Fundamentals of Corporate Finance Chapter 10 Introduction to Risk, Return, and the Opportunity Cost of Capital Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- Topics Covered Rates of Return: A Review A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- Rates of Return Percentage Return = Capital Gain + Dividend Initial Share Price 5.47 + 82 Percentage Return = 31.12 = 202 or 20.2% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- Rates of Return Dividend Yield = Capital Gain Yield = McGraw-Hill/Irwin Dividend Initial Share Price Capital Gain Initial Share Price Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- Rates of Return 0.82 Dividend Yield = 31.12 = 026 or 2.6% 5.47 Capital Gain Yield = 31.12 = 176 or 17.6% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- Rates of Return Nominal vs Real 1+ real ror = + nominal ror + inflation rate + real ror = + 202 + 033 = 1.164 real ror = 16.4% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- The Value of an Investment of $1 in 1900 Index $17,545 $160 2004 $61 Source: Ibbotson Associates McGraw-Hill/Irwin Year End Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- Rates of Return 2004 Common Stocks (1900-2004) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 10 Expected Return Expected market interest rate on normal risk = + return Treasury bills premium (1981) 21.6% = 14 + 7.6 (2005) 10.1% = 2.5 + 7.6 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 12 Measuring Risk Coin Toss Game-calculating variance and standard deviation (1) (2) (3) Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 + 10 - 20 - 30 900 Variance = average of squared deviations = 1800 / = 450 Standard deviation = square of root variance = McGraw-Hill/Irwin 450 = 21.2% Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 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.” McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 14 Risk and Diversification McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 15 Risk and Diversification Portfolio rate of return ( ( = )( )( fraction of portfolio in first asset x rate of return on first asset ) ) fraction of portfolio rate of return + x in second asset on second asset McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 16 2004 Std Dev Stock Market Volatility 1926-2004 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 17 Country Risk Premia (%) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 18 Histogram of Returns McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 19 Risk and Diversification McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 20 Risk and Diversification McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 10- 21 Thinking About Risk Message Some Risks Look Big and Dangerous but Really Are Diversifiable Message Market McGraw-Hill/Irwin Risks Are Macro Risks Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... sources of risk that affect the overall stock market Also called “systematic risk.” McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 14 Risk and Diversification McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 15 Risk and Diversification Portfolio rate of return ( ( = )( )( fraction of portfolio in first asset x rate of. .. asset ) ) fraction of portfolio rate of return + x in second asset on second asset McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 16 2004 Std Dev Stock Market Volatility 1926-2004 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 17 Country Risk Premia (%) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies,... 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 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 12 Measuring Risk Coin Toss Game-calculating variance and standard deviation (1) (2) (3) Percent Rate of Return Deviation from Mean... McGraw- Hill Companies, Inc All rights reserved 10- 18 Histogram of Returns McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 19 Risk and Diversification McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 20 Risk and Diversification McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 21... (3) Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 - 20 0 - 30 0 900 Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = McGraw- Hill/Irwin 450 = 21.2% Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 10- 13 Risk and Diversification Diversification - Strategy designed to reduce risk by... McGraw- Hill Companies, Inc All rights reserved 10- 21 Thinking About Risk Message 1 Some Risks Look Big and Dangerous but Really Are Diversifiable Message 2 Market McGraw- Hill/Irwin Risks Are Macro Risks Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved