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In this chapter, we start from the basic premise that investors like returns and dislike risk. Therefore, people will invest in riskier assets only if they expect to receive higher returns. We define precisely what the term risk means as it relates to invest- ments. We examine procedures managers use to measure risk, and we discuss the relationship between risk and return, In later chapters we extend these relationships to show how risk and return interact to determine security prices. Managers must understand and apply these concepts as they plan the actions that will shape their firms’ futures. The ThomsonNOW Web site contains an Excel file that will guide you through the chapter's calculations. The file for this chapter is 1FM9 Ch02 Too! Kit.x1s, and we encourage you to open the file and follow along as you read the chapter. 31 As you read the chapter, consider how you would answer the following questions. You should not necessarily be able to answer the questions before you read the chapter. Rather, you should use them to get a sense of the issues covered in the chapter. After reading the chapter, you should be able to give at least partial answers to the questions, and you should be able to give better answers after the chapter has been discussed in lass. Note, too, that it is often useful, when answering conceptual questions, to use hypothet- ical data to illustrate your answer. We illustrate the answers with an Exce! model that is available on the ThomsonNOW Web site, Accessing the model and working through it is a useful exer- cise, and it provides insights that are useful when answering the questions. 1. Differentiate between (a) stand-alone risk and (b) risk in a portfolio context. How are they measured, and are both concepts rele- vant for investors? 2. Can an investor eliminate market risk from a portfolio of common stocks? How many stocks must a portfolio contain to be “reasonably well diversified"? Do all portfolios with, say, 50 stocks have about the same amount of risk? 3. a. Differentiate between the terms expected rate of return, required rate of return, and historical rate of return as they are applied to common stocks. b. If you found values for each of these returns for several different stocks, would the values for each stock most likely be the same or different; that is, would INVESTMENT RETURNS Stock A’s expected, required, and his cal rates of return be equal to another? Why? 4. What does the term risk aversion mean, how is risk aversion related to the expe return on a stock? 5. What is the Capital Asset Pricing M (CAPM)? What are some of its key asst tions? Has it been empirically verified? V is the role of the Security Market Lin the CAPM? Suppose you had to estimate required rate of return on a stock using CAPM. What data would you need, w would you get the data, and how confi would you be of your estimate? 6. Suppose you have data that show the | of return earned by Stock X, Stock Y, anc market over the last five years, along the risk-free rate of return and the requ return on the market. You also have mates of the expected returns on X and a. How could you decide, based on t expected returns, if Stocks X and Y good deals, bad deals, or in equilibri b. Now suppose in Year 6 the mark quite strong. Stock X has a high pos return, but Stock Y's price falls bec investors suddenly become quite cerned about its future prospects; th it becomes riskier, and like a bond suddenly becomes risky, its price Based on the CAPM and using the recent five years of data, would Stoc required return as calculated just the end of Year 6 rise or fall? What you say about these results? With most investments, an individual or business spends money today wit expectation of earning even more money in the future. The concept of returr vides investors with a convenient way to express the financial performance investment. To illustrate, suppose you buy 10 shares of a stock for $1,000 In Chapter 1, we told you that managers mined by the size, timing, and risk of its should strive to make their firms more valu- free cash flows (FCF). This chapter shows able, and that the value of a firm is deter- you how to measure a firm's risk. stock pays no dividends, but at the end of one year, you sell the stock for $1,100. ‘What is the return on your $1,000 investment? One way to express an investment return is in dollar terms. The dollar return is simply the total dollars received from the investment less the amount invested: Dollar return = Amount received — Amount invested $1,100 ~ $1,000 $100 If, at the end of the year, you sell the stock for only $900, your dollar return would be —$100. Although expressing returns in dollars is easy, two problems arise: (1) To make a meaningful judgment about the return, you need to know the scale (size) of the investment; a $100 return on a $100 investment is a good return (assuming the investment is held for one year), but a $100 return on a $10,000 investment would be a poor return, (2) You also need to know the timing of the return; a $100 return on a $100 investment is a very good return if it occurs after one year, but the same dollar return after 20 years would not be very good.