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^415

Companies, 2002

To give a more concrete example, stock in American Electric Power (AEP) began

2000 at $32.13 a share. AEP paid dividends of $2.40 ($.60 per quarter) during 2000, and

the stock price at the end of the year was $46.50. What was the return on AEP for 2000?

For practice, see if you agree that the answer is 52.19 percent. Of course, negative returns

occur as well. For example, also in 2000, AT&T’s stock price at the beginning of the year

was $53.38 per share, and 2000 dividends of $.70 per share were paid. The stock ended

the year at $17.25 per share. Verify that the loss was 66.37 percent for the year.

THE HISTORICAL RECORD

Roger Ibbotson and Rex Sinquefield conducted a famous set of studies dealing with

rates of return in U.S. financial markets.^2 They presented year-to-year historical rates of

return on five important types of financial investments. The returns can be interpreted as

what you would have earned if you had held portfolios of the following:

1. Large-company stocks. This common stock portfolio is based on the Standard &
   Poor’s (S&P) 500 index, which contains 500 of the largest companies (in terms of
   total market value of outstanding stock) in the United States.

CONCEPT QUESTIONS

12.1a What are the two parts of total return?

12.1bWhy are unrealized capital gains or losses included in the calculation of returns?

12.1c What is the difference between a dollar return and a percentage return? Why

are percentage returns more convenient?

386 PART FIVE Risk and Return

the situation illustrated in Figure 12.3. What is the dividend yield? The capital gains yield? The

percentage return? If your total investment was $1,000, how much do you have at the end of

the year?

Your $2 dividend per share works out to a dividend yield of:

Dividend yield Dt 1 /Pt

$2/25 .08 8%

The per-share capital gain is $10, so the capital gains yield is:

Capital gains yield (Pt 1 
Pt)/Pt

($35 
25)/25

$10/25

40%

The total percentage return is thus 48 percent.

If you had invested $1,000, you would have $1,480 at the end of the year, representing a

48 percent increase. To check this, note that your $1,000 would have bought you $1,000/25

40 shares. Your 40 shares would then have paid you a total of 40 $2 $80 in cash div-

idends. Your $10 per share gain would give you a total capital gain of $10  40 $400. Add

these together, and you get the $480 increase.

12.2

(^2) R. G. Ibbotson and R. A. Sinquefield, Stocks, Bonds, Bills, and Inflation[SBBI] (Charlottesville, Va.:
Financial Analysis Research Foundation, 1982).