Final Revision

Final exam
• Date: 29 January 2023 (tentatively)

• Venue: TBA
• Duration: 90 minutes
• Format: 20 MCQ questions & 3 Essay/Short answer questions
• Topics included: Lecture 7, 8, 8 (cont), 9
• Allowed materials:
➢ Physical calculator
➢ Pens/Pencils
➢ Draft papers will be provided
➢ A formula sheet will be provided
L.O. 1.3 Copyright ©2022 John Wiley & Sons, Inc. 1

Lecture 7: Risk and Return
Copyright ©2022 John Wiley & Sons, Inc. 2

7.1 Risk and Return
Risk and Return
• The rate of return that investors require for an

investment depends on the risk associated with that
investment
o The greater the risk, the larger the return investors
require as compensation for bearing that risk
• The rate of return is what you earn on an investment,
stated in percentage terms
• Risk is a measure of how certain you are that you will
receive a particular return

7.2 Holding Period Returns
Holding Period Returns
• The total holding period return (RT) consists of capital appreciation

(RCA) and income (RI)
Capital Appreciation P1 − P0 ΔP
R CA = = =
Initial Price P0 P0
Cash Flow CF1
RI = =
Initial Price P0
Equation 7.1
ΔP CF1 ΔP + CF1
R T = R CA + R I = + =
P0 P0 P0

7.3 Expected Returns
Expected Returns
• An expected return is the weighted average of possible

investment returns, i.e. the sum of each possible return multiplied
by the probability that it will occur
Equation 7.2
n
E ( R Asset ) =  ( pi × R i )
i =1

7.4 Variance and Standard Deviation as Measures of Risk
Variance and Standard Deviation as
Measures of Risk
• The two most basic measures of risk used in finance
o Variance
o Standard deviation
• The same variance and standard deviation measures
that you studied if you took a course in statistics

Calculating Variance and Standard
Deviation
• Calculate variance: Equation 7.3
 
n
Var ( R ) = σ =  pi ×  R i - E ( R ) 
2 2
R
i =1
• Calculate standard deviation by taking the square root of the variance:
 R = ( )
2 12
R

Exhibit 7.1: Normal Distribution
Curve

Exhibit 7.2: Standard Deviation and
Width of the Normal Distribution

7.5 Risk and Diversification
Risk and Diversification
• By investing in two or more assets whose returns do not always

move in the same direction at the same time, investors can
reduce the risk in their investment portfolios
o A portfolio is the collection of assets an investor owns
o Diversification involves reducing portfolio risk by investing in
two or more assets whose values do not always move in the same
direction at the same time

Coefficient of Variation
• Returns for individual stocks are largely independent of each

other and approximately normally distributed. A simple tool for
comparing risk and return for individual stocks is the coefficient
of variation (CV)
Equation 7.6
σ Ri
CVi =
E(Ri )

Sharpe Ratio
• The Sharpe ratio is a modified version of the coefficient of

variation which measures return per unit of risk
Equation 7.7
E ( R i ) − R rf
Sharpe Ratio = S =
σ Ri

Portfolios with More Than One Asset
• The coefficient of variation and the Sharpe ratio have a critical

shortcoming when applied to a portfolio of assets: they cannot
account for the interaction of assets’ risks when they are grouped
into a portfolio
• The expected return for a portfolio
Equation 7.8
n
E ( R Portfolio ) =   xi × E ( R i ) 
i =1

Risk of a Portfolio with More Than
One Asset
• The risk for a portfolio of two stocks is less than the average of the
risks associated with the individual stocks
• When stock prices move in opposite directions, the price change of one
stock offsets some of the price change of another stock
• The risk of a portfolio of two stocks is
Equation 7.9
σ R2 2AssetPortfolio = x12 σ R2 1 + x22 σ R2 2 + 2 x1 x2 σ R1, 2
where σR1,2 is the covariance between the two stocks

