Principles of Managerial Finance

CHAPTER 5 Risk and Return 217

TABLE 5.2 Historical Returns for

Selected Security

Investments (1926–2000)

Investment Average annual return

Large-company stocks 13.0%

Small-company stocks 17.3

Long-term corporate bonds 6.0

Long-term government bonds 5.7

U.S. Treasury bills 3.9

Inflation 3.2%

Source: Stocks, Bonds, Bills, and Inflation, 2001 Yearbook

(Chicago: Ibbotson Associates, Inc., 2001).

tuting into Equation 5.1, we can calculate the annual rate of return,k,for each
video machine.

Conqueror (C):

kC 1



1



.



5



%

Demolition (D):

kD 1



2



.



5



%

Although the market value of Demolition declined during the year, its cash flow
caused it to earn a higher rate of return than Conqueror earned during the same
period. Clearly, the combined impact of cash flow and changes in value, mea-
sured by the rate of return, is important.

Historical Returns

Investment returns vary both over time and between different types of invest-
ments. By averaging historical returns over a long period of time, it is possible to
eliminate the impact of market and other types of risk. This enables the financial
decision maker to focus on the differences in return that are attributable primar-
ily to the types of investment. Table 5.2 shows the average annual rates of return
for a number of popular security investments (and inflation) over the 75-year
period January 1, 1926, through December 31, 2000. Each rate represents the
average annual rate of return an investor would have realized had he or she pur-
chased the investment on January 1, 1926, and sold it on December 31, 2000.
You can see that significant differences exist between the average annual rates of
return realized on the various types of stocks, bonds, and bills shown. Later in
this chapter, we will see how these differences in return can be linked to differ-
ences in the risk of each of these investments.

$1,500



$12,000

$1,700$11,800$12,000



$12,000

$2,300



$20,000

$800$21,500$20,000



$20,000