash flows and capital gains or losses 2.17 cents in dividends + 7.25 cents in capital gain = 9.42 cents on the dollar or 9.42% When a return is expressed on a percentage basis, we refer to it as the rate of return or just return on the investment. - Combining th
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