Covariance
• Covariance indicates whether stocks’ returns tend to move in the

same direction at the same time. If so, the covariance is positive.
If not, it is negative or zero
Equation 7.10
 
n
Cov ( R 1 ,R 2 ) = σ R1, 2 =  pi ×  R1,i − E ( R 1 )  ×  R 2,i − E ( R 2 ) 
i=1

Risk and Diversification Equation
• To measure the strength of the covariance relationship, divide the

covariance by the product of the standard deviations of the
assets’ returns. This result is the correlation coefficient that
measures the strength of the relationship between the assets’
returns
Equation 7.11
R1 ,2
R =1 ,2
R1 R2

Correlation Coefficient
• The correlation coefficient cannot be greater than +1 or less than

−1
• Negative correlation indicates that asset prices move in opposite
directions
• Positive correlation indicates that asset prices move in the same
direction
• Zero correlation indicates there is no linear relationship between
return on the assets

Exhibit 7.8: Total Risk in a Portfolio as the
Number of Assets Increases

7.7 Systematic Risk
Why Systematic Risk Is All That
Matters
• Investors do not like risk and will not bear risk they can avoid
by diversification
o Well-diversified portfolios contain only systematic risk
o Portfolios that are not well-diversified face systematic risk plus
unsystematic risk
o No one compensates investors for bearing unsystematic risk, and
investors will not accept risk that they are not paid to take
• Systematic risk cannot be eliminated by diversification
o Competition among diversified investors will drive the prices of
assets to the point where the expected returns will compensate
investors for only the systematic risk

7.7 Systematic Risk
Measuring Systematic Risk
• If the average return for all assets (the market return) is used as
the benchmark and its influence on the return for a specific
stock can be quantified, the expected return on that stock can be
calculated
• The market’s influence on a stock’s return is quantified in the
stock’s beta
• If the beta of an asset is:
o Zero, the asset has no measurable systematic risk
o Greater than one, the systematic risk for the asset is greater than
the average for assets in the market
o Less than one, the systematic risk for the asset is less than the
average for assets in the market
Risk Premium
• The risk premium is the difference between the market rate of

return and the risk-free rate of return
• The difference between the required return on a risky asset 𝑅𝑖 and
the return on a risk-free asset 𝑅𝑟𝑓 is an investor’s compensation
for risk
E ( R i ) = R rf + Compensation for bearing Systematic risk i

Compensation for Bearing Systematic
Risk
• The expected return on an investment is a function of the risk-free rate,
the beta, and the risk premium
Equation 7.12
E ( R i ) = R rf + βi  E ( R m ) − R rf 
Where  E ( R m ) − R rf  is the risk premium
𝜎 R𝑖
𝛽𝑖 = 𝜌Ri,𝑀
𝜎 R𝑀

7.8 The Capital Asset Pricing Model
The Capital Asset Pricing Model
• The capital asset pricing model (CAPM) describes the relation between
risk and expected return for an asset
• We can use Equation 7.12 (the CAPM) to find the expected return for
this stock:
E ( R i ) = R rf + βi  E ( R m ) − R rf 
• Note that we must have three pieces of information in order to use

Equation 7.12: (1) the risk-free rate, (2) beta, and (3) either the market
risk premium or the expected return on the market

CAPM Example
A stock has a beta of 1.5. The expected return on the market is 10%
and the risk-free rate is 4%. What is the expected return for the
stock?
E(Ri ) = R rf + βi  E ( R m ) − R rf 
= 0.04 +1.50 ( 0.10 − 0.04 )
= 0.13, or13%

The Security Market Line

The Capital Asset Pricing Model and
Portfolio Returns
• The expected return for a portfolio is the weighted average of the
expected returns of the assets in the portfolio
• The beta of a portfolio is the weighted average of the betas of the assets
in the portfolio
Equation 7.13
n
βn Asset portfolio =  xi βi
i =1

