The Rate of Return
When we talk of expected rate of return this relates to the estimated value than an investor should invest in a given investment plan. When estimating the expected rate of return an investor should consider the aspect of price of the investment and how the payment will be done. Dividends affects the expected return thus its wise to do the estimation on the expected dividends. The main reason that makes the investor to estimate the rate of return is determine some of the changes that might occur there in between such as the cost and payments to be made. With the help of probability distribution curve, investor will be able to calculate the possible rates. There is a risk free rate of return when the investment is thought to be risky. Given a positive rate of return the investor enables to invest simply because it indicates that he will get better return in the long run. Below is the formula of calculating the expected rate of return, (Scott, 2003).
n
ERR = Σ (Possible Return x Probability)
i = 1
In order to induce an investor or an organization to invest in a given project, the required rate of return should be favorable. Unlike the expected rate of return where costs and payments are the key determinates, required rate of return determines the risk that is probable in the investment thus creating a forum for making a wise decision. Determining the type of risk that will be associated with your investment enables one to determine the return from the investment. With the required rate of return, the investor becomes acquainted with returns from the investment. To calculate the required rate of return, we use the formula; Required rate of return=risk free rate + (market rate of return – risk free rate)* Beta of the stock, (Scott, 2003).
Given 12% as the expected rate of return and 10% required rate of return, a firm or the investor has no obligation to make the investment.
Reference:
Scott, D. L. (2003). Wall Street Words: An A to Z Guide to Investment Terms for Today’s Investor. Houghton Mifflin Company
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