Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 12. Some Lessons from

Capital Market History

© The McGraw−Hill^413

Companies, 2002

Suppose you hold on to your Video Concept stock and don’t sell it at the end of the year.

Should you still consider the capital gain as part of your return? Isn’t this only a “paper”

gain and not really a cash flow if you don’t sell the stock?

The answer to the first question is a strong yes, and the answer to the second is an

equally strong no. The capital gain is every bit as much a part of your return as the div-

idend, and you should certainly count it as part of your return. That you actually decided

to keep the stock and not sell (you don’t “realize” the gain) is irrelevant because you

could have converted it to cash if you had wanted to. Whether you choose to do so or

not is up to you.

After all, if you insisted on converting your gain to cash, you could always sell the

stock at year-end and immediately reinvest by buying the stock back. There is no net

difference between doing this and just not selling (assuming, of course, that there are no

tax consequences from selling the stock). Again, the point is that whether you actually

cash out and buy sodas (or whatever) or reinvest by not selling doesn’t affect the return

you earn.

Percentage Returns

It is usually more convenient to summarize information about returns in percentage

terms, rather than dollar terms, because that way your return doesn’t depend on how

much you actually invest. The question we want to answer is: How much do we get for

each dollar we invest?

To answer this question, let Ptbe the price of the stock at the beginning of the year

and let Dt 1 be the dividend paid on the stock during the year. Consider the cash flows

384 PART FIVE Risk and Return

FIGURE 12.2

Percentage Returns

Dividends

Inflows

Outflows

Ending

market value

Time t t  1

• $37

$42.18

$1.85

$40.33

Total

Percentage return =

Dividends paid at

end of period 

Change in market

value over period

Beginning market value

1  Percentage return =

Dividends paid at

end of period

Market value

at end of period

Beginning market value