Dividends (Divj)

Ending price per share (Pj)

Thus, the stock's dividend yield, its capital gain yield, and its total return are 8 percent, 40 percent, and 48 percent, respectively.

Suppose you had $5,000 invested. The total dollar return you would have received on an investment in the stock is $5,000 X 0.48 = $2,400. If you know the total dollar return on the stock, you do not need to know how many shares you would have had to purchase to figure out how much money you would have made on the $5,000 investment. You just use the total dollar return.4


^ ,--------. What are the two parts of total return?

o i ? • Why are unrealized capital gains or losses included in the calculation of returns?

O J • What is the difference between a dollar return and a percentage return?

4Consider the stock in the previous example. We have ignored the question of when during the year you receive the dividend. Does it make a difference? To explore this question, suppose first that the dividend is paid at the very beginning of the year, and you receive it the moment after you have purchased the stock. Suppose, too, that interest rates are 10 percent, and that immediately after receiving the dividend you loan it out. What will be your total return, including the loan proceeds, at the end of the year?

Alternatively, instead of loaning out the dividend you could have reinvested it and purchased more of the stock. If that is what you do with the dividend, what will your total return be? (Warning: This does not go on forever, and when you buy more stock with the cash from the dividend on your first purchase, you are too late to get yet another dividend on the new stock.)

Finally, suppose the dividend is paid at year-end. What answer would you get for the total return?

As you can see, by ignoring the question of when the dividend is paid when we calculate the return, we are implicitly assuming that it is received at the end of the year and cannot be reinvested during the year. The right way to figure out the return on a stock is to determine exactly when the dividend is received and to include the return that comes from reinvesting the dividend in the stock. This gives a pure stock return without confounding the issue by requiring knowledge of the interest rate during the year.

Ross-Westerfield-Jaffe: I III. Risk I 9. Capital Market Theory: I I © The McGraw-Hill

Corporate Finance, Sixth An Overview Companies, 2002


Chapter 9 Capital Market Theory: An Overview 225

Borrowing Basics

Borrowing Basics

Some small business persons cannot understand why a lending institution refused to lend them money. Others have no trouble getting funds, but they are surprised to find strings attached to their loans.

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