Lecture 8: The Fundamentals of
Capital Budgeting

Classification of Investment Projects
• Independent projects
o Projects for which the decision to accept or reject is not
influenced by decisions about other projects being
considered by the firm
• Mutually exclusive projects
o Projects for which the decision to accept one project is
simultaneously a decision to reject another project
o These projects typically perform the same function
• Contingent projects
o Projects for which the decision to accept one project
depends on acceptance of another project

10.2 Net Present Value
Net Present Value Techniques
NPV is the present value of the expected net cash flows (NCF), where
NCFt = ( Cash inflows − Cash outflows ) t
Equation 10.1
NCF1 NCF2 NCFn
NPV = NCF0 + + + .. +
1 + k (1 + k ) 2
(1 + k )
n
n
NCFt
=
(1 + k )
t
t =0

Concluding Comments on NPV
Decision Rule: NPV > 0 → Accept the project

NPV < 0 → Reject the project
Key Advantages
1. Uses the discounted cash flow valuation technique to adjust for the
time value of money
2. Provides a direct (dollar) measure of how much a capital project will
increase the value of the firm
3. Is consistent with the goal of maximizing stockholder value
Key Disadvantage
1. Can be difficult to understand without an accounting and finance
background

10.3 The Payback Period
Computing the Payback Period
To compute the payback period, estimate a project’s cost and its future net cash flows
Equation 10.2
Remaining cost to recover

PB = Years before cost recovery +
Cash flow during the year

Discounted Payback Period
• Future cash flows are discounted by the firm’s cost of
capital
• The major advantage of the discounted payback is that
it tells management how long it takes a project to reach
a positive NPV

Evaluating the Payback Rule
Summary of Payback Method
Decision Rule:
Payback period ≤ Payback cutoff point → Accept the project
Payback period > Payback cutoff point → Reject the project
Key Advantages
1. Easy to calculate and understand for people without a
strong accounting and finance background
2. A simple measure of a project’s liquidity risk

Key Disadvantages of Payback
Method
Key Disadvantages
1. Most common version does not account for time value
of money
2. Does not consider cash flows past the payback period
3. Bias against long-term projects such as research and
development and new product launches
4. Arbitrary cutoff point

10.4 Internal Rate of Return
Calculating the IRR using the Trial-
and-Error Method
Equation 10.4
NCF1 NCF2 NCFn
NPV = NCF0 + + + +
1 + IRR (1 + IRR ) 2
(1 + IRR )
n
n
NCFt
= =0
(1 + IRR )
t
t =0

When the IRR and NPV Methods
Agree
• IRR and NPV Methods agree when:
o you are evaluating independent projects, ones that can
be selected with no effect on the viability of any other
project
o projects’ cash flows are conventional, ones with an
initial cash outflow followed by one or more cash
inflows

NPV Profile for the Ford Motor
Company Project
Exhibit 10.9

When IRR and NPV Disagree
• Unconventional cash flows which may exhibit many patterns
o Positive and negative net cash flows
o A negative net cash flow at the end of a project’s life
o With unconventional cash flows, the IRR technique may provide
more than one rate of return. This makes the calculation
unreliable and it should not be used to determine whether a
project should be accepted or rejected
• Mutually Exclusive Projects
o The IRR and NPV methods can produce different accept/reject
decisions if projects are mutually exclusive

NPV Profile for Gold-Mining
Operation with Multiple IRR Solutions

IRR for Mutually Exclusive Projects
• There is a discount rate at which the NPVs of two mutually
exclusive projects will be equal; that rate is the crossover point
• Depending on whether the required rate of return is higher or
lower than the crossover rate, the ranking of the projects will be
different
• It is easy to identify the superior project based on NPV, but it
cannot be done using IRR due to ranking conflicts

