Question

Question #5: Measuring returns 1. What is accounting rate of return? What is the discounted cash flow analysis? What are the differences, advantages, and disadvantages of each approach? 2. What is the difference between price returns and total returns of a stock? 3. Download monthly S&P 500 index from January 2000 to December 2018. Calculate monthly price return of S&P 500 index. How many months did the S&P 500 have positive return and negative return? 4. If you invested $1,000 in S&P 500 in January 2000, how much did you have by the end of 2018? What was the rate of return during 2000-187 And the annual compounded rate of return?

Answer 1

1). The accounting rate of return is the ratio of average net profit to the average investment made into a project. The project would be accepted if the ARR exceeds to required hurdle rate for a company otherwise not. It is an easy to calculate ratio which provides a broad idea about whether to go ahead with a project or not. However, it has certain drawbacks, the most notable one being that it does not take into account, the time value of money. Also, the net profit figure includes all non-cash expenses like depreciation so it does not reflect the actual cash flows from a project.

The Discounted Cash Flow (DCF) analysis calculates the value of a project taking into account the time value of money. DCF method finds the present value of the future cash flows using a discount rate.The sum of all these present values is the value of a proposed project. If this net present value is greater than the cost of investment and positive then the project can be considered for investment. Given the method of analysis, DCF offers the best estimate of the true value of a project. A few limitations of a DCF analysis is estimating the correct cost of capital (since the risk-free rate can change over the life of a project). Also, greater the number of future projections, higher are the chances of them being accurate as it is quite difficult to predict cash flows 4-5 years into the future. Thus, calculating the salvage value at the end of the project life can be challenging.

2). Total return of a stock is inclusive of the dividends received while the stock was held which price returns only takes into account the capital gains. For example, suppose a stock was bought for $50 which paid a dividend of $5 and was then sold for $60. The total return for the stock will be ($60-$50+$5)/$50 = 30% while the price return will be ($60-$50)/$50 = 20%