Economics Essay on Total Return

2021-06-16 08:48:13
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Carnegie Mellon University
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The total return includes interest, capital gains, dividends as well as appropriations over a given period of time. It is a measure of an investments overall performance. The total return of 27 percent is therefore the actual rate of return obtained from preference stock over a given period of time. In this case, a total return of 27 percent implies that the stock increased by 27 percent of its original value and this could have probably been brought about by price increase, dividend distribution, coupons or capital gains. Ideally, the total return is essential in establishing the true growth over time. Additionally, the total return can be used in evaluation of the companys historical performance. Thus, with a total return of 27 percent, investors can expect that future investments can generate a significant amount to risks in the enterprise.

Capital gains.

Capital gains yield = P1 P0

P0

CGY = 125 100

100

CGY = 25/100

CGY = 0.25

The capital gains indicate how much the price fluctuates. Thus, the capital gain of 25 percent indicates that prices of stock rose by approximately 25percent and this represents an appreciation in the capital over a period of time. The higher the capital gains, the more value and worth is the asset. Thus, capital gains can also help investors to identify which investments are good investment choices by comparing the capital gains over a period of time. If an asset is sold at a higher price than the purchase price, it results to capital gains. Thus, the capital gains yield of 25percent could mean that the value of the security appreciated with 25percent as compared to the original value.

Dividend yield

Dividend yield = D/P0

DY = 2/100

DY = 0.02

The dividend yield represents the amount of cash dividends distributed to the shareholders as per the market value per share. It is useful in showing how the investment in stock is generating either cashflows in the form of dividends or stock appreciations. In other words, it is the payoff of investments to shareholders. A company can choose to investment the profits/gains it has obtained from an investment. When the company chooses to pay the profits to the shareholders, it establishes the percentage of the profit to distribute. Thus, the dividend yield of 2percent represents the percentage of distributable profits to the shareholders. There residue/balance represents the retained earnings.

Total return

4% Preferred stock for $100

Market price = $120

Total return = Dividend/Price

TRP = 4%(100)/120

TRP = 4/120

TRP = 0.033

TRP = 3.33%

The total return of 3.33% represents the amount of return that preference shareholders gained from their investments. It is more of less, the profits that are distributed to the preference shareholders. The shareholders receive payments of their returns before the ordinary shareholders.

Capital asset pricing model (CAPM)

Beta = 1.2

Expected market return = 12%

Risk-free rate = 5%

Expected rate of return

R = Rf + (Rm-Rf)bR = 5% + (12-5)1.2

R = 5 + 7*1.2

R = 5+8.4

R = 13.4

It describes the relationships between systematic risk and expected return for assets especially the stocks. It is the pricing of risky securities and useful in evaluation of computing the cost of capital. There are two ways of compensating investors: time value of money as well as risk. The risk free rate (rf) represents the time value of money and it is what investors get for investing their money over a period of time. The risk free rate is ideally the return from investments in securities such as the government bonds.

WACC

Weight of common stock (We) = 80%

Weight of debt (Wd) = 20%

Cost of equity = 12%

Cost of debt (kd)= 7%

Tax rate = 30%

WACC = E/V*Re + D/V*Rd*(1-Tc)

WACC = We*ke + Wd*kd(1-t)

WACC = 12%(0.8) + 7%(0.2)(1-0.3)

WACC = 0.096 + 0.049

WACC = 0.145

WACC = 14.5%

The WACC represents the overall required return for a firm. The weighted average cost of capital is 14.5% indicating that the average cost obtained from equity and debt was 14.5%. Common sources of capital include common stock, preferred stock, bonds as well as long terms debts. Increase in beta and return on equity leads to increase in the WACC, while an increase in WACC denotes a decrease in valuation and an increase in risk.

The proportion of equity in the capital is 80 percent while the proportion of debt in the capital is 20percent. This indicates that in this valuation, a higher proportion of capital is financed from equity. The cost of capital represent the value that equity holders as well as debt holders expect and thus, the WACC represents the return that equity and debt holders expect to receive. To compute the value of debt, the after tax cost of debt (1-tc) is multiplied by the cost of debt and weight of debt. In this case, tax deductions availed on interest paid and this is usually for a plus on the company. The net cost of companys debt which represents the amount of interest a company may be paying subtract the saving in taxes which amounts out of the tax-deductible interest payments.

References

Barberis, N., Greenwood, R., Jin, L., & Shleifer, A. (2015). X-CAPM: An extrapolative capital asset pricing model. Journal of Financial Economics, 115(1), 1-24.

Raviv, A., Raviv, A., Thompson, T., Thompson, T., Gresh, P., Gresh, P., ... & Hennessy, S. (2017). Bed Bath & Beyond: The Capital Structure Decision. Kellogg School of Management Cases, 1-14.

Fong, W. M., & Ong, Z. (2017). The Long and Short of Profitable Dividend Yield Strategies (Digest Summary). CFA Digest, 47(1).

Wang, A., & Ye, Z. (2014, May). Total return swap valuation with counterparty risk and interest rate risk. In Abstract and Applied Analysis (Vol. 2014). Hindawi Publishing Corporation.

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