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Chapter 9Fundamentals of Corporate FinanceThird Edition
Introduction to
Risk,Return,
and the
Opportunity
Cost of Capital
Brealey Myers Marcus
slides by Matthew Will
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Topics Covered
?Rates of Return
?73 Years of Capital Market History
?Measuring Risk
?Risk & Diversification
?Thinking About Risk
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Rates of Return
3 9, 5 %o r, 3 9 5=
= R e t u r nP e r c e n t a g e
74
1,2 5 + 28
P e r c e n t a g e R e t u r n = C a p i t a l G a i n + D i v i d e n d In i t i a l S h a r e P r i c e
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Rates of Return
D i v i d en d Y i eld = D iv id end I n it ial S h ar e P r ice
Ca pi ta l G a in Y ie ld = C a pi ta l G a inI ni ti a l S h a r e Pr ic e
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Rates of Return
%0 1, 7o r 0 1 7.
74
1, 2 5
= Y i e l dD i v i d e n d
?
%3 7, 8o r 3 7 8.
74
28
= Y i e l dG a i n C a p i t a l
?
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Rates of Return
Nominal vs,Real
1 + r e a l r o r = 1 + n o m i n a l r or1 + i n f l a t i o n r a t e
3 7, 3 %r o r r e a l
3 7 3.1=r o r r e a l+1,0 16 + 1,3 95 + 1
?
?
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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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The Value of an Investment of $1 in 1926
Source,Ibbotson Associates
0,1
10
1000
1930 1940 1950 1960 1970 1980 1990 1998
C om m on S toc k s
Lon g T-B on d s
T-B i l l s
Inde
x
Year End
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Rates of Return 1926-1998
Source,Ibbotson Associates
- 6 0
- 4 0
- 2 0
0
20
40
60
26 30 35 40 45 50 55 60 65 70 75 80 85 90 95
C o m m o n S t o cks
L o n g T - B o n d s
T - B i l l s
Year
Pe
rce
nta
ge
R
etu
rn
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Expected Return
9, 3+4, 8=1 4, 1 % ( 1 9 9 9 )
9, 3+14=2 3, 3 % ( 1 9 8 1 )
p r em i u m
r i s k n o r m al
+
b i l l sT r ea s u r y
on r a t ei n t er es t
=
r e t u r n
m ar k et E x p ec t ed
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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) ( 2) ( 3)
P e r c e nt R a te of Re tu rn D e via tion f r om Me a n S qua r e d D e via tion
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
V a r ia nc e = a ve r a g e of squa r e d d e via tion s = 1800 / 4 = 450
S ta nda r d d e via tion = squa r e of r oot va r ia nc e = 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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Risk and Diversification
D e v i a t i o n f r o m S q u a r e d
Y e a r R a t e o f R e t u r n A v e r a g e R e t u r n D e v i a t i o n
1994 1, 3 1 - 2 3, 4 4 5 4 9, 4 3
1995 3 7, 4 3 1 2, 6 8 1 6 0, 7 8
1996 2 3, 0 7 - 1, 6 2, 8 2
1997 3 3, 3 6 8, 6 1 7 4, 1 3
1998 2 5, 5 8 3, 8 3 1 4, 6 7
T o t a l 1 2 3, 7 5 8 0 1, 8 4
A v e r a g e r a t e o f r e t u r n = 1 2 3, 7 5 / 5 = 2 4, 7 5
V a r i a n c e = a v e r a g e o f s q u a r e d d e v i a t i o n s = 8 0 1, 8 4 / 5 = 1 6 0, 3 7
S t a n d a r d d e v i a t i o n = s q u a r e d r o o t o f v a r i a n c e = 1 2, 6 6 %
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Risk and DiversificationP ortf olio r a te
of r e turn
=
f r a c tion o f portf oli o
in fir st a sse t
x
r a te of r e turn
on fir st a sse t
+
f r a c tion o f portf oli o
in se c ond a sse t
x
r a te of r e turn
on se c ond a sse t
(
( (())
))
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Stock Market Volatility 1926-1998
0
10
20
30
40
50
60
1926 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 1998
Std
De
v
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Risk and Diversification0
5 10 15
N u m b e r o f Se c u r i ti e s
Po
r
tfo
l
i
o
s
ta
n
d
a
r
d
d
e
v
i
a
ti
o
n
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Risk and Diversification0
5 10 15
N u m b e r o f Se c u r i ti e s
Po
r
tfo
l
i
o
s
ta
n
d
a
r
d
d
e
v
i
a
ti
o
n
M ar ket r i sk
U n i q u e
r i sk