Chapter 10

Fundamentals of Corporate Finance

Fourth Edition

Introduction to Risk, Return, and the Opportunity Cost of Capital

Slides by Matthew Will

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Topics Covered
Rates of Return A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk

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Rates of Return
Percentage Return =
Capital Gain + Dividend Initial Share Price

0.56 PercentageReturn = 6 +43

= .153 or 15.3%
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Rates of Return

Dividend Yield =

Dividend Initial Share Price

Capital Gain Yield =

Capital Gain Initial Share Price

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Rates of Return
Nominal vs. Real

1 + real ror =
1 + real ror =

1 + nominal ror 1 + inflation rate

1 + .153 1 + .028

1.222

real ror 22 .2%

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Rates of Return
Common Stocks (1900-2001)
60 40
Return (%)

20 0 -20 -40
1901 1908 1915 1922 1929 1936 1943 1950 1957 1964 1971 1978 1985 1992 1999

-60

Year
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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.

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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.

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Risk and Diversification

Portfolio rate fraction of portfolio = x of return in first asset + fraction of portfolio x

( (

in second asset

)( )(

rate of return on first asset

rate of return

on second asset

) )

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Stock Market Volatility 1926-2001

60 50

Std Dev

40 30 20 10 0
26 35 40 45 50 55 60 65 70 75 80 85 90 95 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 00

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Risk and Diversification

Portfolio standard deviation

0 5 10 15 Number of Securities

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Risk and Diversification

Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

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Measuring Market Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

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Measuring Market Risk

Example - continued
Month Market Return % Turbo Return % 1 2 3 4 5 6
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+ 1 + 1 + 1 -1 -1 -1

+ 0.8 + 1.8 - 0.2 - 1.8 + 0.2 - 0.8

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Measuring Market Risk

Example - continued When the market was up 1%, Turbo average % change was +0.8% When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8.

B =
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1.6 2

= 0.8

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Portfolio Betas
Diversification decreases variability from unique risk, but not from market risk. The beta of your portfolio will be an average of the betas of the securities in the portfolio. If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0
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Measuring Market Risk

Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.
14 12

Expected Return (%) .

10 8 6 4 2 0 0 0.2 0.4 Beta 0.6 0.8

Market Portfolio

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Measuring Market Risk

CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.

Market risk premium = rm - rf Risk premium on any asset = r - rf Expected Return = rf + B(rm - rf )

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Measuring Market Risk

Security Market Line - The graphic representation of the CAPM.

Expected Return (%) .

Security Market Line Rm

Rf

Beta
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1.0

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Capital Budgeting & Project Risk

The project cost of capital depends on the use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.

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Problems

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Problems

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Problems

Portfolio Analysis. Use the data in the previous problem and consider a portfolio with weights of .60 in stocks and .40 in bonds. a. What is the rate of return on the portfolio in each scenario? b. What is the expected rate of return and standard deviation of the portfolio? c. Would you prefer to invest in the portfolio, in stocks only, or in bonds only?
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Problems CAPM and Expected Return. If the risk-free rate is 6 percent and the expected rate of return on the market portfolio is 14 percent, is a security with a beta of 1.25 is overpriced or underpriced with respect to expected return? CAPM and Valuation. A share of stock with a beta of .75 now sells for $50. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 4 percent, and the market risk premium is 8 percent. If the stock is perceived to be fairly priced today, what must be investors expectation of the price of the stock at the end of the year?
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Problems

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