BU283 Chapter Notes - Chapter 5: Dividend Yield, Expected Return, Weighted Arithmetic Mean
Chapter 5
• Expected return is the return that is expected to be earned each period on a given asset in
the future
• Risks are the variability in outcomes coupled with the possibility of harm
• The less certain the investor is about projected cash flows the riskier the investment
becomes
• Uncertainty arises from factors that are difficult to predict and will influence the firm’s
future
• Risk is determined by the uncertainty of future cash flows and this uncertainty is the
result of factors peculiar to each asset
• Once investors establish the riskiness of the asset the market allows the price of the asset
to adjust so that the expected return on the asset fairly compensates investors for their
perceived risk
• The perceived risk of the asset is determined first and then the market establishes a price
that will provide an expected return that is sufficient
• As risk increases return increases
• Goal is to maximize the price of the firm’s shares and this price depends on the risk of the
firm
Computing the Return on a Single Asset
• The holding period return consists of the earnings from dividends paid plus the return (capital
gain) in its share price
• The HPR is the percent of your investment earned during the time you held it
•
• the numerator of the HPR equation represents what you earned and the denominator is what
you invested to achieve this income
• dividend yield = dividends/beginning price
• capital gain = ending price – beginning price / beginning price
• average compound return is the return computed that recognizes that interest or earnings are
paid on accumulated interest or earnings. It is also called a compound return
Expected Returns
• objects that have more than one possible outcome are called random variables
• the possible outcomes of random variables are called states of nature (future scenarios)
• stock returns are states of nature and states of nature are economic scenarios
• states of nature are probabilities which quantify the likelihood of events occurring
• the expected return reflects the investor’s evaluation of the probable yield of an investment
• the expected return and the actual return can differ
• expected return = E(k)= Pr1k1 +Pr2k2+….
Ki = the return in the ith state of nature
Pri = the probability of occurrence of the ith outcome
n= number of possible outcomes
Evaluating the Risk of Holding a Single Asset
• risk entails two components: harm and uncertainty
• harm means small or negative returns
• uncertainty is the variability in outcomes
