Page 73 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes I P – P
Where t is called the current yield, and t t–1 is called the capital gain yield.
P t-1 P t–1
Or
RoR = Current yield + Capital gain yield
Illustration 3: The following information is given for a corporate bond. Price of the bond at the
beginning of the year: 90, Price of the bond at the end of the year: 95.40, Interest received for
the year: 13.50. Compute the rate of return.
Solution:
The rate of return can be computed as follows:

13.50 +(95.40 – 90)
= 0.21 or 21% per annum
90
The return of 21% consists of 15% current yield and 6% capital gain yield.
There is always a direct association between the rates of return and the asset prices. Finance
theory stipulates that the price of any asset is equal to the sum of the discounted cash flows,
which the capital asset owner would receive. Accordingly, the current price of any capital asset
can be expected, symbolically, as

n
P = å E(I ) + P n
t
0 t=1 (1+ r) t (1+ r) n ...(3)
Where E (I ) = Expected income to be received in year 't'
t
P = Current price of the capital asset
0
P = Price of the asset on redemption or on liquidation
n
r = The rate of return investors expect given the risk inherent in that capital asset.
Thus, 'r' is the rate or return, which the investors require in order to invest in a capital asset that
is used to discount the expected future cash flows from that capital asset.
Illustration 4: Mr. American has purchased 100 shares of 10 each of Kinetic Ltd. in 2005 at 78
per share. The company has declared a dividend @ 40% for the year 2006-07. The market price of
share as on 1-4-2006 was 104 and on 31-3-2007 was 128. Calculate the annual return on the
investment for the year 2006-07.

Dividend received for 2004-05 = 10 × 40/100 = 4
Solution:
Calculation of annual rate of return on investment for the year 2006-07
d +(P – P ) 4 +(128 – 104)
R = 1 1 0 = = 0.2692 or 26.92%
P 0 104

4.5 Risk-return Relationship

The most fundamental tenet of finance literature is that there is a trade-off between risk and
return. The risk-return relationship requires that the return on a security should be commensurate
with its riskiness. If the capital markets are operationally efficient, then all investment assets
should provide a rate or return that is consistent with the risks associated with them. The risk
and return are directly variable, i.e., an investment with higher risk should produce higher
return.
The risk/return trade-off could easily be called the "ability-to-sleep-at-night test." While some
people can handle the equivalent of financial skydiving without batting an eye, others are

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