NPV Profiles for Two Mutually
Exclusive Projects

IRR versus NPV: A Final Comment
• A major weakness of the IRR compared to the NPV method is
the reinvestment rate assumption
o IRR assumes that cash flows from a project are reinvested to earn
the IRR while NPV assumes that they are reinvested and earn the
firm’s cost of capital
o The optimistic assumption in the IRR method leads to some
projects being accepted when they should not – the reinvested
cash flows cannot earn the IRR

Modified Internal Rate of Return
(MIRR)
A major weakness of the IRR compared to the NPV method is the reinvestment rate
assumption
In the MIRR technique, cash flow is assumed to be reinvested at the firm’s cost of capital
a. The compounded value are summed to get a project’s future or
terminal value (TV) at the end of its life
b. The MIRR is the rate which equates a project’s cost to its terminal
value
Equation 10.5
TV
PVcost =
(1 + MIRR )
n

Summary of Internal Rate of Return
(IRR) Method
Summary of Internal Rate of Return (IRR) Method
Decision Rule: IRR > Cost of capital → Accept the project
IRR < Cost of capital → Reject the project
Key Advantages
1. Intuitive and easy to understand
2. Based on discounted cash flow technique

Key Disadvantages of IRR
1. With nonconventional cash flows, IRR approach can yield
no usable answer or multiple answers
2. A lower IRR can be better if a cash inflow is followed by
cash outflows
3. With mutually exclusive projects, IRR can lead to incorrect
investment decisions
4. IRR calculation assumes cash flows are reinvested at the
IRR

10.5 Investment Decisions with Capital Rationing
Capital Rationing in a Single Period
The PI provides a measure of the value of project generates for each dollar invested in that
project
a. Useful for capital rationing when firms have limited resources
and therefore cannot invest in all projects that have a positive
NPV
The PI will choose a set of projects that is consistent with the idea of shareholder wealth
maximization
Equation 10.6
Benefits PV of future free cash flows

PI = =
Costs Initial investment
NPV + Initial investment
=
Initial investment

Lecture 8 (cont): Cash Flows and
Capital Budgeting

Exhibit 11.1: The Free Cash Flow
Calculation for a Project

Computing Terminal-Year FCF
• FCF in the last, or terminal, year of a project often includes cash
flows not typically included in the calculations for prior years
o Long-term assets and working capital that are no longer needed to
support the project may be sold and funds used in other ways
o Net cash flows from the sale of assets and the impact of the sale
on the firm’s taxes are included in the terminal-year FCF
Equation 11.4
Add WC = Change in cash and cash equivalents
+ Change in accounts receivable
+ Change in inventories
– Change in accounts payable
11.2 Estimating Cash Flows in Practice
Five General Rules for Incremental After-
Tax Free Cash Flow Calculations (1 of 2)
1) Include cash flows only
o Do not include allocated costs or overhead unless they occur
because of the project
2) Include the impact of the project on cash flows of other
product lines
o If a project is expected to affect cash flows of another
project, include the expected impact on the cash flows of the
other project in the analysis
3) Include all opportunity costs
o Benefits that could have been earned by choosing another
project are a cost to the firm
Five General Rules for Incremental After-
Tax Free Cash Flow Calculations (2 of 2)
4) Forget sunk costs
o Sunk costs have already been incurred or committed to and
will not be influenced by the project
5) Include only after-tax cash flows
o Incremental pre-tax cash flow earnings of a project only
matter to the extent that they determine the free after-tax
cash flows

Nominal versus Real Cash Flows
• Nominal dollars represent the actual dollar amounts that we
expect a project to generate in the future, without any
adjustments for purchasing power
o When prices increase, a given nominal dollar amount will
buy less than before
• Real dollars represent dollars stated in terms of constant
purchasing power
• Constant purchasing power is in terms of prices that existed
in an earlier period
o Constant purchasing power: “Last year this cost $50. Today
it costs $60.” The price increased by 20%; in real terms, $60
today has the buying power of $50 a year ago
The Cost of Capital
The cost of capital, k, can be written as:
Equation 11.3
1 + k = (1 + Pe )  (1 + r )
k = (1 + Pe )  (1 + r ) − 1
Where:
k is the nominal cost of capital
∆Pe is the expected rate of inflation
r is the real cost of capital

