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Chapter 11Fundamentals of
Corporate
Finance
sixth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Introduction to Risk, Return, and the Opportunity Cost of
Capital
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 2
Topics Covered
Rates of Return: A ReviewA Century of Capital Market HistoryMeasuring RiskRisk & DiversificationThinking About Risk
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 3
Rates of Return
20.2%or .202=
31.12
.825.47 =Return Percentage
P e rc e n ta g e R e tu rn = C a p i ta l G a in + D iv id e n d In i t ia l S h a re P r ic e
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 4
Rates of Return
D iv id e n d Y ie ld = D iv id e n d In i t ia l S h a re P r ic e
C a p i t a l G a in Y ie ld = C a p i t a l G a inIn i t i a l S h a r e P r i c e
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 5
Rates of Return
%2.6or 026.31.12
0.82= Yield Dividend
%17.6or 176.31.12
5.47= YieldGain Capital
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 6
Rates of Return
Nominal vs. Real
1+ real ror = 1 + nominal ror1 + inflation rate
%4.16ror real
164.1=ror real+1 .033 + 1.202 + 1
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 7
Market Indexes
Dow Jones Industrial Average (The Dow)
Value of a portfolio holding one share in each of 30 large industrial firms.
Standard & Poor’s Composite Index (The S&P 500)
Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 8
The Value of an Investment of $1 in 1900
Source: Ibbotson Associates
1
10
100
1000
10000
100000
Common StocksLong T-BondsT-Bills
Inde
x
Year End
$17,545
$160
$61
2004
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 9
Rates of Return
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
Ret
urn
(%
)
Year
Common Stocks (1900-2004)
2004
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 10
Expected Return
7.6+2.5=10.1% (2005)
7.6+14=21.6% (1981)
premium
risk normal+
billsTreasury
on rateinterest =
return
market Expected
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 11
Measuring Risk
Variance - Average value of squared deviations from mean. A measure of volatility.
Standard Deviation - Average value of squared deviations from mean. A measure of volatility.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 12
Measuring RiskCoin Toss Game-calculating variance and standard deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 13
Risk and Diversification
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 14
Risk and Diversification
Deviation from SquaredYear Rate of Return Average Return Deviation
1999 23.7 19.52 381.03 2000 (10.9) (15.08) 227.41 2001 (11.0) (15.18) 230.43 2002 (20.9) (25.08) 629.01 2003 31.6 27.42 751.86 2004 12.6 8.42 70.90
Total 25.1 2,290.63 Average rate of return = 25.1/6=4.18%Variance = average of squared deviations = 2290.63/6=381.77Standard deviation = squared root of variance = 19.54%
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 15
Risk and Diversification
Portfolio rate
of return=
fraction of portfolio
in first assetx
rate of return
on first asset
+fraction of portfolio
in second assetx
rate of return
on second asset
((
((
))
))
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 16
Stock Market Volatility 1926-2004
0
10
20
30
40
50
60
Std
Dev
2004
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 17
Country Risk Premia (%)
0
2
4
6
8
10
12Italy
Japan
France
Germany (ex 1922/3)
Australia
South Africa
Sweden
USA
Average
UK
Ireland
Canada
Spain
Switzerland
Belgium
Denmark
Norway
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 18
Histogram of Returns
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 19
Risk and Diversification
05 10 15
Number of Securities
Po
rtfo
lio
sta
nd
ard
dev
iati
on
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 20
05 10 15
Number of Securities
Po
rtfo
lio
sta
nd
ard
dev
iati
on
Market risk
Uniquerisk
Risk and Diversification
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 21
Thinking About Risk
Message 1Some Risks Look Big and Dangerous but
Really Are Diversifiable
Message 2Market Risks Are Macro Risks
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 22
Web Resources
www.globalfindata.com
www.mscidata.com
www.econ.yale.edu/~shiller
http://pages.stern.nyu.edu/~adamodar
Click to access web sitesClick to access web sites
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