Cost of Capital^43
subject to various constraints, primarily risk. Return is the motivating force, inspiring
the investor in the form of rewards, for undertaking the investment. The importance of
returns in any investment decision can be traced to the following factors:
l It enables investors to compare alternative investments in terms of what they
have to offer the investor.
l Measurement of past returns enables the investors to assess how well they have
done.
l Measurement of historical returns also helps in estimation of future returns.
Why are we discussing the return so much? The value of the security to an investor is
directly proportional to the return that he is expected to get from that security. Higher
the return expected, higher is the value. But what are we going to do with the value of
the security? Well, value of the security is the price that you are going to pay for that
security. This means that the present value of the security is that value which is dependent
on the return from the security and the risk profile of that security. Now let us go
further on return.
The Components of Return
Return is basically made up of two components:
l The periodic cash receipts or income on the investment in the form of interest,
dividends, etc. The term yield is often used in connection with the component of
return. Yield refers to the income derived from a security in relation to its price,
usually its purchase price.
l The appreciation (depreciation) in the price of the asset is referred to as capital
gain (loss). This is the difference between the purchase price and the price at
which the asset can be, or is, sold.
Measuring the Rate of Return
The rate of return is the total return the investor receives during the holding period (the
period when the security is owned or held by the investor) stated as a %age of the
purchase price of the investment at the beginning of the holding period. In other words
it is the income from the security in the form of cash flows and the difference in price
of the security between and the end of the holding period expressed as a %age of the
purchase price of the security at the beginning of the holding period. Hence, total return
can be defined as:
Purchase price of the assetTotal Returns = Cash Payment received^ +^ Price^ change^ over the^ period