Chapter 10

Fundamentals of Corporate Finance
Fourth Edition

Introduction to Risk, Return, and the Opportunity Cost of Capital
Slides by Matthew Will

Irwin/McGraw Hill

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

All rights reserved . Inc.2 Topics Covered Rates of Return A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.10.

Inc. All rights reserved .56 PercentageReturn = 6 +43 = .3 Rates of Return Percentage Return = Capital Gain + Dividend Initial Share Price 0.3% Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.10.153 or 15.

Inc. All rights reserved .10.4 Rates of Return Dividend Yield = Dividend Initial Share Price Capital Gain Yield = Capital Gain Initial Share Price Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.

56 Dividend Yield = 43  .5 Rates of Return 0.013 or 1.140 or 14.0% Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.10. All rights reserved .3% 6 Capital Gain Yield = 43  . Inc.

10.2% Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.028  1.153 1 + .6 Rates of Return Nominal vs. Real 1 + real ror = 1 + real ror = 1 + nominal ror 1 + inflation rate 1 + . Inc. All rights reserved .222 real ror  22 .

All rights reserved . Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.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. Inc.10.

Inc.10.8 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 Irwin/McGraw Hill Year End Copyright © 2003 by The McGraw-Hill Companies. All rights reserved .

Inc.10.9 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 Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies. All rights reserved .

5% = = 14 1.7% (2002) 9.8 + + 7.10 Expected Return Expected market interest rate on normal risk = + return Treasurybills premium (1981) 21.10. Inc.7 9.3 Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies. All rights reserved .

10. All rights reserved .Average value of squared deviations from mean. Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies. A measure of volatility.11 Measuring Risk Variance . A measure of volatility. Standard Deviation . Inc.Average value of squared deviations from mean.

2% Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.20 (2) + 30 0 0 .12 Measuring Risk Coin Toss Game-calculating variance and standard deviation (1) + 40 + 10 + 10 . All rights reserved . Inc.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 = 21.10.

Also called “diversifiable risk.Strategy designed to reduce risk by spreading the portfolio across many investments. Also called “systematic risk.13 Risk and Diversification Diversification . All rights reserved .” Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.10.” Market Risk .Risk factors affecting only that firm. Inc. Unique Risk .Economy-wide sources of risk that affect the overall stock market.

28 -22.89 2001 -10.15 12.36% Deviation from Average Return 20.43 1999 23.81 Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.16 Standard deviation = squared root of variance = 18.81/5 = 337.17 -22.28 Variance = average of squared deviations = 1685.69 495. Inc.29 1998 23.78 491.56 2000 -10.25 Squared Deviation 400.10. All rights reserved .97 Total 56.65 150.45 147.24 1685.14 Risk and Diversification Year Rate of Return 1997 31.01 12.41/5 = 11.41 Average rate of return = 56.

10.15 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 ) ) Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies. Inc. All rights reserved .

Inc. All rights reserved .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 Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.

All rights reserved .10.17 Risk and Diversification Portfolio standard deviation 0 5 10 15 Number of Securities Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies. Inc.

18 Risk and Diversification Portfolio standard deviation Unique risk Market risk 0 5 10 15 Number of Securities Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies. All rights reserved .10. Inc.

stern.com Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies.10.globalfindata. All rights reserved . Inc.19 Web Resources Click to access web sites Internet connection required http://pages.nyu/~adamodar www.