Question

1. Explain why estimating expected rate of return (rs) for a stock is so much harder than estimating the expected rate of return on a bond (rd).

Answer 1

A bond pays fixed cash flows and even the timing is known well in advance but a stock does not guarantee any cash flows or payments and timings of the payments if any are also not well known in advance.

Also, a bond can be categorised into ratings and based on rating one can use other companies' bonds. But stock is not assigned any rating and every company is different in terms of size, future prospects, management, capital structure, accounting policies etc. all of which affect the expected return. Hence, it is very difficult to estimate the rate of return on stock.