Required Vs Expected Vs Actual Returns
Friends,
I was asked this question in an interview by an LA boutique.
What is difference between required, expected and actual return on debt? What is difference between required, expected and actual return on equity?
I explained it as much as I can but the guy did not seem convinced.
Can someone shed some light on the right answer?
(I do not have any experience in banking. Am a student at Hass)
-jiz
So, actual returns are historical. No projections, no probability, etc. It's what actually happened to the asset. Could be sliced any number of ways: monthly, yearly, daily, etc.
For stock (assume no dividends), this is just your day-to-day or month-to-month, etc. swings in price and what your return is based at what you buy in at, or vice versa if you short.
For debt, this is your return based on changes in interest rates, in addition to your dividends that actually get paid.
Required return is your cost of capital: the hurdle rate necessary above what it cost you to raise funds.
For debt, this is debt less the tax shield. For equities, it's some cost of equity (as determined by CAPM, three-factor, whatever your fancy)
Expected return: could be cut a number of ways. In portfolio allocation this can be proxied by using historical returns, otherwise in general I take this to mean valuation of either equities or bonds?
Again, just a stab, haha. My finance is getting rusty in consulting world.
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