Question

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Analyze the expected returns on the six main types of investments or portfolios.

Answer 1

Analyze the expected returns on the six main types of investments or portfolios.

Expected return

Expected return refers anticipated profit or loss against the investment made by the investor into any instrument of investment. The anticipated rate is known as rate of return(RoR) . There can be several outcomes of gain or loss therefore, probability to be considered for measuring expected rate of return.

The formula of expected rate of return = Sum(Returnᵢ ˣ probability)

Each return of the project is called “ i”

The notable fact is that the expected return can also be termed as cost of capital which is known as opportunity cost that is evolved for not exercising the investment into other opportunities thus the return of such alternative investment is forgone by the investors is known as cost of capital. The investor must earn at least the return equivalent to cost of capital in the current project which is also known as expected return of that project.

Expected return from six types of investment

1. expected return form shares

There are several techniques in finding out the expected dividend by making the investment in equities. One of the popular method for measuring expected dividend is constant growth model.

In this model it is assumed that based on the past records the growth rate of dividend is fixed.

that is D1 = D0(1+g)^1 where D1 is the dividend return of the first year based on the current dividend D0

The required rate of return of the share which is shown by ‘k’ depend on the alternative opportunities by the investors and their risk perception relating to that particular share.

Therefore, in this share valuation model two types of expected returns are present. These are expected dividend and required rate of return of the share.

2. Expected Return from bond

Bond is also another types of investment. The measurement of expected return from the bond can be shown through the calculation of yield to maturity.

The expected rate of return here is known as IRR which equalise the market price of the bond with cash inflow of the bond for the entire holding period and the terminal cash flow that is received at the end of the holding period. This IRR is known as YTM and is used as a compound interest technique where the intermediate cash flows are reinvested by means of interest and it is helpful for the investors to earn interest on interest for the entire holding period.

3. Expected return from floating debenture

   In case of debt instrument the issuer of the debt may charge varied rate. In case of floating debenture certain percentage of debt rate is fixed and the lender may levy extra rate of interest as per the situation of the market. Therefore, in such nature of debenture the presence of fixed interest rate and variable interest rate is found. Here the variable portion acts as a risk premium for the investors. The fixed portion of interest rate and variable portion of interest rate is shown as LIBOR + fixed rate of interest is said to the expected return of the floating debt.

4. Expected return for preferred stock

The expected return for preferred stock can be calculated by dividing the dividend amount declared by the firm for the preferred stock holders by the stock value. Although it is general approach in respect of calculating the required rate of return of preferred stock. The dividend of the preferred is fixed in nature. The dividend discount approach should be incorporated to find the actual rate of return of the preferred stock.

The formula is K = ( DS)+g

Where K is known as required rate of return of the preferred stock

D is the dividend amount to be paid

S is the share price

g stands for growth rate fixed in nature.

5. Required return from marketable securities

Marketable securities are a type of instrument that can be converted into cash promptly for any to meet the requirement during the emergency purpose. It matures less than a year and is shown in the current asset at the balance sheet. The return of this security is not so high as it is deposited only for a short term period. This fund is important for the nature of its liquidity. It meets the urgency of the firm when cash is required for solid investment. So the investment in the marketable securities is very important as it used as a reserve fund of the firm with low return but at times it becomes viable for the firm.

6. Real rate of return on Savings account

It is an another form of investment by the investors that help the investors to access the amount as and when necessary as kept the money idle brings no result conversely if it is deposited with bank some gain will arise in the future considering the inflation rate in the market which is a restrained factor on the part of the bank to deliver the interest in a lower rate thus reduce the purchasing power of the accumulated amount in the savings account. It is important to see the rate of interest in the light of real rate of return which is liable to change the purchasing power capacity of the money over time.