Expected Return

Definition

Expected return is the anticipated profit or loss an investor can expect from an investment, factoring in all possible outcomes and their probabilities. It plays a crucial role in decision-making, as investors use it to evaluate the potential profitability of various investments while considering their risk profiles. This concept ties together both the assessment of risks associated with capital projects and the cost of financing that underpins these investments.

5 Must Know Facts For Your Next Test

1. Expected return is calculated using a weighted average of all possible returns, where weights are assigned based on the probability of each outcome occurring.
2. Investors often compare expected returns against benchmarks or historical averages to assess performance and make informed decisions.
3. In capital budgeting, expected return is essential for evaluating investment projects and determining whether they will meet a firm's required return threshold.
4. The riskier an investment, the higher its expected return generally needs to be to attract investors seeking adequate compensation for taking on that risk.
5. When calculating the cost of capital, expected return helps determine the appropriate rate at which future cash flows should be discounted to evaluate an investment's present value.

Review Questions

• How does expected return influence an investor's decision-making process when assessing potential investments?
  • Expected return significantly impacts an investor's decision-making by providing a benchmark for evaluating potential profitability. Investors analyze expected returns alongside risks to determine if an investment aligns with their financial goals and risk tolerance. By considering different outcomes and their probabilities, investors can make more informed choices about where to allocate resources and whether to pursue high-risk opportunities or safer bets.
• In what ways does the expected return relate to risk analysis in capital budgeting?
  • In capital budgeting, expected return is pivotal as it helps firms estimate the profitability of potential projects. By calculating expected returns based on projected cash flows and their associated risks, companies can prioritize investments that align with their strategic objectives. This process enables organizations to assess whether anticipated returns justify the risks taken, ensuring that resources are allocated efficiently towards projects that enhance overall value.
• Evaluate how the concept of expected return integrates with the components of cost of capital in corporate finance.
  • Expected return plays a central role in understanding the components of cost of capital by helping determine the appropriate discount rates for various financing options. Investors expect returns that reflect both market conditions and specific project risks, impacting how firms calculate their weighted average cost of capital (WACC). By aligning expected returns with financing costs, corporations can ensure that their investments generate sufficient profits to cover costs while providing shareholders with competitive returns, ultimately guiding strategic financial decisions.

Related terms

Risk Premium: The additional return expected by an investor for taking on additional risk compared to a risk-free investment.

Discount Rate: The interest rate used to determine the present value of future cash flows, reflecting the opportunity cost of capital.

Variance: A statistical measure of the dispersion between expected returns and actual returns, which indicates the level of risk associated with an investment.