Fundamentals of corporate finance 5e mcgraw chapter 010

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