Income

1.

Mahmoud salah
20152234
the determinants of required rate of
return

2.

the determinants of required rate of return
• Required Rates of return are one of the key facto
rs which influence an investment decision. Actual
ly, Determinants of Required Rates of Return hel
ps to calculate the required rates of return on in
vestment. Sometimes the required rates of retur
n are considered as the cost of capital/expected
rates of return which basically used as a discount
ing or compounding factor. By using this factor,
we actually calculate the present and future valu
e of cash flows.

3.

the determinants of required rate of return
• Three Components of Required Return:
Required Return is the minimum rate of return that
you should accept from an investment to compens
ate you for deferring consumption.
The required rate of return that compensates the i
nvestor for :
– The time value of money during the time period
– The expected rate of inflation during the period
– The risk involved

4.

The time value of money during the time period
The time value of money (TVM) is the concept that a sum of money is w
orth more now than the same sum will be at a future date due to its ear
nings potential in the interim.
The time value of money is also referred to as present discounted value.
Investors prefer to receive money today rather than the same amount of
money in the future because a sum of money, once invested, grows over
time. For example, money deposited into a savings account earns interest
. Over time, the interest is added to the principal, earning more interest.
That's the power of compounding interest.

5.

The time value of money during the time period
another example, say you have the option of receiving $10,000 now or $10,000 t
wo years from now. Despite the equal face value, $10,000 today has more value an
d utility than it will two years from now due to the opportunity costs associated wi
th the delay.
In other words, a payment delayed is an opportunity missed.

6.

How Does the Time Value of Money Relate to Opportunity Cost?
Opportunity cost is key to the concept of the time value of money. Mone
y can grow only if it is invested over time and earns a positive return.
Money that is not invested loses value over time. Therefore, a sum of mo
ney that is expected to be paid in the future, no matter how confidently i
t is expected, is losing value in the meantime.

7.

The time value of money during the time period
• Why Is the Time Value of Money Important.
• The concept of the time value of money can help
guide investment decisions.
• For instance, suppose an investor can choose betw
een two projects: Project A and Project B. They are
identical except that Project A promises a $1 millio
n cash payout in year one, whereas Project B offer
s a $1 million cash payout in year five.

8.

The expected rate of inflation during the period
• Every economy may have inflation which is alright up t
o a considerable percent but exceeding inflation is not
good for the economy. At the time of calculating expe
cted rates of return, we must consider inflation. Higher
the inflation, the higher the required rates of return. It
is a central bank and government responsibility to ado
pt an effective economic policy by which an accepted
rate of inflation can be there for an economy. The inve
stment selection process is influenced by the required
rate of inflation.

9.

WHY ARE INFLATION EXPECTATIONS IMPORTANT?
• nflation expectations are simply the rate at which people—c
onsumers, businesses, investors—expect prices to rise in the
future. They matter because actual inflation depends, in par
t, on what we expect it to be. If everyone expects prices to
rise, say, 3 percent over the next year, businesses will want t
o raise prices by (at least) 3 percent, and workers and their
unions will want similar-sized raises. All else equal, if inflatio
n expectations rise by one percentage point, actual inflation
will tend to rise by one percentage point as well.

10.

Involvement of Risk with Investment
• here is nothing where risk is not involved. And it is money we talk
about is more sensitive towards risk. Risk can vary from industry t
o industry, company to company, person to person. But the com
mon thing is higher the risk higher the rates of return person exp
ect from an investment. Although you may find there is a variatio
n of risk-taking behavior among the individuals which is influence
d by the personal trait of an individual. Risk can be broadly categ
orized into two heads; one is systematic and the other is an unsys
tematic risk.

11.

Involvement of Risk with Investment
• Systematic Risk: Directly involved with the syste
m which arises from the macroeconomic factors a
nd it is not possible to minimize this type of risk thr
ough diversification of investment.
• Unsystematic Risk: Unsystematic is a type of risk
that is possible to minimize through diversification
of investment. With this risk, there is a correlation
between risk and diversification.

12.

Involvement of Risk with Investment
• The determination process is involved with complicated work bec
ause the process is depending on how market change over time
and how investors behave with it.
• Market change because of the following reasons:
1. A wide range of available investment alternatives
2. Return on specific assets change dramatically
3. Change in interest rate over the time period

13.

determinants of business risk
• The risk premium is the excess return above the risk-free rate that
investors require as compensation for the higher uncertainty
associated with risky assets. The five main risks that comprise the
risk premium are business risk, financial risk, liquidity risk,
exchange-rate risk, and country-specific risk. These five risk factors
all have the potential to harm returns and, therefore, require that
investors are adequately compensated for taking them on.

14.

Business Risk
• Business risk is the risk associated with the uncertainty of a
company's future cash flows, which are affected by the oper
ations of the company and the environment in which it ope
rates. It is the variation in cash flow from one period to ano
ther that causes greater uncertainty and leads to the need f
or a greater risk premium for investors. For example, compa
nies that have a long history of stable cash flow require less
compensation for business risk than companies whose cash
flows vary from one quarter to the next, such as technology
companies. The more volatile a company's cash flow, the m
ore it must compensate investors.

15.

Financial Risk
• Financial risk is the risk associated with a company's ability to ma
nage the financing of its operations. Essentially, financial risk is th
e company's ability to pay its debt obligations. The more obligati
ons a company has, the greater the financial risk and the more co
mpensation is needed for investors. Companies that are financed
with equity face no financial risk because they have no debt and,
therefore, no debt obligations. Companies take on debt to increas
e their financial leverage; using outside money to finance operati
ons is attractive because of its low cost.
• The greater the financial leverage, the greater the chance that the
company will be unable to pay off its debts, leading to financial h
arm for investors. The higher the financial leverage, the more com
pensation is required for investors in the company.

16.

Liquidity Risk
• Liquidity risk is the risk associated with the uncertainty of
exiting an investment, both in terms of timeliness and cost.
The ability to exit an investment quickly and with minimal
cost greatly depends on the type of security being held. For
example, it is very easy to sell off a blue-chip stock because
millions of shares are traded each day and there is a
minimal bid-ask spread. On the other hand,small cap stocks
tend to trade only in the thousands of shares and have bi
d-ask spreads that can be as high as 2%.The greater the ti
me it takes to exit a position or the higher the cost of sellin
g out of the position, the more risk premium investors will r
equire.

17.

Exchange-Rate Risk
• Exchange-rate risk is the risk associated with investments d
enominated in a currency other than the domestic currency
of the investor. For example, an American holding an invest
ment denominated in Canadian dollars is subject to exchan
ge-rate, or foreign-exchange, risk. The greater the historical
amount of variation between the two currencies, the greater
the amount of compensation will be required by investors. I
nvestments between currencies that are pegged to one ano
ther have little to no exchange-rate risk, while currencies th
at tend to fluctuate a lot require more compensation.

18.

Country-Specific Risk
• Country-specific risk is the risk associated with the political
and economic uncertainty of the foreign country in which a
n investment is made. These risks can include major policy
changes, overthrown governments, economic collapses, and
war. Countries such as the United States and Canada are se
en as having very low country-specific risk because of their
relatively stable nature. Other countries, such as Russia, are
thought to pose a greater risk to investors. The higher the c
ountry-specific risk, the greater the risk premium investors
will require.