Project Cash Flows
• Project cash flows should be stated either in nominal
dollars or in real dollars
o Value nominal cash flows using a nominal interest rate
o Value real cash flows using a real interest rate

Marginal and Average Tax Rates
• The average tax rate is the total taxes paid divided by
taxable income
• In contrast, the marginal tax rate is the tax rate that is
paid on the last dollar of income earned
• When you are making investment decisions, the
relevant tax rate to use is usually the marginal tax rate.
The reason is that new investments (projects) are
expected to generate new cash flows, which will be
taxed at the business’s marginal tax rate.
• As a result, the marginal tax rate is the relevant rate for
financial decision making
11.3 Risk Analysis
Sensitivity Analysis
• Sensitivity analysis involves examination of the sensitivity
of the results from a financial analysis to changes in
individual assumptions
• An analyst might examine how a project’s NPV changes if
there is a decrease in the value of individual cash inflow
assumptions or an increase in the value of individual cash
outflow assumptions

Scenario Analysis
• Scenario analysis is an analytical method concerned with
how the results from a financial analysis will change under
alternative scenarios
• An analyst who wants to examine how the results from a
financial analysis will change under alternative scenarios
performs a scenario analysis

Simulation Analysis
• Simulation analysis is an analytical method that uses a computer to
quickly examine a large number of scenarios and obtain probability
estimates for various values in a financial analysis
• Rather than selecting individual values for each of the assumptions
(such as unit sales, unit price, and unit variable costs), the analyst
assumes that those assumptions can be represented by statistical
distributions
• A computer program known as Monte Carlo simulation, repeatedly
draws numbers from the distributions for various assumptions, plugs
them into the cash flow model, and computes the annual cash flows
and NPV
• Provides an estimate of the distribution of cash flows for each year of
the project

Lecture 9: Dividends, Stock
Repurchases, and Payout Policy

Types of Dividends:
• Regular Cash dividend

• Extra dividend
• Special dividend
• Noncash dividend
• Liquidating dividend

The Dividend Payment Process:
Timeline for a Public Company

9.2 Stock Repurchases
Stock Repurchases
• A company buys some of its shares from stockholders
• An alternative way for the company to distribute value to
the stockholders

How Stock Repurchases Differ from
Dividends (1 of 2)
• Not a pro-rata distribution of value to the stockholders
• When a company repurchases its own shares, it removes
them from circulation, reducing the number of shares,
which changes ownership of the firm
• Third, stock repurchases are taxed differently than
dividends
o Dividends are taxed as income
o When a stockholder sells shares back, they are taxed only on
the profit from the sale

How Stock Repurchases Differ from
Dividends (2 of 2)
• Accounting for dividends and stock repurchases on a
company’s balance sheet different
o A cash dividend reduces the cash account on the asset side
of the balance sheet and the retained earnings account on the
liabilities and stockholder’s equity side
o Repurchasing stock also reduces the cash account, but the
treasury stock account on the liabilities and stockholder’s
equity side of the balance sheet is increased

How Stock is Repurchased
• Open-market repurchases
• Fixed-price tender offer
• Dutch auction tender offer
• Targeted stock repurchase

9.3 Dividends and Firm Value: Theories
Dividend Policy Does Not Matter
• Miller and Modigliani (“M&M”) argued that in a world
without taxes, transaction costs, and symmetric information
among all investors, a company’s dividend policy should
have no impact on its cost of capital or on shareholder
wealth.
• The dividend decision is independent of a company’s
investment and financing decisions.
• There is no meaningful distinction between dividends and
share repurchases.
• In the real world, market imperfections create some
problems for MM’s dividend policy irrelevance
propositions .
Dividend Policy Matters: The Bird in
the Hand Argument
• Even under perfect capital markets assumptions, investors
prefer a dollar of dividends to a dollar of potential capital
gains from reinvesting earnings because they view
dividends as less risky
• Graham, Dodd, Cottle, and Tatham (1962): the typical
dollar of reinvestment has less economic value to the
shareholder than a dollar paid in dividends
“a bird in the hand is worth two in the bush.”

