Introduction to Corporate Finance

PART 2: VAlUATION, RISK AND RETURN

while Kumar devoted just $750 to his investment in Garcia Transportation. Intuitively, we might expect

Terrell to earn a higher dollar return than Kumar because he invested so much more than Kumar.

Another way to compare outcomes is to calculate the percentage return on each investment. The total

percentage return equals the total dollar return divided by the initial

Eq. 6.2 Totalpercentagereturn

Totaldollarreturn

Initialinvestment

=

example

Continuing from the previous example: given that

Terrell initially invested $2,500, while Kumar invested

just $750, we can calculate their total returns on a

percentage basis as follows:

×

Terrell’sreturn=

100 ($1+$5)

$2, 500

=

$600

$2, 500

=0.24=24%

Kumar’sreturn=

50 ($10)

$750

=

$500

$750

=0.67=67%

×

On a percentage basis, Kumar’s investment

performed better than Terrell’s, but on a dollar

return basis, the opposite is true. The conflict arises

here because the initial amount invested by Terrell

is so much larger than Kumar’s up-front investment.

Which investment would you rather have: one that

makes you $600 richer, or one that increases your

initial stake by 67%? Comparing the returns on

investments that involve different amounts of money

is a fundamental problem to which we will return in

Chapter 9. For now, we only say that dollar returns

and percentage returns can lead to different relative

rankings of investment alternatives.

Just as the total dollar return was the sum of an investment’s income and its capital gain or loss, the

total percentage return equals the sum of the investment’s yield and its percentage capital gain or loss. Recall

that the dividend yield equals a share’s dividend divided by its market price. Using the beginning-of-year

price of a Micro-Orb share to calculate its dividend yield, we have:

Micro-Orbdividendyield=

$1

$25

=0.04=4%

Similarly, the percentage capital gain equals:

Micro-Orbcapitalgain=

$5

$25

=0.20=20%

Therefore, the total percentage return on Micro-Orb equals the sum of the dividend yield and the

percentage capital gain:

Micro-Orb total percentage return = 4% + 20% = 24%

Let us summarise the important points from this section:

■ Measuring an investment’s performance requires a focus on total return.

■ The total return consists of two components, income and capital gain or loss.

■ We can express total returns either in dollar terms or in percentage terms.

■ When ranking the performance of two or more investments relative to each other, it is important to

be careful that the amount of money initially invested in each asset is the same.

■ If one asset requires a much larger up-front monetary commitment than the other, then dollar returns

and percentage returns may lead to different performance rankings.