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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10- 3

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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10- 5

Rates of Return
0.56 Dividend Yield = 43 .013 or 1.3%

6 Capital Gain Yield = 43 .140 or 14.0%

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10- 6

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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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 & Poors 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.

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The Value of an Investment of $1 in 1900

1000 Common Stocks Long T-Bonds T-Bills 10

Index

0.1 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Source: Ibbotson Associates
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Year End
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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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10- 10

Expected Return
Expected market interest rate on normal risk = + return Treasurybills premium (1981) 21.7% (2002) 9.5% = = 14 1.8 + + 7.7 9.3

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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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Measuring Risk
Coin Toss Game-calculating variance and standard deviation
(1) + 40 + 10 + 10 - 20 (2) + 30 0 0 - 30 (3) 900 0 0 900

Percent Rate of Return Deviation from Mean Squared Deviation

Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2%

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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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10- 14

Risk and Diversification

Year Rate of Return 1997 31.29 1998 23.43 1999 23.56 2000 -10.89 2001 -10.97 Total 56.41 Average rate of return = 56.41/5 = 11.28 Variance = average of squared deviations = 1685.81/5 = 337.16 Standard deviation = squared root of variance = 18.36% Deviation from Average Return 20.01 12.15 12.28 -22.17 -22.25 Squared Deviation 400.45 147.65 150.78 491.69 495.24 1685.81

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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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10- 16

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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10- 18

Risk and Diversification

Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

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Web Resources
Click to access web sites Internet connection required

http://pages.stern.nyu/~adamodar www.globalfindata.com

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