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2.b Computation of Return

Computation of Return

When investing in a financial asset, the primary goal is to earn a return on that investment. The return represents the gain or loss made on the investment relative to the amount initially invested. Understanding how to compute the return helps investors evaluate the performance of their investments and make informed decisions.

The computation of return generally involves three key components:

  1. Current Return
  2. Capital Return
  3. Total Return

1. Current Return

Current Return represents the periodic income received from an investment relative to its initial cost. This income could come from dividends, interest payments, or other forms of regular payouts. The current return is an important measure because it shows how much cash flow the investment generates while it is held.

Formula for Current Return:

\[ \text{Current Return} = \frac{\text{Income Received (Dividends or Interest)}}{\text{Initial Price of the Investment}} \times 100 \]

Example:

  • Initial Price of Investment (P): Rs 60
  • Dividends Received (D): Rs 2.40

The current return is calculated as: [ \text{Current Return} = \frac{2.40}{60} \times 100 = 4\% ]

This means that the investor earns a 4% return annually from dividends relative to the initial investment cost.

2. Capital Return

Capital Return is the return generated due to the change in the price of the investment from the time of purchase to the time of sale. It reflects the appreciation (or depreciation) in the value of the investment.

Formula for Capital Return:

\[ \text{Capital Return} = \frac{\text{Ending Price} - \text{Beginning Price}}{\text{Beginning Price}} \times 100 \]

Example:

  • Beginning Price of Investment (P): Rs 60
  • Ending Price of Investment (E): Rs 69

The capital return is calculated as: [ \text{Capital Return} = \frac{69 - 60}{60} \times 100 = \frac{9}{60} \times 100 = 15\% ]

This indicates that the investment's price increased by 15% over the period, representing the gain in value from the original purchase price.

3. Total Return

Total Return is the sum of the current return and the capital return. It provides a comprehensive measure of the investment's performance by accounting for both the income generated and the change in the asset's price.

Formula for Total Return:

\[ \text{Total Return} = \text{Current Return} + \text{Capital Return} \]

Example:

  • Current Return: 4%
  • Capital Return: 15%

The total return is calculated as: [ \text{Total Return} = 4\% + 15\% = 19\% ]

This means that over the period, the investor earned a total return of 19%, considering both the income received from dividends and the appreciation in the asset's value.

Summary of the Example Calculation:

In this detailed example, the investor purchased a stock at Rs 60 and received a dividend of Rs 2.40 by the end of the year. By the end of the year, the stock price had risen to Rs 69. The returns are computed as follows:

  • Current Return: 4%
  • Capital Return: 15%
  • Total Return: 19%

This total return reflects the overall performance of the investment, combining both the periodic income and the increase in the stock's value.

Importance of Return Computation:

Accurately computing returns is essential for investors because it enables them to: - Assess the performance of their investments. - Compare the returns from different investments. - Make informed decisions regarding buying, holding, or selling investments. - Understand the risks associated with the investment relative to the returns.

By computing returns in detail, investors can better evaluate how well their investments are meeting their financial goals.

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