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- 2

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- 3

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- 4

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- 5

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- 6

Rates of Return
Nominal vs. Real

1+ real ror =

1 + nominal ror
1 + inflation rate

1 + real ror =

1 + .202
1 + .033

= 1.164

real ror = 16.4%
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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 & 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.

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10- 8

The Value of an Investment of $1 in 1900

Index

$17,545

$160

2004

$61

Source: Ibbotson Associates
McGraw-Hill/Irwin

Year End
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10- 9

Rates of Return

2004

Common Stocks (1900-2004)

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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

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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.

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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

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 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

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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

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10- 16

2004

Std Dev

Stock Market Volatility 1926-2004

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10- 17

Country Risk Premia (%)

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10- 18

Histogram of Returns

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10- 19

Risk and Diversification

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10- 20

Risk and Diversification

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10- 21

Thinking About Risk
Message 1
Some

Risks Look Big and Dangerous but
Really Are Diversifiable

Message 2
Market

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Risks Are Macro Risks

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