Dividend Policy Matters: The Tax
Argument
• In some countries, dividend income has traditionally been
taxed at higher rates than capital gains.
• Taxable investors should prefer companies that pay low

dividends and reinvest earnings in profitable growth
opportunities.

The Information Content of Dividend
Actions: Signaling
• Under asymmetric information assumption: dividend
increases or decreases may affect share price because they
may convey new information about the company.
• Empirical studies broadly support the thesis that dividend

initiations or increases convey positive information and are
associated with future earnings growth.
• Dividend omissions/reductions convey negative information

and are associated with future earnings problems.
Agency Costs and Dividends as a
Mechanism to Control Them
• The potential overinvestment agency problem might be
alleviated by the payment of dividends. By paying out all
FCF to equity in dividends, managers would be constrained
in their ability to take on negative NPV projects.
• Market reaction to dividend change announcements to be
stronger for companies with greater potential for
overinvestment.
• Paying dividends can exacerbate the agency conflict
between shareholders and bondholders as it reduces the
cash available for the payments to bondholders.
Benefits of Dividends
• Dividends attract investors who prefer to invest in stocks
that generate income.
• Some argue that a large regular dividend indicates that a
company is financially strong because the “signal” of
strength can result in a higher stock price.
• Dividends that are more than the excess cash that the
company is producing from its operations will have to be
paid from selling equity periodically in the public markets.
This helps align the incentives of managers with those of
stockholders because it increases the cost to managers of
operating the business inefficiently

Costs of Dividends
• There are costs to the firm associated with dividends
o Taxes are among the most important costs
o To the extent that a company uses a lot of debt financing,
paying dividends can increase the cost of debt
• To eliminate brokerage fees, some companies offer
dividend reinvestment programs (DRIPs) to sell new
shares, commission free, to dividend recipients who have
elected to reinvest their dividends

Dividends versus Stock Repurchases
(1 of 4)
• Distributing value by stock repurchase has distinct

advantages over dividends
• Stockholders can choose
o when they receive the distribution
o which affects the timing of the taxes they must pay
o as well as the cost of reinvesting funds not immediately
needed
• Stockholders pay taxes only on the gains they realize
• Historically these capital gains have been taxed at a lower
rate than dividends

(2 of 4)
• Stock repurchases give management greater flexibility in

distributing value
• Investors know that management can always quietly cut back or
end the an announced repurchase scheme at any time
o If future cash flows are not certain, managers are likely to prefer
to distribute extra cash today by repurchasing shares through
open-market purchases, to preserve some flexibility
o Since most ongoing stock repurchase programs are not as visible
as dividend programs, they cannot be used as effectively to send a
positive signal about the company’s prospects to investors

(3 of 4)
• A more subtle issue: managers can choose when to repurchase

shares in a stock repurchase program
• Managers prefer purchasing shares when they are undervalued
in the market
o Managers have better information about the prospects of the
company than do other investors
o They can take advantage of this, to the detriment of other
investors
o Management should act in the best interest of all its stockholders

9.4 Stock Dividends and Stock Splits
Stock Dividends
• One type of “dividend” that does not involve the
distribution of value is known as a stock dividend
• Distributes new shares of stock on a pro-rata basis to
existing stockholders (usually 2-10%).
o The number of shares each stockholder owns increases and
their value goes down proportionately
o The stockholder is left with exactly the same value as before
o Book value of equity increases.

