Financial Management: Principles and Applications, 13/e

Chapter Summaries

7.1 Calculate realized and expected rates of return and risk. (pgs. 194–202)

Summary:

We refer to the actual rate of return earned on an investment as the realized rate of return. This can be expressed as a percentage or as a cash amount gained or lost on the investment. But because investment returns are uncertain, we must speak in terms of expected returns. The expected rate of return is the rate we anticipate earning on an investment and is the rate relied on when evaluating a particular investment opportunity. We can calculate the expected rate of return using Equation (7–3):

$$\begin{array}{l}\begin{array}{cc}\begin{array}{c}\text{Expected}\text{Rate}\\ \text{of}\text{Return}\\ \left[E\left(r\right)\right]\end{array}& =\left(\begin{array}{ccc}\begin{array}{c}\text{Rate}\text{of}\\ \text{Return}\text{1}\\ \left(r_1\right)\end{array}& \times & \begin{array}{c}\text{Probability}\\ \text{of}\text{Return}\text{1}\\ \left(P{b}_1\right)\end{array}\end{array}\right)+(\begin{array}{ccc}\begin{array}{c}\text{Rate}\text{of}\\ \text{Return}\text{2}\\ \left(r_2\right)\end{array}& \times & \begin{array}{c}\text{Probability}\\ \text{of}\text{Return}\text{2}\end{array}\end{array}\end{array}\end{array}$$