Stock Splits
• A stock split is quite similar to a stock dividend, but it
involves the distribution of a larger multiple of the
outstanding shares
• Think of a stock split as an actual division of each share
into more than one share
• Book value of equity remains unchanged
• Stock dividends are typically regularly scheduled events,
like regular cash dividends
• Stock splits tend to occur infrequently during the life of a
company

Reasons for Stock Dividends and
Stock Splits (1 of 2)
• The trading range argument proposes that successful companies
use stock dividends or splits to make their shares more attractive
• Historically it was more expensive purchase odd lots of less
than 100 shares than round lots of 100 shares due to lower
liquidity.
• It is relatively expensive for companies to service odd-lot
owners
• Researchers have however found little support for this
explanation. The transaction costs argument no longer carries
much weight

Reasons for Stock Dividends and
Stock Splits (2 of 2)
• One real benefit of stock splits is that they can send a positive
signal to investors about the outlook that management has for
the future
• This, in turn, can lead to a higher stock price
o Management is unlikely to split stock if the price is expected to
decline
o It is only likely to split the stock when confident that the stock’s
current market price is not too high
• Reverse stock splits may be undertaken to satisfy exchange
requirements

9.5 Setting a Dividend Payout
What Managers Tell Us – Lintner
Survey
• The best-known survey of dividend policy, by John Lintner
in 1956
• Asked managers at 28 industrial firms how they set their
firms’ dividend policies
o Firms tend to have long-term target payout ratios
o Changes follow shifts in long-term sustainable earnings
o Focus more on dividend changes than on the absolute level
(dollar amount) of the dividend
o Reluctant to make changes that might have to be reversed

What Managers Tell Us – Brav et al
Survey
• A more recent study by Brav, Graham, Harvey, and Michaely,
published in 2005, updates Lintner’s findings
o Link between earnings and dividends has weakened
o Tend to repurchase shares using cash that is left over after
investment spending rather than setting a target
o Many managers prefer repurchases because:
• More flexible than dividend programs
• Can be used to time the market by repurchasing shares when
management considers a company’s stock price too low
o Managers who were interviewed appeared to believe that
institutional investors do not prefer dividends over repurchases or
vice-versa

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Final exam

• Date: 29 January 2023 (tentatively)

L.O. 1.3 Copyright ©2022 John Wiley & Sons, Inc. 1

Copyright ©2022 John Wiley & Sons, Inc. 2

• The rate of return that investors require for an

L.O. 7.1 Copyright ©2022 John Wiley & Sons, Inc. 3

• The total holding period return (RT) consists of capital appreciation

L.O. 7.2 Copyright ©2022 John Wiley & Sons, Inc. 4

• An expected return is the weighted average of possible

L.O. 7.3 Copyright ©2022 John Wiley & Sons, Inc. 5

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 6

• Calculate standard deviation by taking the square root of the variance:

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 7

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 8

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 9

• By investing in two or more assets whose returns do not always

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 10

• Returns for individual stocks are largely independent of each

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 11

• The Sharpe ratio is a modified version of the coefficient of

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• The coefficient of variation and the Sharpe ratio have a critical

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σ R2 2AssetPortfolio = x12 σ R2 1 + x22 σ R2 2 + 2 x1 x2 σ R1, 2

where σR1,2 is the covariance between the two stocks

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• Covariance indicates whether stocks’ returns tend to move in the

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• To measure the strength of the covariance relationship, divide the

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• The correlation coefficient cannot be greater than +1 or less than

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• The risk premium is the difference between the market rate of

E ( R i ) = R rf + Compensation for bearing Systematic risk i

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Where  E ( R m ) − R rf  is the risk premium

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• Note that we must have three pieces of information in order to use

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NCFt = ( Cash inflows − Cash outflows ) t

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Decision Rule: NPV > 0 → Accept the project

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Remaining cost to recover

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